In fairness to her, if you read the article closely, she says that this is an idea being considered by policymakers. She may have been asked/encouraged to float a trial balloon.

I think it’s also hard for a journalist to talk meaningfully about CDOs even in a paper like the the FT due to space limitations and the variability of the structures. I personally get annoyed that writers fail to distinguish between actively managed CDOs and “passive” ones where the assets (at least in normal circumstances) are not traded. They will make generalizations and you can infer from how it is written which type they are talking about.

Similarly, per your point, the focus has been almost without exception on the asset side, not on the leverage, how much it can vary, and how it is created.

This article is another example. Dismantling CDOs eh? bankers don’t get to simply take CDOs apart – they are SPEs governed by their own rules and debtholders often have rights.

depending on how the CDO was originally funded, some structures that very funded in the short term markets are currently being restructured out to longer term debt. But its nearly impossible that banks and investors would have any need to unwind.

tett also absolutely hates derivatives and makes a point to reference them as much as possible even if a swap is not involved. its bizarre.

Thank you for the reply and the clarification.

You run a great blog and the effort is much appreciated.

JS

I did not draft my earlier comment sufficiently clearly. Yes, the chart (http://www.frbdiscountwindow.org/discountmargins.pdf) shows that AAA CDOs are acceptable collateral. However, I have not seen anything that indicates that any bank has actually submitted a CDO as collateral.

Also note that for some other types of collateral. not just CDOs, the Fed will accept only AAA rated paper (or the paper is inherently AAA, like Treasuries and agency paper).

In addition, note that the Fed imposes a pretty large haircut on face value if there is no market price available.

What I have read suggests that banks mainly bought AAA paper because it had much higher yield than other AAA paper (ha, they thought there was a free lunch) and AAA paper requires the bank to hold less regulatory capital against it. While some banks also hold equity tranches, from what I have read (via Tanta as Calculated Risk), it’s likely to be the banks with big mortgage servicing operations. For reasons way too long to go into here (it’s what she calls UberNerd material), the servicer’s interest is often opposed to that of the investors. Having them hold some MBS equity aligns their interests.

Finally, the risk to banks is NOT via direct holdings of CDO paper, but indirectly, via, for example, companies tapping their backup credit lines because they can’t roll ABCP (at least US banks, Gillian Tett warned us that some foreign banks were over their head, witness the collapse of German bank IKB).

The folks who are seriously exposed are hedge funds and investment banks. They don’t have access to the discount window.

If it can’t unwind, aren’t we headed for a total meltdown? Help me here. I hear and read soothing blah blah but I don’t get a sense that the honchos know how to get this to unwind. Since we’ll be getting bad news for another year at least as mortgages reset, how can this temporary feel good moment last?

I’m trying to figure out what to do with my 401K. Sell everything and go into a bond fund? What do you suggest. Thanks.

The discount window margin table seems to state on the former and imply on the later otherwise. There are non AAA collateral the Fed will accept (MBS, non CDO/CLO ABS, etc). In addition note the listed changes at the bottom of the pdf. On 8-17-07 the Fed added parenthetical clarifications to specifically include as acceptable collateral AAA CDO. In other words, even if a bank has not yet submitted a CDO (given this clarification I would be surprised if they haven’t) the Fed is clearly encouraging banks to do so.

As an aside, I think the parenthetical exclusion of non AAA CDO and CLO speaks volumes about who is going to get punished when there is a bailout. Unfortunately, since the other tranches represent the real money, I anticipate more “financial innovation” in the not too distant future. If Bernanke is serious about bitch-slapping the moral hazard crowd he needs to let everyone bleed.

JS

http://www.imf.org/external/pubs/ft/survey/so/2007/RES0823A.htm

“Losses should be dispersed to exposed investors rather than taken over by taxpayers if borrowers cannot be assisted through loan modifications”

Remember also that use of the discount window is for repo purposes, not a sale. The paper comes back to you. This is just a loan against collateral. Remember the Street has and still is lending against this stuff via their prime brokerage operations, so they are implicitly valuing it too for lending purposes. But there is a great deal of uncertainty as to what the real value of the collateral is if it were valued as it should be, in an arm’s length sale. That is why the Street may not want values to settle to their true level. The knock-on effects of having true marks out there would be large.

Finally, keep in mind that all the Fed is accepting is AAA only paper. I haven’t seen anything that suggests that any bank has submitted a CDO (as opposed to simpler mortgage-backed paper).

But despite a very large portion of the value of a CDO being in the AAA tranches, that may not have enough upside to interest a bottom-fisher. Yet from what I can tell, it’s the lower grades that have most often been repackaged, but the further packaged stuff is what is so much harder to value.

But I still think the general case holds: the Street has an idea of where at least the simpler variants of this paper are, and could facilitate price discovery. Maybe that isn’t a big deal in the AAA paper (enough of that may trade that further price discovery is not needed).

But they also have the deal documents, and the regulators might infer more if they had access to them for all, or say a large proportion, of the paper that has been created.