Apologies for the terse posts tonight; out of town, will be lighter than usual today and tomorrow.
The Financial Times has been keeping tabs on the results, or perhaps more accurately, the lack thereof, of collateralized debt obligations. A couple of weeks ago, it highlighted research by Morgan Stanley and Wachovia that concluded that nearly half the CDOs made from asset backed securities.
Today, Gillian Tett of the FT discusses research on CDOs by JP Morgan and Wachovia. I’m assuming that JP Morgan released an additional study (as opposed to the first article having mistakenly mentioned Morgan Stanley, as opposed to JP Morgan). Tett mentions not only the impressive level of failures, but also the horrid recovery rate.
From the Financial Times:
Just how much should a debt vehicle backed by subprime mortgage bonds be worth these days? Two years ago, most banks and insurance companies assumed the answer was close to 100 per cent of face value – or more…But as the zeroes relating to writedowns multiply, a peculiar – and bitter – irony continues to hang over these numbers. Notwithstanding the fact that bankers used to promote CDOs as a tool to create more “complete” capital markets, very few of those instruments ever traded in a real market sense before the crisis – and fewer still have changed hands since then.
Thus, the “prices falls” that have blasted such terrible holes in the balance sheets of the banks have not been based on any real market numbers, but on models extrapolated from other measures such as the ABX, an index of mortgage derivatives…
But now, at long last, one shard of reality has just emerged to piece this gloom. In recent weeks, bankers at places such as JPMorgan Chase and Wachovia have been quietly sifting data ….
From late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds (known as mezzanine CDO of ABS) and much of the rest from safer tranches (high grade CDO of ABS.)
Out of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi.
The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32 per cent for the high grade CDOs. With mezzanine CDO’s, though, recovery rates on those AAA assets have been a mere 5 per cent.
I dare say this might be an extreme case. The subprime loans extended in 2006 and 2007 have suffered particularly high default rates and the CDOs that have already been liquidated are presumably the very worst of the pack.
Even so, I would hazard a guess that this is easily the worst outcome for any assets that have ever carried a “triple A” stamp. No wonder so many investors are now so utterly cynical about anything that bankers or rating agencies might say these days.
After all, when the ABX started taking a dramatically bearish tone 18 months ago, many banks claimed that it was ridiculous that they were writing their mortgage assets down to prices extrapolated from the ABX, since it was popularly claimed that the ABX overstated likely future loss. Even the Bank of England appeared to share that view.
But with the ABX now suggesting that triple A subprime mortgage assets are worth around 40 cents on the dollar (depending on the precise vintage), the message from that might almost be too optimistic in relation to some CDOs. So where does that leave the banks? In reality we will not know whether that horrific 95 per cent loss is unusual until the rest of the CDO of ABS are liquidated too. But for my part, I suspect that the saga strengthens the case for financiers now biting the bullet – and conducting some open auctions of this stuff, to get a bit of market price discovery….
After all, if an open auction ends up pricing mortgage-linked CDOs near zero, at least the capital hit to the banks and insurance companies will be clear; and if it is higher than zero, it might even cheer investors up.
Our sentiments exactly.
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Re: Do chat among yourselves. No food fights, however.
How is the food out West? Ambac Financial Group, Inc. Announces Fourth Quarter Net Loss of $2,340.8 Million
This seems on topic: Ambac’s President and Chief Executive Officer, David Wallis, commented, “While our financial results continue to be affected by the disappointing housing market and other economic conditions, I am encouraged by the progress made in relation to some of our strategic initiatives. We continue to place significant emphasis on de-risking our portfolio. The successful commutation of $3.5 billion of CDO of ABS exposures, including two CDO-squared deals, was constructive and we will continue to pursue this de-risking approach. Equally encouraging have been the remediation efforts on our mortgage exposure which continues to reveal opportunities to recover losses in that portfolio.
Net unrealized gains on Ambac’s CDO portfolio amounted to $394.1 million in the fourth quarter 2008, compared to net unrealized losses of ($5,199.0) million in the fourth quarter 2007. The net unrealized gains during the fourth quarter 2008 resulted primarily from reclassification of $1.0 billion to realized losses in connection with the CDO commutation settlements described above plus a gain on those settlements and the larger discounting effect of wider AAC credit spreads, partially offset by (i) lower values on the reference obligations across all asset classes; and (ii) internal ratings downgrades of the CDO of ABS portfolio. The net effect of adjusting the fair value of credit derivative liabilities to reflect AAC’s own credit risk, as required under SFAS 157, resulted in an approximate $3.2 billion reduction of the change in unrealized losses in the fourth quarter of 2008.