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More on the Simply Dreadful Performance of CDOs

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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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27 comments

  1. doc holiday

    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.

  2. Anonymous

    Cross-pollination experiment:

    Re: "No wonder so many investors are now so utterly cynical about anything that bankers or rating agencies might say these days."

    ** Combine that cynicism with the following ratings fraud (from the previous Antidote du jour links post from Huffington) then, mix in accounting fraud, then bounce back up to the denial by Ambac above, then toss in a tsunami of non-regulation, and that spells financial chaos. Thanks for playing!

    > "It is impossible to detect fraud without reviewing a sample of the loan files. Paper loan files are bulky, so they are photographed and the images are stored on computer tapes. Unfortunately, "most investors" (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.

    > That means that neither they nor the Treasury know their asset quality. It also means that Geithner's "stress tests" can't "test" assets when they don't have the essential information to "stress." No files means the vital data are unavailable, which means no meaningful stress tests are possible of the nonprime assets that are causing the greatest losses."

  3. Anonymous

    I am just an ordinary citizen trying to learn all I can. I have been thinking about all the slicing and dicing that went on with mortgages through MBSs,CDOs and CDSs.

    What would happen if a class action attorney took on the case of people being foreclosed on? When you get to court does somebody have to produce the original mortgage? If the mortgage is required to be produced, can that even be done? How do they figure out who owns what part?

  4. Yophat

    The test is secret…who cares whether its meaningful or not…just as long as it accomplishes the mission!

    Banking roll-up!

  5. Anonymous

    Someone help me out here. How can a mortgage backed CDO have only a 5 percent recovery rate? What process is used to unwind the CDO? Even if every single mortgage in the CDO went into default and every property was overvalued by 200 percent (3 times its current value) at the time of the mortgage, once everything is liquidated there should still be a recovery rate of around 30 percent (even after transaction costs). Shouldn’t there? What am I missing?

  6. Anonymous

    “How can a mortgage backed CDO have only a 5 percent recovery rate?”

    because they really contain that much “meat” the rest is filler. (statistic gimmicks of inflated market pricing of other dubious asset)

  7. bb

    does anyone remember how sleek john thain sold some AAA CDO for 22 cents on the dollar with 17 cents financed by merrill. even if they’ve been just average lone star capital pocketed 200% profit on the deal.

    where is andrew cuomo? ahhh, he’s too busy peeking at others’ bonuses.

  8. Steve

    I’m glad to see an FT article point out that secondary markets never really existed for lots of pieces of CDOs. It’s also worth pointing out that when these kinds of illiquid securities were revealed to be among the assets backing some SIV and CP issuances, a freeze in those markets was inevitable. For many months Bernanke and Paulson went on about illiquidity in the asset-backed space as though it were a mysterious eruption of irrational investor behavior…when the banks had in fact pushed this stuff into money market structures to give illiquid assets the illusion of liquidity while shuffling them off the balance sheet. The money markets caught on and we’re still living with the consequences.

  9. Anonymous

    “The monosyllable of the clock is Loss, loss, loss” (even if you devote your heart to its opposition.)

  10. Anonymous

    5% remaining value seems almost unbelievable until you consider 30 to 1 factoring.

    When will the criminality stop?

  11. brushes9

    Re: Obama, Vision and Data Points

    I suggest that the data in all the data sets are being manipulated, that is, for all domains for which data is collected. Not one, but many and competing centers of control provide this manipulation. Everyone knows of the website, Shadowstats but, I know that the fraud extends from A to Z within our society.

    Today, we have institutions, societal norms and linguistic syntax entrenched in our culture, based on this false data!..a vast overhang.

    The “building” that was off a tenth of a centimeter at ground level, is now off a meter at the eightieth floor.

    It is no wonder that people of conscience are finding the world a bit surreal, compared with less encumbered, conservative acquaintances – a conservative is fully comfortable trusting others, rather than “their own lying eyes;”…”the facts don’t matter!”

    Unlike us, they just don’t see the clocks dripping off the walls, or the large brown, bean strolling down the highway, grinning, with two drawers spilling from its side, labeled “Mission Accomplished.”

    While prototype, my theory is that it is only economic depression and mental trauma that can cause all Americans to see the same thing, again! Only trauma can wipe away the false data sets that now corrupt our minds.

    When the sensory “trade imbalance” between us and these Ayn Rands and Shawn Hannities is erased, then we will have our bull indicator.

    While Obama is screwing up now, Barak can redeem himself by pointing us to the data sets that we will need, on that day of trauma and eraser.

    Progressives can be ready with the data for President Obama to point at. No prize goes to the best kept secret, even if it is the truth.
    .

  12. pd130

    From Ms. Tett’s article:

    “Notwithstanding the fact that bankers used to promote CDOs as a tool to create more “complete” capital markets [...]“

    Uh, this why the creation of these things always touted as so incomprehensibly non-linear?

  13. Anonymous

    CDO’s give owners a share of a pool of loans and comprise both principle and interest. If you had a five year loan for say 100000 you might expect to pay 6 percent interest a year so the CDO might be worth around 140000. I am guessing that as soon as the loan defaults the CDO is already down to around 70 percent regardless of any devaluation of the property.

    What worries me is that this might only cover residential mortgage pools and the hit from commercial CRE CDOs and CMBS REMICs may not be included in the big numbers.

    On a different note should we be concerned about Albert Edwards claims that yen weakness will have major global implications and result in the devaluation of the Chinese yuan. The worry is that buy American will fall on deaf ears as prices for imported goods fall and US politicians will be forced into protectionism.

    Barrons – An odd decouple

  14. Jim

    The third sentence seems to be incomplete:

    ‘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’.

  15. Anonymous

    Here’s a prediction: for those homeowners who survive to pay off their mortgages, many will find out that the deed they paid for has been lost, or can’t be produced. If the banks and investors can’t produce a deed in a foreclosure proceeding, it is unlikely they will be able to do so for a paid-off loan, either. The consequences of The Age of Fraud will still be biting us decades, hence.

  16. Anonymous

    What I’m wondering, if one uses the valuations suggested in the article, what does that do to the balance sheets of various financial institutions holding them? Or more precisely, just how much worse does it make them?

  17. Anonymous

    ” 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.”

    I haven’t had coffee, but wtf is up with that sentence?

  18. russell1200

    http://www.riskglossary.com/link/collateralized_debt_obligation.htm

    A good link.

    CDO is not all what it appears to be. It can have a credit default swap sold out of it (making it a synthetic CDO) for instance. In some cases the higher rated portions were made up of large chunks of agglomerated left overs that had no takers. Through a second tranching of the junk, they were able to turn some of the junk into a higher grade product (take the top of the income stream of a bunch of Bs and get some As out of it. The idea being that not all of the lower tranche mortgage bonds will go belly up because “of course” they act independently of each other.

  19. Disgusted

    Astonishingly, the lawyers and credit officers who oversaw this business (FI Legal, Structured Credit) are STILL WORKING at the large firms (or their successors) who went down as a result of over-indulging in this crap. One big one is head of AI at Credit Suisse and another keeping his head under the radar at Merrill, while yet another is holding down the fort for Legal and trying to edge out the competition at Barclays. To those of us who for years screamed to senior management, the Fed, the SEC, whoever would listen, that this business was unsustainable and much of it illegal (they were shilling it like it was IBM when I was at one of them in the late 90s/early 2000s)…it seems like nothing has changed. The same peabrains are calling the shots and the regulators are keeping their heads in the sand. One very good lawyer from UVa I believe had his head chopped off for drawing to his bosses’ (and Gary Lynch’s) attention how very nefarious the CDO business at Credit Suisse was circa about 2000-2001. His former managers are still hanging around, one at CS, one at UBS, and of course Gary Lynch is GC at MS. To this day, no one at the SEC has an interest in hearing what really went on on those desks.

  20. Anonymous

    “How can a mortgage backed CDO have only a 5 percent recovery rate?”

    Costs associated with foreclosure, legal fees, back taxes, neglect, vandalism, fraud in pricing, zombie neighborhoods, no buyers, no financing for new buyers, no bottom in sight, cheap rentals, etc.

  21. Cathryn Mataga

    I’m a little relieved, really. After all this time, the true level of the disaster is coming out. Let’s get more of the bad news out sooner!

    I think this means we’re finally done with screwball schemes to transfer this stuff to Uncle Sam in exchange for actual money. Like come on.

    I would also suggest a AAAA rating and an AAAAA (no we really mean it this time) for investments that are actually safe, now that AAA has been so debased.

  22. Cathryn Mataga

    I just thought of something. Didn’t CITI get something like $300B in guarantees for this stuff? How does that work exactly? Does this mean the government might actually have to come up with the $300B?

  23. CityUnslicker

    Cathryn do you work in the educational system per chance?

    Nothing will be fixed until the ratings agencies get tar heeled. Auditors too. You can’t have a clean system run by dirty players.

  24. Krakpotkin

    Brits tend to use different terminology in structured finance.

    This FT piece seems to be talking about what we call CMOs — Collateralized Mortgage Obligations. What we call CDOs tend to be diversified (eg, all the CDOs I worked on this decade had no more than 5% mortgage assets). This article is not talking about them.

    A CMO goes into technical default if ANY of its tranches eg fail to meet an interest payment. Thus a AAA tranche can be in default even if it’s still getting its interest every quarter.

    As for the miserable liquidation return reported. If a CMO gets unwound, that means you crack open the s-f shell and sell the assets inside. In this case, mortgage bonds (MBS — mortgage ABS).

    But the market for same has been zero during the crisis. Thus anyone unfortunate enough to liquidate a CMO during the crisis is going to get very little when he goes to sell the MBS inside — regardless of how the MBS are themselves performing.

    All of this to my eye tends to mitigate the horror of the headline to this story. Not that the world is not horrible.

    The great error during this time is to liquidate the mortgage assets in a non-existent market. Compulsions to do so can come from various sources. Lucky are the holders who are able either by the terms of their agreements or negotiation to re-write the instruments to allow the portfolio managers to hold on.

    At bottom the question is — how are the mortgages performing? And then: how are the MBS (composed of mortgages) performing? Only then can one evaluate, really, the state of affairs at to CMO (composed ob MBS) performance.

    Still — the numerical tidbits in the article are worth filing.

    Accurate data on true performance is generally closely held by the holders. No different that the daily price of porgies among the various players at the Fulton Fish Market.

  25. dd

    Can we stop calling them “CDOs?” They are beneficial interests in a trust. It’s the modern version of Bleakhouse and the entire trust estate will be consumed soon enough.

  26. Ginger Yellow

    While I’m all for writing down CDOs of ABS to zero or thereabouts, I’m not really sure where Tett’s logic is coming from.

    “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”

    Investors are free to completely write off the CDO of ABS holdings themselves in their capital calculations if they want a worst case scenario. The holders are finally giving enough disclosure to allow that. I fail to see how actually liquidating the entire sector in the middle of a financial and economic crisis and guaranteeing a worst case scenario helps things. It certainly doesn’t make things clearer in any meaningful sense.

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