Who is the Bagholder in the Subprime Correction?

In recent years, financial services firms have become increasingly adept at the game of “pin the liability on the bagholder.” Wall Street players structure complicated new products and seem peculiarly able to strip a disproportionate share of the economic value out as up-front fees. I say “peculiarly” simply because investors buy this stuff, even the risky equity tranches of asset-backed securities or collateralized debt obligations, which are informally called “nuclear waste,” yet can wind up in supposedly conservative portfolios.

The Financial Times raises the interesting question: with all the distress in the subprime market, who are the bagholders? The paper, which has been following the CDO market closely for some time (see here and here for two of many examples, concludes that CDO investors are likely to take the brunt of the losses.

For readers new to this thread, a couple of points of information. First, the reason CDO holders haven’t already take an hit is that most investors in that sector are not required to mark to market. They instead mark to a model approved by the rating agencies. The FT and others have already noted that this leads to distorted incentives and behavior.

Second, the FT story refers to “CDO managers.” There are two types of CDOs, passive and active. Passive CDOs resemble other ABS, in that underlying assets (which often include securities from other ABS, as well as whole loans) are tranched into varying grades of credit quality by virtue of their priority in payment. CDOs may apply leverage, unlike ABS.

An active CDO is a blind pool version of a CDO. Investors pony up the funds, and the manager goes out and acquires assets, and also trades them over the life of the CDO. Hence the term, “CDO manager.”

From the Financial Times:

Here is a mystery. The value of securities backed by subprime mortgages has been in precipitous decline. The losses, though hard to quantify, must run into tens of billions of dollars. But who is hurting? Wall Street’s brokers appear to have avoided much of the fallout. Sure, a hedge fund managed by Bear Stearns is in trouble, but Bear itself had minimal exposure and the equity at stake was small beer relative to the market meltdown.

One hunch is that a chunk of the losses are sitting in collateralised debt obligations, which repackage loans into securities. These are split into tranches, with those that will absorb the first hit dubbed equity, while the safest portions can be rated triple-A. But in CDOs, even triple-A securities can trip up investors if the riskier tranches are undermined by weak underlying collateral.

No one yet knows how liquid the market for the riskier CDO securities will prove, but finding out may be unpleasant. Unlike hedge funds, CDO managers fund their bonds with long-term money. They do not have to worry about margin calls. Of course, they try to assess what they could sell the securities for, but it is hardly an exact science. There is a market of sorts out there: an index, based on the ABX credit derivatives index, is sometimes quoted as a proxy, but CDO managers could argue it is an imperfect one. Until they sell the bonds, no losses are crystallised.

The day of reckoning could be getting nearer. A big rash of downgrades would do the trick, since there are ratings tests across portfolios that managers have to take into account. There are signs the agencies are getting tougher – witness Moody’s rating action on second-lien subprime mortgage-backed securities last week. Downward pressure on pricing, perhaps as the Bear-managed hedge fund sells assets, might also prompt others to start worrying about the collateral underpinning CDOs. The risk appetite that spurred the creation of CDOs squared (CDOs of CDOs), or even CDOs cubed, may be a thing of the past.

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