Who is Carrying the CDO Risk? Look to the Dealers

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With the holiday news slowdown, we thought we’d use the opportunity to focus on good posts on other sites.

One by Christopher Whalen at Seeking Alpha, “Collateral Debt Obligations: Mark-to-Dealer,” addresses some topics near and dear to our heart, namely, whether there is systemic risk and if so, where will it manifest itself?

Whalen’s views are in accord with out own: the dealers are the weak link. In the old days, financial crises operated through the banks, and for that very reason, the Fed is chartered to assure the safety of the banking system (and soundness of currency). But disintermediation of banks started in the 1970s and now a lot of activities that were the purview of banks now flow through the capital markets.

If a crisis were to lead to big losses at some of the big investment banks, it would reduce their equity bases, which in turn means they’d have to shrink their balance sheets (and given that events like that makes the industry cautious, you’d see both the impaired and any unaffected firms almost certainly gearing their equity less than before). Bye bye liquidity.

And what might cause a downdraft? Read Whalen’s scenario:

One reader who manages several billion dollars worth of CDOs asked: “Is it fair to say that the fund of funds and others hitting the exit will force mark-to-market? Any idea when the banks reprice the $1 trillion CDO complex?”

Short answer is yes. This is a slow-motion train wreck and the unwind is going to take time — probably months. The Sell Side took years to create this mess, so the process of “coming to Jesus” will take as long. The important thing to understand, however, is that while Buy Side investors are going to be hurt, the Sell Side and particularly the dealer community is in the greatest danger.

Between the direct credit and market risk from the declining value of collateral and the indirect, operational risk in the form of litigation, damage to reputation and regulatory sanctions, we see a strong possibility that some of the larger Sell Side names are going to lose as much money in the next twelve months as they made in the past couple of years originating CDOs. The reason: excessive leverage funding illiquid assets.

When the market value of mortgage collateral was rising and yield spreads were collapsing, both for cash and derivatives, leverage worked to make everybody concerned a pile of money — record profits, in fact — but mostly on paper. Now leverage is the enemy of all concerned, for clients and especially the dealers. As one bond market veteran recently retired from Goldman Sachs (NYSE:GS) observed last week: “Everybody is involved.”

For every dollar of client money at risk in a Buy Side fund, there is 15, 20 or more dollars of debt tied to CDOs and other types of derivative securities, debt held by a dealer bank or broker. Whether or not the dealer cares to make an aggrieved client a cash bid for the CDO is less important that the fact that the CDO is losing value and cannot be readily sold to cover margin loans. This is the liquidity trap that apparently is causing Bear Stearns (NYSE:BSC) and other Wall Street dealers such agitation.

Remember that the deteriorating fundamentals of loans which underlie a CDO are less important than the changing investor perception of these illiquid instruments. At high tide, many investors fooled themselves into thinking that CDOs were a functional equivalent of exchange-traded bonds and conventional mortgage-backed securities. Now comes the realization that these ersatz securities are no more liquid than residential real estate, with or without an investment-grade rating from Moody’s (NYSE:MCO) or S&P.

More than a couple of readers asked for our estimate of the aggregate loss that the mark-to-market process in CDOs would create. The answer varies with the specific issues, but if you take into account the lack of liquidity, the negative trend in real estate valuations and consumer credit conditions, the widening of spreads and rising yields generally, we think that a 20-25% haircut on the notional par value of late vintage CDO production is not unreasonable. Remember, you won’t know the answer until you get a cash bid and the trade clears.

Over the past decade, as decimalization and competition slowly took the profits out of most cash markets, the Sell Side moved its business focus and that of major institutional clients into progressively less liquid instruments. The apparent spreads were huge and the profits equally rich, but the unfortunate events in recent weeks have shown that the risk inherent in illiquid instruments like CDOs far outweighs the profits.

To the question about the banks and their need to mark-to-market their CDO holdings (not to mention those of their clients), last week is just the beginning of the fun. As you read these lines, most of the chief financial officers of major commercial banks and Buy Side funds are asking that very same question. But the folks whose huevos are really in a vice are the auditors.

As we like to remind our clients periodically, the auditor of an insured depository institution cannot be indemnified by their clients. Worse, if the bank suffers a significant loss and ends up in a regulatory resolution, the audit firm can face not just a civil lawsuit by investors — but an enforcement action by the Fed, OCC and/or FDIC. In the event, the audit firm gets to explain why they relied upon “mark-to-dealer” pricing to value CDOs on the books of their bank clients.

The moral of the story: Next time you call your friendly dealer for the monthly market-to-market on your CDOs, instead of merely asking for an “indicative price,” ask for a live bid in $5 or $10 million — and then hit the bid.

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