Monday, the Financial Times’ MergerMarket blog (hat tip Felix Salmon) gave a sighting of CDO market prices, and it wasn’t pretty:
However, AAA rated subprime CDOs currently trade from the high single digits on junior tranches to 60% of face on super senior tranches, according to a sellsider and a buysider…..
Merrill Lynch in the third quarter discounted its own super senior ABS CDO holdings by an average 19%, while mezzanine AAA notes were written down by 37%.
Although these data points, including the clarification of the Merrill writedown, are helpful, there is less here than might appear. What is a subprime CDO, exactly? CDOs can, and do have just about anything in them in the debt family that is moderately risky – lower rated residential mortgage bond tranches, from both subprime and prime deals, commercial mortgages and mortgages, whole mortgages, and buyout loans. While a lot of subprime debt went into CDOs, there is considerably more non-subprime paper in CDOs in aggregate.
But at least we now know that the worst reputed CDOs have AAA tranches trading at 60% of face. And most of the CDOs held by investment banks are likely to have a high level of subprime exposure, since they generally came to have them as a result of their own subprime/mortgage-related structured finance activiites. Merrill’s CDOs appear likely to have a fairly high subprime composition, along with Citi’s. Any reader input very much appreciated.
But then we have the further complication that any ‘subprime CDOs,” however you define it, aren’t likely to have AAA rated tranches very much longer. From Calculated Risk:
Fitch Ratings downgraded Monday the credit ratings of $37.2 billion of global collateralized debt obligations, with more than $14 billion worth of transactions falling from the highest-rated AAA perch to speculative-grade, or junk, status….
The rating agency said more than 60 CDO transactions are still on watch for potential downgrade, with a resolution due on or before Nov. 21.
On Monday, nearly $20 billion worth of transactions was cut from investment-grade to junk, said Kevin Kendra, managing director at Derivative Fitch.
Note this isn’t the first time CDOs have been downgraded from AAA to junk in one fell swoop, either.
The Financial Times’ Lex column catalogues the worries about financial firms’ CDO exposures. The first, the “surprise, that wasn’t so off-balance-sheet after all” has become familiar, and the second, the reliability of the valuation models, is a longs-standing worry, But the third, the effect of hedges, may be new to most readers:
“Exposure” has become a scary word these days. When banks start talking about it, you can bet a mention of collateralised debt obligations is not far behind. Then comes the size of the writedown – pick a number, any number, as long as it is in the billions of dollars.
But it turns out that pinning down what “exposure” actually means is not that straightforward. It is little wonder that Citigroup’s $43bn of highly rated CDO exposure came as something of a shock to observers. More than half of it was never expected to land on Citi’s balance sheet in the first place. But it did, as Citi customers exercised their right to put securities back to Citi when they faced liquidity problems.
Now Bank of America has disclosed that it, too, has CDO exposure, approximately $10bn, also courtesy of liquidity support. So lesson number one is that CDO exposure can come from mere funding commitments that few observers had focused on.
The second issue concerns the assumptions behind the banks’newly reported exposures. Who knows what discount rates the banks are applying to the cash flows they still expect from their CDO holdings? How do the models change if assumptions, such as house prices, change? True, Morgan Stanley has taken a radical approach: its $6bn exposure represents the most it could lose if the underlying collateral defaulted and the bank recovered nothing. in today’s market, an absolute downside of this size is actually reassuring.
The third issue concerns hedging. The banks have detailed their exposures of CDOs net of hedging positions. But where they have managed their exposure down in this way, it is at least reasonable to ask how effective the hedging will prove to be. Wall Street investors may understand even less than they thought they did