More CDO Jitters and Price Decay

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


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  1. dearieme

    “that few observers had focused on” sounds like a euphemism for “that few observers had troubled to understand”.

  2. Ginger Yellow

    Unfortunately the FT article is worded really badly, so it’s hard to base a firm judgement on those numbers. Pilbury contrasts “junior tranches” with “super senior tranches” of “AAA rated subprime CDOs”, which doesn’t make much sense. Are these CDOs backed by AAA rated subprime RMBS, which makes a bit more sense, or is she talking about super senior and subordinated AAA tranches of CDOs backed by AAA or BBB subprime? The latter doesn’t make much sense in terms of ABX prices.

    There’s a really important distinction to be made between CDOs of mezzanine ABS, which because of the underlying ratings are likely to suffer losses even at the super senior level, and “high grade” CDOs of ABS, backed mainly by AAA and AA tranches. The former need only (relatively) low cumulative losses across a wide range of subprime pools to trigger default even on the most senior CDO tranches, whereas high grade CDOs behave much more conventionally, with very high losses needed across a smaller range of pools to trigger default. Obviously it’s prudent to write both down, but how much depends on the type and the specifics of structure and collateral. Citigroup’s structured credit research team recently suggested average write downs of 30% for high grade CDOs and 60% for mezzanine – all of this for 2006 vintages onward. This coincides with Citigroup’s own write downs, if you go through the disclosure they’ve given.

    Secondly, this liquidity put issue is really fascinating. I don’t know yet how widespread this practice is, but if bank’s exposures are anything like proportionate to Citi’s, then it might have been a hidden factor in the liquidity crunch.

  3. Anonymous

    The putative children of banks through conduits are numerous HSBC has 32 billion USD of assets under management; Dresdner is managing a pool of assets under the name of K2,that is larger than HSBC.
    They will have to fund them as their financials guaranty through the iTraxx is more expensive than the non financials (courtesy of the sub prime)
    The LBO trench in the AAA senior debt is as well a questionable subject of rating review.
    Yes 70 Billion USD seem just like skimming the top of the pot.

  4. Anonymous

    Just when you thought things couldn’t possibly get worse…

    Deutsche Bank Foreclosures Tossed Out of Ohio Federal Court – “They Own Nothing!”


    by Moe Bedard and Aaron Krowne

    Turns out the slice and dice brigade don’t actually have title to the underlying property.

    Now imagine you’re a “Super-duper-senior-topdog-supremo-noteholder”, like the ones that triggered Carina.

    You’ve been saying to yourself “Even if it all goes wrong we’ve got the property. And I’m first. So I’m completely safe.”

    Uh huh!


  5. Anonymous

    OK, I just found this blog and am wondering if the plethora of pessimistic posts are a function of the blogger’s biases or are we really in this much trouble?

    Thanks for the great work!

  6. Yves Smith

    Ginger Yellow,

    The confusing nomenclature may have come from Citi’s use of the term “super senior” in association with the CP it bought from its sponsored CDOs. That doesn’t justify the FT not being clearer, but so many of the firms that own various types of dubious paper are going to some length to stress that what they hold is relatively safe, and it’s muddying the discussion.

    Anon of 2:33 PM:

    Both could be true, that I am pessimistic and things really are that bad.

    A seminal paper by Shelley Taylor and Jonathon (no typo) Brown, “Illusion and Well-Being: A Social Psychological Perspective on Mental Health” found that:

    Many prominent theorists have argued that accurate perceptions of the self, the world, and the future are essential for mental health. Yet considerable research evidence suggests that overly positive self evaluations, exaggerated perceptions of control or mastery, and unrealistic optimism are characteristic of normal human thought…. These strategies may succeed, in large part, because both the social world and cognitive-processing mechanisms impose filters on incoming information that distort it in a positive direction; negative information may be isolated and represented in as unthreatening a manner as possible

    The paper is very well documented. I’d provide a link, but it is no longer available on line. If you want to read it, e-mail me and I’ll send a pdf.

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