Thursday, August 21, 2008

Taking Stock of CDOs

(FT Alphaville) 101 CDO tranches were downgraded by Moody’s yesterday.

All had experienced events of default, but the proximate cause for the downgrade was the fact that the controlling noteholders in all of the 29 CDOs involved had opted to liquidate.

That’s interesting because earlier this year, there was a lot of hesitancy in the market: controlling noteholders were sitting on their hands, rather than pushing the nuclear button.

S&P also cut ratings on a host of CDOs - 11, in fact, worth $4.4bn.

There’s obviously a little more clarity about who those controlling noteholders now are, and clearly - what with Merrill’s 22 cents on the dollar sale - there’s a lot more kitchen-sinking going on.

Who could have seen all this coming?

Dear John Thain notes, pointedly, that if you’d read banks’ SEC filings a year ago, you’d be hard pressed to find mention of CDOs anywhere in the voluminous documents, let alone an indication of what they were, or how banks were exposed to them.

…what did I find? Terrible disclosure. I was able to find almost no information. Certainly no information that would have helped come up with an estimate for losses from these firms based in any sort of logic or fact.

Part of that problem was in a large part due to the fact that banks thought they were palming off most of the risk to their clients: to institutional investors and hedge funds. Banks were suckered into believing the credibility of their own structures.

Monoline counterparty risk and an ABS correlation crisis scuppered that notion though: negative basis trades unwound (Merrill’s problem) and liquidity puts had to be made good on to LSS conduits (Citi’s problem).

Could banks have seen it coming? It’s always easy to look back with hindsight. But it’s also easy to blame things on complexity. Complex though things were, for those with all the information at their finger tips -those designing the structures - there was a total lack of foresight.

Greg Newton at Naked Shorts links to this - an article from Credit magazine circa 2005. It’s worth reading. It’s all there.

A couple of excepts below. Emphasis - on the clues that should have given the game away - ours:

Asset-backed securities are popular as collateral because they have historically suffered fewer defaults and downgrades than corporate bonds, says Gibson, even though they trade at wider spreads.

CDOs offer a handsome return these days of up to 240 basis points over comparable corporate bonds because the market is complex, opaque and illiquid.

We need to continuously innovate, says Norell. We don’t necessarily want everything to be too simple and universally accepted by everyone, because then the relative increase in yield to investors who do want to take the time to understand complex product is going to be difficult to find.

Some analysts worry about the consequences on ABS CDOs if the real-estate market stalls. The biggest thing is always the leverage in the CDO market. When the general high-yield bond market got hit

…in 2001…

…CBOs backed by high-yield bonds got hit even more, says Michiko Whetten, quantitative credit derivative analyst at Nomura Securities. The same thing is concerning lots of market participants now, in that ABS CDOs have a very high exposure to the residential mortgage-backed securities market. So the fortunes of the ABS CDO market can go up and down with the housing market.

…after pricing the Marathon deal and finishing his Chinese lunch, Ricciardi led a few members of his team to a windowless conference room to discuss a secret project they had been working on for two years. Their mission was to use a new type of asset to back an existing category of CDOs. This type of deal had never been done before, and collateral had to be sourced, issuers persuaded and rating agencies brought on board.

One undeniable source of risk, which helps contribute to the yield on CDOs, is the lack of a real secondary market… Liquidity is tricky, and the rule seems to be that its never there when you really need it, he says, explaining that when a transaction performs poorly investors have a difficult time selling it.

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