CDO Boom Masks Subprime Losses, Abbeted by S&P, Moody's, Fitch

[maciek]

An interesting article I found on Bloomberg- interesting for those who already have taken classes by Prof. Sylvain Raynes

 

[bob]

Good article.

It points out the amount of risk that a CDO can disguise. When you wrap other structured securities into a CDO, the amount of leverage with respect to the underlying assets can be very high depending upon the quality of the assets themselves and how the liabilities are structured, but many investors don't know that. These things look like vanilla structured securities, but they have certain characteristics of derivatives, with many of the risk-amplification qualities as well. Just wait until these losses eat their way up into CDO^2....

The other side of this story--not reported in this article--is the degree to which the CDO market has contributed to causing these meltdowns in the first place. With so much capital out there looking for bonds to acquire, it's only natural that spreads are driven down, and there's an incentive to get as much supply to the market as possible. This makes it ever more profitable for originators to close their eyes to dubious underwriting practices. So you have assets priced too low for the risk going into securitizations that would be priced too low for the risk even if the assets were of the quality their spreads seem to advertise, which they aren't.

Gillian Tett from FT did a nice little piece on this side of the causation recently--sometime last week, I believe.

 

[John]

Good article.

The other side of this story--not reported in this article--is the degree to which the CDO market has contributed to causing these meltdowns in the first place. With so much capital out there looking for bonds to acquire, it's only natural that spreads are driven down, and there's an incentive to get as much supply to the market as possible. This makes it ever more profitable for originators to close their eyes to dubious underwriting practices. So you have assets priced too low for the risk going into securitizations that would be priced too low for the risk even if the assets were of the quality their spreads seem to advertise, which they aren't.

Bob, this is an excellent point. The demand from CDO managers for assets (including ABS tranches backed by subprime mortgages) the last few years has contributed to the mispricing of the risk, especially at the lower end of the credit spectrum.

I personally believe that the situation might not get a whole lot better as many of the hybrid ARMs originated in 2005-2006, will start resetting this and next year. Moreover, the home prices have come down in many of the areas where the subprime mortgage constituted the bulk of the house financing, putting additional pressure on these homeowners. A recent research paper from JPMorgan [see attachment] on the state of the house, surveys the 'home price appreciation' (HPA) in different parts of the country and paints a pretty bleak picture for those areas with high concentration of subprime debtors.