Collateralized Debt Obligations: Don't Ask, Don't Tell

"Keep a cool head. We're not done going down. Tomorrow could be ugly." Jim Cramer on Mad Money, 6/7/07

Watching the retreat this week in the bond and equity markets, its seems that investors finally accept that credit spreads really are too tight and equity market valuations really are too high given the US economic picture. This realization is likewise affecting US real estate markets, where leverage has distorted valuations by a similar magnitude.

In this regard, The Quarterly Banking Profile published by the FDIC last week contains a few notable passages. Here's one of our favorites:

Some categories of real estate loans experienced shrinkage during the quarter,while growth in other categories slowed. Institutions’ residential mortgage loans declined for the first time in thirteen quarters, falling by $6.5 billion (0.3 percent), home equity lines dropped by $2.6 billion (0.5 percent), and real estate loans secured by multifamily residential properties declined by $1.1 billion (0.6 percent). Real estate construction and development loans grew by $16.8 billion, but this was the smallest quarterly increase for these loans since the second quarter of 2004.

With credit availability waning, the apparent credit troubles first noticed in sub-prime are likely to multiply. For some time we've been wondering how quickly spreads would widen when commercial banks curtailed the supply of new credit to the real estate sector and consumers generally. The answer, at least until this week, seemed to be that spreads for whole loans and Collateralized Debt Obligations or CDOs fell to all time lows. A last hurrah?

A Sell Side analysis last week called the tightening in spreads "almost breathtaking" as AA rated CDOs have fallen from almost 50bp in March to half that level today. Certainly breathtaking is the change in BBB rated CDOs, which moved from 800bp over the curve in March to just 340bp last week.

A 340bp spread for BBB CDOs is at the bottom of the default rate range for BBB paper. Also, this rating is the result of derivative "enhancement," meaning that the sub-prime collateral inside the CDO probably performs a couple of notches lower, B to CCC or somewhere between an 11% to 28% implied probability of default or P[D]. Makes us wonder just who are the natural buyers of such risk. Below are the ratings break points we use to general bond equivalent default ratings in the IRA Bank Monitor:

The current and prospective rate of loan defaults is a key part of the valuation analysis for CDOs, especially since residential mortgage loan default experience still remains low by historical standards. Lots of upside, at least in terms of yields.

The FDIC notes that "Insured institutions set aside $1.1 billion more in loss provisions than they charged off during the quarter, contributing to a $993-million (1.3-percent) increase in loan-loss reserves. This is the largest increase in loss reserves since the fourth quarter of 2002."

Facing the deteriorating loan data, the banking industry is clearly preparing for a surge in defaults later in 2007 and beyond. The American Banker reports that some of the largest banks already are shooting collection agencies and taking post-default loan servicing activities back in house. As default event volumes increase, banks clearly want to lower recovery costs and thereby boost LGD performance.

During the height of the real estate bubble, banks would sell those rare retail loan defaults for pennies on the dollar, most often to a collection firm or hedge fund, but not anymore. Since most investors who own or trade CDOs now expect default rates to rise, a situation for mischief arises.

Imagine you are a broker dealer who makes markets in CDOs and the underlying collateral. And imagine that you also own or control a mortgage servicing business which covers much of the collateral used in the deals you underwrite.

Now imagine you decide, one day, to ease-up on the aggressiveness of your servicing operation and that you, for example, fire 10% of the people in your call centers. Since the mortgage industry has shed more than 10% of the total head count in the past twelve months, such a move would hardly be remarkable.

Well, give it a month or two and the non-performing rate on the collateral that you service very likely will start to rise. And the spreads on CDOs containing such collateral will also likely widen as the word goes round the Street that deal XYZ has gone rancid. Indeed, a bull stampede might occur, driving secondary market prices down well below the true value of the collateral. Get the idea?

The natural targets of such a Sell Side strategy are, of course, hedge funds, especially the smaller fish with inferior access to the non-public market "color" which the leading prime brokers routinely provide larger clientele. Just remember that a credit default "swap" or CDS is not really an exchange of value between parties; it's a peculiar form of gaming, not unlike insurance, whereby one party pays a fee and the other party hopes that nothing happens.

A number of hedge funds led by Paulson & Co, for example, have complained bitterly to the SEC about efforts by Sell Side lenders to lower default rates among residential mortgage holders, saying that the lenders' forbearance might cost them some coin on short CDS positions betting on a surge of residential loan defaults. The sorrow and the pity.

But just imagine how much greater could be the negative effect on spreads for CDOs, cash and derivatives, if loan servicers decide to drag their feet regarding remediation of defaults. Could it be that the folks at Paulson, who are obviously smarter than everyone else, have missed the proverbial forest for the trees? Will the unwind of CDS of CDOs claim some larger players from hedge fund land?

Such musings take added significance because of the near-total breakdown in specialization on the Street. One operations veteran, speaking to The IRA over a health lunch at the Burger Joint in Midtown Manhattan, describes a situation where equity and energy traders are taking punts in CDOs, creating a market environment where the only product specialists in most firms are in the back office.

Isn't this how a hedge fund formerly known as Amaranth got into deep kimchi?

Since many participants in the CDO market today would no more be able to assess the market risk of a given mortgage pool than to, say, properly operate a backhoe, we wonder: Would anybody in the marketplace for CDOs notice if their friendly prime broker started to back away from their fiduciary responsibility to service a loan portfolio? Or would they just think that the spike in loan defaults met expectations?

To end on a happy note, we hear from a fellow market voyeur that several big public sector retirement funds and their trial lawyers are preparing claims against the larger rating agencies for their role in creating the CDO bubble.

As spreads widen, equity market valuations suffer and public sector investors take their lumps, look for the trial lawyers and AGs in states like Ohio and California to launch new and imaginative attacks on the Sell Side, a sector definition which now seems to include the major ratings shops.

That Buy Side ratings business model looks better every day.

Comments

[Sr. Pessimist:]

FICO enables the US Dollar to be so deceivingly disastrous to economic equality. FICO itself is pure conspiracy. You have to be an idiot to rely on FICO to judge creditworthiness. Absolutely ignorant. FICO is not far from useless.

2007 Jun 08 11:26 PM