CDO History Repeating Itself: Liquidity Crunch Looms

Citigroup (C) is reporting: Defaults on Some 'Alt A' Loans Surpass Subprime.

Defaults on some so-called Alt A mortgages packaged into bonds last year are now outpacing those from subprime loans, according to Citigroup Inc.

The three-month constant default rate for 2006 Alt A hybrid adjustable-rate mortgages is 2.3 percent, compared with 2.2 percent for subprime ARMs, New York-based Citigroup analysts led by Rahul Parulekar wrote in a July 20 report. The figures represent the percentage of balances in a mortgage-bond pool expected to default in the next year based on 90-day trends.

[Mish comment: Here's the key phrase "expected to default in the next year based on 90-day trends". Wasn't it reliance on trends that got rating companies into hot water in the first place? Essentially Moody's, Fitch, and the S&P, all used trends to predict that housing would rise forever into the future at a slow steady rate. None of the rating companies allowed for reversion to the mean or even a flat market for that matter. I talked about this in Fitch Discloses Its Fatally Flawed Rating Model. I suspect that we are going to find 2% is a very optimistic number. If nothing else the illiquid CDO market now acts as if 2% is optimistic.]

The speed at which Alt A hybrid ARMs are being paid off due to home sales or refinancing has also fallen to about the same level as for subprime ARMs, which typically prepay more slowly, the analysts said. Slower prepayments can make the same rates of defaults more damaging by leaving more of the initial balances outstanding to eat into bond-investor protections.

The combination of challenges mean 2006 bonds backed by Alt A mortgages, a credit grade above subprime loans, may need "lower loss severities to still come out with lower cumulative losses than subprimes," the Citigroup analysts wrote.

More than $800 billion of subprime mortgage bonds and $700 billion of Alt A bonds are outstanding, with ARM bonds totaling more than $600 billion and $450 billion, respectively, according to a March report by Zurich-based Credit Suisse Group.

[Mish comment: Those numbers are telling. $800 billion in total subprime debt, of which $565 billion is in the most toxic years (2005-2006) and a mere 3% of that debt has been downgraded even though Bloomberg calculates that a full 65% of that debt no longer meets the grades originally assigned. See Are The Ratings Agencies Really Taking a 'Tough Stance' on Subprime Mortgage Debt? for more information.]

The Citigroup analysts used Alt A ARMs with five years of fixed rates for their study. They didn't include so-called option ARMs, a type of loan with minimum payments that produce growing debt in $200 billion of Alt A bonds.

[Mish comment: There's nothing like excluding the worst of the garbage when coming up with your number.]

Between June 1 and July 17, typical spreads on BBB rated Alt A securities widened by 125 basis points to 475 basis points, while spreads for similar subprime securities rose 200 basis points to 450 basis points, according to Citigroup.

A Near Halt

As investors flee the market, a near halt in non-guaranteed mortgage-bond sales and a greater differentiation among securities with the same labels and ratings is limiting consensus among analysts on typical levels. Analysts at Credit Suisse and New York-based Bear Stearns reported higher spreads for both Alt A and subprime securities in reports last week.

[Mish comment: This is enormously compounding the ability of homebuilders to sell homes. Some are going bankrupt. It's the same every cycle. Risk is piled upon risk as trend players project the past forever into the future. Greed and fraud both run rampant then the whole thing blows up.]

Alt A and subprime loans compose about 13 percent to 14 percent of all outstanding home mortgages, according to estimates Federal Reserve Bank of St. Louis President William Poole cited in a speech last week.

[Mish comment: Bulls have been citing the small percentage of subprime debt as if it's too small to matter. How many times have we heard, subprime is only 8% of the market. Hmmm Now it's subprime and Alt-A are only 14% of the market. But is 14% the extent of the problem? Of course not. The right questions are: How much total garbage was rated "A" that did not deserve to be. How much of the originally deserving "A" paper also deserves to be downgraded? Thus a seemingly bullish factor is anything but. In fact it serves as a warning about how overrated all this debt was in the first place]

Mispriced Risk

Risk was seriously mispriced as evidenced by the complete collapse of the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund and the sudden widening BBB rated Alt A securities credit spreads by 125 basis points to 475 basis points.

Given how little debt has actually been downgraded so far, those spreads have a long, long way to widen.

CDOs Grind to a Halt

Bloomberg is reporting Homeowners Face Funding Drain as CDO Sales Slow.

The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $9.1 billion in the U.S. this month from $42 billion in all of June, analysts at New York-based JPMorgan Chase & Co. said in a report yesterday.

From $42 billion to $9 billion is quite a collapse. Look at the reduction in underwriting fees. Think about how much harder this make it to buy a new house or sell and existing one. How quick we forget. Was it a mere 7 years ago that the same thing happened in the dotcom bubble?

The Ghost of Drexel Burnham Lambert

Kevin Depew on Minyanville gave everyone a history lesson in point one of Tuesday's Five Things.

1. Ghost in the Machine Slowly Grinding to a Halt

The market for collateralized debt obligations is slowly grinding to a halt, according to Bloomberg, threatening one of Wall Street's sacred cash cows - (read: $8.6 bln in annual underwriting fees) - and reducing the availability of credit for everyone from major Wall Street buyout firms to homeowners themselves.

Sales of collateralized debt obligations (CDOs), which are used to pool bonds, loans and their derivatives into new debt, fell to $9.1 billion in July, down from $42 billion in June, analysts at JPMorgan Chase (JPM) said, according to Bloomberg.

What's behind the declining appetite for CDOs?

The near collapse of two Bear Stearns (BSC) hedge funds, for one. The downgrade of 75 CDOs by the ratings agency S&P, for two. And concern about growing losses due to rising homeowner mortgage defaults, for three. Those are just for starters.

OK, so what are we really talking about here with these so-called CDOs?

CDOs were created in 1987 by bankers at Drexel Burnham Lambert.

Wait a minute.

Did you say Drexel Burnham Lambert?

Isn't that the same firm that was driven into bankruptcy in 1990 due to illegal trading in junk bonds driven by Drexel employee Michael Milken?

And did you say they were created in 1987?

The same year the market crashed?

And wasn't the 1980s known as the "Decade of Greed"?

Yes, yes, yes, yes and yes.

So let's see if we got this right.

Today, in 2007, the market for securities that were created in the "Decade of Greed" by a firm that was only a short time later forced into bankruptcy due to illegal trading in high-risk bonds is grinding to a halt?

They say that history does not repeat but it does rhyme. In this case they have it wrong. CDO History is indeed repeating. What will also repeat is how the Fed will react to the problem. That way of course will be the same way the Fed reacts to every problem (by cutting rates). Regardless of whether or not that tactic works the next time (I doubt it), the attempt itself should be good for gold as the yield curve steepens.