How Much Can Investors Recover from CDOs?

Includes: DIA, QQQ, SPY
by: Thomas Tan, CFA

On Monday, the S&P cut assumptions on recovery rate for CDOs related to subprime mortgages, about 40% of all CDOs, as linked here. Their new assumptions are shockingly low.

Some of you probably remember, I commented on Bill Gross' article of "Pyramid Crumbling" a couple times in my blogs here. I indicated his assumption of general recovery estimate of 50% is too high. What S&P has come up with  is actually even lower than my expectation.

In their new recovery assumptions for structured finance CDOs,  the S&P assumed that for any deals rated A or lower, recoveries were likely to be zero, while AA-rated slices would be at best 5%. How about the most seniors, the so-call AAA ones? AAA-rated tranches were likely to recover 60%, while junior AAA-rated tranches could expect to recover only 35%, the S&P indicated. So they are definitely not as good as US Treasuries. It looks that 50% average recovery estimate applies to the AAA tranches only; everything else is pretty much wiped out.

This new assumptions will have a rippling effect, causing more downgrades by rating agencies, subsequently forcing more write-downs by investment banks and other institutions holding CDOs.

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