Friday, February 27, 2009

Data on the CDO Mess

The Financial Times reports on a study by JP Morgan and Wachovia showing that half of all collateralized debt obligations (CDO) that were composed of the marginal pieces of asset backed securities (mortgage bonds) have defaulted. Paul Krugram and Naked Capitalism have both commented but I would like to add a few thoughts to follow up on my earlier post about the topic.

Here are the key paragraphs from the FT report:

The conclusions are stunning. From late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds (known as mezzanine CDO of ABS) and much of the rest from safer tranches (high grade CDO of ABS.)

Out of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi.

The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32 per cent for the high grade CDOs. With mezzanine CDO’s, though, recovery rates on those AAA assets have been a mere 5 per cent.

Let me put this in context of what was going on with structured finance at the time i.e. packaging individual mortgages in to bonds and then repackaging those bonds. The first picture below shows a typical mortgage backed security. An investment bank would purchase a bunch of mortgages (usually thousands) and pool them together so that all of the principle and interest payments would go into one fund. The investment bank would then create a series of bonds that they could sell to investors. Within this series of bonds would be low risk bonds that wold be paid first, moderate risk bonds that would be paid second, and high risk bonds that would only be paid if the first two groups were paid.

The investment banks had a fairly easy time selling the low risk bonds to conservative investors. Actually these bonds are still doing OK because even after foreclosure houses are never worth $0. They also didn't have much trouble selling the high risk bonds to risk taking investors because they had very high yields. These have turned out to be bad investments but they are really not a big part of the problem because the investors knew that they were high risk to begin with. The problem for the investment banks is that according to the FT report, from 2005-2007 the investment banks had $450bn of moderate risk bonds that were difficult to sell and if they could not find find something to do with them they would not make back the money that they spent on the mortgages in the first place. The solution was to repackage these moderate risk mortgage backed bonds with other moderate risk mortgage backed bonds to create some new low risk bonds that they could sell to conservative investors. The picture below shows how this would work.

So keep in mind what this report is saying. It says that the $450bn of asset backed bonds that were hard to sell in the first place and hence were packaged into CDOs and resold are in reality turning out to be terrible investments. So it would appear that the investors who initially balked at purchasing "moderate risk" bonds were not far off the mark. The problem of course is that repackaging these bonds as CDOs did not do anything to reduce the risk and the reason for that is that all of the "moderate risk" bonds are failing in the same way - the payouts to the low risk bonds in each series are eating up all of the principle and interest payments each month leaving very little for the moderate risk bonds. That was the correlation that everyone missed.

Also keep in mind what this report is not saying. It is not talking about how the low risk portions of the original mortgage backed security are doing. That is a much bigger piece of the total pie than this $450bn. As of now, many of the Markit indexes AAA indices are still doing ok, although they have taken significant losses since my last post on the topic. The troubling thing of course is that if the moderate risk bonds are taking such huge loses now how will the low risk bonds preform in the future?

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