Thursday, November 01, 2007

The rating game: CDOs crash, banks may reveal more writedowns

While the commentariat has spent the summer talking about the subprime crisis and the credit crunch like they’re interchangeable, it would seem that the former is only just coming home to roost.

Having weathered the storm through August and September, October has been disastrous for CDOs. The value of the leading tracker indices has plummeted as the rating agencies have rushed to downgrade senior debt across the CDO spectrum.

It’s all been part of a subprime chain reaction. First there was all that bearish housing news in September - which markets ignored because the Fed had cut rates, equities were rallying and CDS spreads were tightening.

Second, the rating agencies hit mortgage backed securities. That bad housing news - rising subprime delinquencies and a sector which looked like it was heading for a recession fed into the outlook for MBS. On October 8 Fitch downgraded $18.4bn of MBS. Then, on the 11th, Moody’s followed suit with $33.4bn in MBS downgrades. Five days later and Standard & Poor’s joined in - cutting ratings on $23.25bn of subprime securities. And again, three days later, on a further $22bn.

And then, predictably, CDOs - chock full of MBS - came in line for downgrades: On October 22 Standard & Poor’s said it could cut ratings on $21bn of CDOs. Moody’s said it would do the same with $33.4bn on October 26, and on October 29, Fitch said it was reviewing ratings on all $300bn of CDOs out there. Moody’s not wanting to be outdone went one further: saying this Wednesday that it could downgrade 500 CDO deals by tomorrow.

Little wonder then, that the main tracker indices have crashed in the past couple of weeks:

For asset backed securities:


And that’s the AAA tranche - currently worth just over 80 cents in the dollar. AA is predictably worse:


Just under 50 cents in the dollar. For an AA rated security.

For CDO’s themselves it doesn’t look any better. Take the TABX, which is a useful proxy for CDO prices:


So why is the AAA taking a battering? CDOs are opaque and generic. Investors bought CDO paper purely on the back of its ratings. What’s spooking people are some of the shock downgrades - Moody’s, for example, cut the Aaa rated trance of a CDO issue called Vertical 07-01, issued by the absurd-sounding Vertical Capital, by fourteen notches to B2. In one go.

Some are sanguine. The Fed rate cut on Wednesday provoked a small return in confidence - evident in the graphs above. And Pimco has announced it’s going to invest heavily in CDOs. The fund said it bought $5bn of CDOs over the past few weeks, and intends to buy another $2bn in the next couple.

But on the other hand, evidence from the US housing market would suggest there’s plenty of pain yet to work itself out of the system. Given the way subprime delinquencies are set to carry on rising into 2008, there could yet be a lot of subprime, Alt-A and even prime securities to be downgraded.

And some CDOs themselves are beginning to crack. Moody’s said seven have experience “events of default” on Wednesday. And true to their word, they’ve downgraded tranche after tranche of CDO debt since then.

What’s more, since the CDO markets have crashed in the last few weeks, writedowns in banks’ Q3s - only just reported - are likely to be much worse. Citi, for example, reported writedowns totalling $1.3bn on subprime MBS it had warehoused for use in CDOs. That was on October 1. The graphs above give a pretty good indication of where the market has moved since then.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.