SAN FRANCISCO (MarketWatch) -- The shakeout in the subprime-mortgage business is inexorably worming its way through the credit markets that fueled the sector's rapid growth.
As delinquencies and foreclosures rise, losses will likely hit some of the riskiest parts, or tranches, of subprime mortgage-backed securities, or MBS, experts say. Then collateralized debt obligations, which invested in some of the lowest-rated subprime MBS tranches, will feel the pain.
But who holds these securities?
Hedge funds have become big credit-market players in recent years, and many firms trade the riskiest bits of subprime MBS and CDOs.
But while some funds, such as Saye Capital's Tranquility fund and others managed by Cheyne Capital and Cambridge Place Investment Management, have suffered, most hedge funds made a lot of money in February betting that the subprime crisis would hit, according to several investors who didn't want to be identified.
A credit fund run by Paulson & Co. was up almost 67% in February, while other hedge funds run by Harbinger Capital Partners, MKP Capital Management and Bear Stearns (BSC![]()
BSC ) also generated gains from the trend, investors said.
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So who ultimately holds the risk?
Most experts say it's almost impossible to know. Sales teams at investment banks and other firms that offered CDOs won't talk and no one else contacted by MarketWatch has kept track. The Federal Deposit Insurance Corporation, which monitors risk in the banking system, tracks holdings of MBS, but not the different tranches. It has no information on who holds CDOs.
Many experts point vaguely to Asian and especially Japanese investors who have been hungry for any assets yielding more than the almost-nonexistent interest rates offered by the world's second-largest economy in recent years.
But that's where the trail ends, which is a big problem, according to some.
"It's pathetic, but it's almost impossible to find out, which is no good for the system or anyone really," Josh Rosner, a managing director at research firm Graham Fisher & Co., said. "On the CDO side we know even less and regulators know even less because there aren't very clear reporting requirements."
Rosner and Joseph Mason, an associate finance professor at Drexel University's business school, published a study in March highlighting CDOs' big exposure to the subprime mortgage business. See full story.
Despite toiling for months on the project, the two can't give a definitive answer on who holds the risk.
Rosner's theory is that hedge funds hold a lot of the lowest-rated bits of subprime MBS and CDOs, called the equity tranches. Pension funds and insurers probably hold the less risky, senior tranches because rules restrict them from investing in lower-rated securities, he added.
Still, many CDOs bought the lower-rated bits of subprime MBS, so Rosner is concerned that rising losses from mortgage defaults and foreclosures could even eat their way up into the investment-grade tranches of CDOs.
Pension funds and insurers may also have invested in hedge funds that hold the riskier CDO tranches, Rosner and Mason said.
"There is a real risk that a lot of these assets are held by unsuspecting end holders like pension plans," Rosner said.
Karen Weaver, a veteran MBS analyst who runs a 300-person research group at Deutsche Bank, thinks foreign investors hold a lot of the riskiest parts of these securities.
Since the subprime crisis began to emerge in February, Weaver has been getting phone calls from many different people, asking advice. Most of the callers have been either senior bank managers, business reporters or overseas investors.
"I've had almost no calls from investors in the U.S.," she said.
Most investors in the U.S. haven't been surprised by subprime problems and because of that, they've avoided buying these securities, she concluded.
"We don't know exactly who holds these risks, but, in a way, we all hold this risk," Mason said. "The risk doesn't go away. Somebody has to have it."
Subprime chain
The chain of derivative structures that turn a home loan into part of a CDO begins when a mortgage is packaged together with other mortgages into an MBS.
That security is then sliced up into different tranches, which pay a range of interest rates depending on the risk. When the borrower makes a mortgage payment, the cash flows first to the highest-rated tranches. These pay the lowest rates, but are the least risky. Then the money flows down like a waterfall, with holders of the next riskiest tranche being paid next, and so on.
The riskiest MBS tranches get paid last, but they offer the highest interest rates. And when losses occur from mortgage defaults and foreclosures, the riskiest tranches are hit first, while the top-rated bits suffer last - like a waterfall in reverse.
CDOs, a cross between an investment fund and an asset-backed security (ABS), perform this slicing and dicing process all over again.
In recent years, CDO issuance has exploded and many have been buying the riskiest tranches of MBS that are backed by subprime loans. Subprime mortgages are offered to poorer borrowers with spotty credit records.
About 40% of CDO collateral is residential MBS. Almost three quarters of that is in subprime, with the rest in higher-quality, prime home loans, according to the study by Mason and Rosner.
'Severe'
Stagnant home prices and rising delinquencies on subprime mortgages have sparked concern that some riskier MBS tranches could suffer losses. That, in turn, could hit CDOs.
Influential rating agency Moody's Investors Services warned late last month that defaults and downgrades of subprime MBS could have "severe" consequences for CDOs that invested heavily in the sector.
CDOs that Moody's rated from 2003 to 2006 had 45% exposure to subprime MBS on average, the agency said. But that varied widely from almost zero to 90%. Recent CDOs have high concentrations of such collateral, it added.
"Based on our testing, we found that the effects were generally mild to moderate in cases where the subprime RMBS exposure was low or even approached the observed average of
45%," Moody's said.
"But in cases where the concentration levels were higher, the potential downgrade impact on the SF CDO Notes was severe - in some cases 10 or more notches," it added.
The secondary market for CDOs has already responded to these heightened risks, pushing prices down and widening spreads - the difference between interest rates on riskier debt and measures of short-term borrowing costs such as the London Interbank Offered Rate (Libor).
Spreads on BBB-rated ABS CDOs have widened by roughly 125 basis points to 657 basis points over Libor since the end of 2006, according to Anthony Thompson, head of CDO research at Deutsche Bank (DB![]()
DB ) . A year ago, spreads were about 330 basis points over Libor, he added. (A basis point is one hundredth of a percentage point).
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Most CDOs are the cash flow variety, which aren't particularly sensitive to the market value of their underlying assets, Thompson noted.
However, if a CDO manager decides to sell an asset at a loss, that can dent the value of the CDO. Also, when the underlying securities are downgraded, rating agencies can sometime force a CDO manager to carry some of the assets at a lower value, he explained.
But very few CDOs are in such sticky situations now because widespread downgrades of subprime MBS haven't happened yet, Thompson said.
"Things tend to move very slowly, but clearly the market is expecting problems," he concluded.
Tranquility disturbed
Some hedge funds have already felt the effects of the subprime shake out, while many more managers cashed in on the crisis.
Tranquility Fund, run by Saye Capital, a Los Angeles-based firm that's active in the subprime market, lost roughly 8% in February, according to two hedge fund investors who declined to be identified.
Tranquility invested in MBS, but also took short positions on mezzanine tranches of CDOs as a hedge, according to Luke Imperatore, who helps market the fund.
The value of the MBS positions declined, while the mezzanine CDO tranches have yet to reflect the deterioration in the subprime market, he explained.
Greg Miller, a portfolio manager at Saye, declined to comment. It's not clear how well Tranquility did in March, but the fund's fortunes may improve.
Christopher Flanagan, head of global structured finance research at J.P. Morgan Chase (JPM![]()
JPM ) , said a lot of hedge funds have been trading different parts of the CDO capital structure.
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A common trade is to buy the lowest-rated equity tranche of CDOs and short the slightly higher rated mezzanine part. While the equity tranches are the riskiest, the interest rate they pay is very high and cash flows into these slices are quick, Flanagan explained.
Investors in mezzanine tranches of CDOs have to wait longer for their cash. If there are problems with the underlying collateral, by the time the deal is wound up, there may be little cash left for these parts of the security, he said.
"Equity CDO owners could get hurt, but it's the mezzanine tranches that will be really hurt," he predicted.
Queen's stumble
Other funds have been hit by their holdings of subprime MBS.
Queen's Walk Investment Ltd. (UK:QWIL: news, chart, profile) is a fund listed on the London Stock Exchange that's managed by Cheyne Capital, one of the largest hedge funds in Europe.
Queen's Walk mainly buys the equity tranches of asset-backed securities. At the end of 2006, the fund had 86% of its assets in residential MBS and 5% in CDOs. U.S. assets accounted for 12% of the portfolio.
Queen's Walk shares slumped 22% on Friday after the fund warned that the shakeout in the U.S. subprime market and other problems with its U.K. holdings could knock the value of its assets.
Current market conditions have made it much harder to value Queen's Walk's assets, the fund added, withdrawing its dividend forecast.
Queen's Walk shares are down 44% so far this year. A hedge fund run by Cheyne, called the Cheyne ABS Opportunities Fund LP, owns 44.1% of Queen's Walk.
Cheyne said on Friday that it wants to buy more Queen's Walk shares because markets are undervaluing its assets.
Cambridge Place, a $10.5 billion London-based fund manager that specializes in credit markets, has also been hit.
Shares of Caliber Global Investments Ltd. (UK:CLBR: news, chart, profile) , a London-listed fund managed by Cambridge Place, have slumped more than 40% so far this year.
Spread widening in the U.S. residential MBS market, where Caliber invests roughly half its money, has knocked the value of its assets, the fund said last month.
Paulson's pay-out
Still, many hedge funds have made money from the subprime shakeout.
Paulson & Co., a New York hedge fund firm that oversees more than $10 billion, did especially well.
The Paulson Credit Opportunities fund, set up last year to take advantage of mortgage turmoil, was up 67% in February. The firm's flagship merger arbitrage fund was up almost 16% that month too.
A hedge fund run by Harbinger Capital, a $7.5 billion firm that invests in real estate, private equity and fixed-income strategies, returned roughly 8% in February, according to two investors who didn't want to be identified.
Other credit hedge funds run by MKP and Tricadia Capital had similar success in February, investors said. The Bear Stearns Structured Risk Partners fund was up almost 9% that month, one of the investors noted.
Other hedge funds that don't specialize in credit markets also got in on the action, mostly by shorting parts of the ABX index, which tracks the cost of insuring some MBS against default, another investor said.
'Murkier'
Hedge funds' success has left some experts still wondering who has experienced the most losses and who retains the most risk in the mortgage market.
George Tintor helps run a firm called Palomar Capital Advisors, which invests in structured credit hedge funds. In September and October, he began checking with managers and other players to see who might be exposed if the U.S. mortgage market turned sour.
"We talked to our hedge funds and called all the big banks involved in the business," he recalls. "We got answers that were all over the map. Since then, it's only got murkier."
Generally though, Tintor reckons the most senior tranches of CDOs are held by banks, which have hedged the positions by purchasing derivatives offered by insurers such as Ambac (ABK![]()
ABK ) and MBIA (MBI![]()
MBI ) .
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The mezzanine tranches were bought by other CDOs, he said, adding that it wasn't clear who owned these CDOs.
The riskiest, equity tranches are probably owned by Asian investors, such as Japanese institutions looking to higher yielding assets, Tintor added.
None of the hedge funds Palomar invests in has a meaningful exposure to these securities, he noted. Indeed, the Palomar Structured Credit Strategies fund was up 0.68% in February and should be in positive territory in March, Tintor said.
The riskier tranches of CDOs have even been offered to rich individual investors who probably don't understand the securities much, Mark Adelson, head of structured finance research at Nomura Securities International, said.
"A partial understanding of it is often no better than no understanding," he said. "The devil is in the details; if you understand it vaguely, you can get your lights punched out."
Some CDO investors probably relied on the talent of the manager of the security or ratings from agencies like Moody's, rather than studying the risk of the underlying assets, Adelson explained.
Still, he said it's too early to tell how MBS and CDO investors will be affected by the subprime shakeout.
It's possible that defaults on subprime mortgages won't rise too much and the crisis will dissipate. But there's also a chance that losses will climb enough to hit BBB-rated tranches of MBS and CDOs, Adelson said.
"In MBS, that won't matter too much. But in the CDOs, if BBB tranches get hit, it would create a blood bath," he added. "It will be months before we know." 
Alistair Barr is a reporter for MarketWatch in San Francisco.
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