Moue Magazine

It is impossible to name one culprit behind the current economic crisis because there were so many correlated pieces that went into this disastrous puzzle. But collateralized debt obligations (CDOs) -specifically, those of asset-backed securities (ABS)-were, continuing the puzzle metaphor, a large corner piece.

To understand CDOs, you have to know a little bit about the securitization of mortgages. A homeowner gets a mortgage from their bank, providing the bank a monthly income of loan payments assuming the homeowner doesn’t miss payments/default/etc. That bank will often sell the rights to the mortgage income payments to a second bank for a price that’s near what they would’ve earned in the long run from the mortgage.

The buyer bank is usually an investment bank that will securitize this newly purchased mortgage by putting it in a pool with many other mortgages. The pool has an overall price (total of all the mortgages inside) and can be divided into tranches, or slices, to sell off individually. What is being sold off is a portion of that mortgage backed income stream. A pool can have thousands of slices and an overall price in the hundred millions. 

The tranches are priced based on risk- the lower the risk, the higher the price and vice versa. In a CDO, the tranches from one pool are tiered in such a way that those with the least risky loans get paid first and those with the riskiest get paid last. When people began to default on their mortgages at astounding rates, the funding for these pools began to dry up with the impact moving quickly up the tier. 

As I mentioned, that explanation is a simplification. These transactions are complex to the point that the bankers aren’t always sure what is going on. According to the Financial Times, the banks that are to face Geithner’s stress test regulators are trying to figure out exactly what happened to those CDOs: 

In recent weeks, bankers at places such as JPMorgan Chase and Wachovia have been quietly sifting data trying to ascertain what has happened to those swathes of troubled CDO of ABS.

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.

I dare say this might be an extreme case. The subprime loans extended in 2006 and 2007 have suffered particularly high default rates and the CDOs that have already been liquidated are presumably the very worst of the pack.

Even so, I would hazard a guess that this is easily the worst outcome for any assets that have ever carried a “triple A” stamp. No wonder so many investors are now so utterly cynical about anything that bankers or rating agencies might say these days.

A triple A rating is the highest possible and carries with it an implication of low risk. It may seem odd that a high risk tranche could carry that rating but it only means that it is less risky than the other slices in the pool. When the money flow stops coming in, it will be the last level to dry up. 

This rating is assigned by a ratings agency. Hilzoy wrote of the ratings agencies:

And how about those ratings agencies? They would have done a better job using a Magic 8-Ball to rate the CDOs. (“Signs point to junk!”) 

The ratings agencies happen to be another large corner piece of the economic catastrophe puzzle. There are three major agencies: Moody’s, Standard & Poor’s and Fitch. TIME magazine recently named S & P’s leader- Kathleen Corbet- as one of the 25 People to Blame for the Financial Crisis due to the agencies mismanagement (intentional and otherwise) of the ratings system in relation to CDOs. The New York Times ran an excellent article last year about the troubles at Moody’s.