From the Financial Times, via the shrill one:
Insight: Time to expose those CDOs
In my short (in the same sense that War and Peace is short) overview of the origins of the credit crisis last week, I talked a lot about CDOs, or collateralized debt obligations -- Wall Street's weapon of choice for blowing up the planet, or at least the global credit markets. And I noted how the magic of financial engineering had been used to turn extremely risky, unsecured pieces of CDO debt (known as mezzanine tranches) into AAA-rated, investment-grade paper:
The confidence investors (and their supposed watchdogs, the credit rating agencies) placed in the honesty, reliability and solvency of the average American homeowner truly was touching. To the point where you had CDOs that invested entirely in the mezzanine tranches (a very junior, very unsecured form of debt) of other CDOs, which in turn invested entirely in securities backed by pools of second subprime mortgages with loan-to-value ratios greater than 110% – in other words, in loans that were underwater even at the top of the bubble.
And yet many of these CDOs – the ones at the top of the food chain – had tranches rated AAA, on the grounds that diversification (buying many little pieces of shit) and overcollateralization (giving some investors less shit than others) would protect the senior tranches from harm. My mouth still hangs open in awe over this.
Even now, however, there are financial analysts -- most of them on either Wall Street's payroll or Uncle Sam's (of course, it's getting hard to tell the difference) -- who insist these "assets" are not as toxic as even a cursory knowledge of underwriting standards during the bubble suggests they are. Thus the hope private speculators might somehow be coaxed by the US Treasury into taking a flyer on the possibility of recovery in prices.
Until now, this argument has been a little tough to debunk, for the simple reason that there hasn't been a liquid, functioning market for the beasts.
This in itself is a bad sign, since it suggests that buyers (i.e. speculators) of CDOs are simply unwilling to pay prices that sellers (i.e. banks) can afford to take and remain nominally solvent. But it means that the little price data we have comes from secondary derivative markets -- indexes of credit default swaps on CDOS -- which are very thin and highly volatile. This has left a small window for the optimists to argue that the problem really is just one of illiquidity, and lack of confidence -- not the shit-like quality of the "assets" themselves.
However, as Big Shitpile decomposes, analysts are beginning to pick apart complex credit structures like CDOs and look at the specific loans and mortgages inside them -- which, in some cases, have started to trade again in volumes that permit more realistic price judgments.
And, according to the FT, those judgments are not good:
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.
So pieces of paper rated AAA by the credit rating agencies (implying virtually no risk of default loss) and sold for a 100 cents on the dollar (or more) are now worth a nickel -- a 95% haircut. Something like $150 billion in the stuff was issued in the last two years of the bubble alone. Another $300 billion in slightly higher quality AAA-rated debt is probably worth 35-40 cents -- at best.
As the FT notes, this kind of thing doesn't exactly inspire investor confidence:
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.
Which in turn suggests that sooner or later Milo Minderbinder and company are going to have to go back to the drawing board and figure out a better way to dispose of Big Shitpile than coating it in chocolate.