Overlapping Subprime Exposure Mask Risks of CDOs, Moody's Says

Discussion in 'Wall St. News' started by blast19, Apr 4, 2007.

  1. blast19


    By Jody Shenn

    April 4 (Bloomberg) -- Some collateralized debt obligations that invest in subprime mortgage bonds, related derivatives and other CDOs may be less diversified than they appear, raising investors' risks, according to Moody's Investors Service.

    Greater use of credit-default swap contracts is creating more situations in which CDOs may be doubling up on exposures to the risks of specific bonds, either through multiple direct investments or purchases of other CDOs' bonds, according to a report this week by Moody's.

    The CDOs receive cash for taking on risks from asset-backed bonds to pass on to buyers of their own securities. The report focused on CDOs' investments in benchmark credit swaps called ABX contracts, which are linked to 20 bonds, and TABX contracts, which slice up ABX risk.

    TABX contracts in particular are ``becoming a real concern for some deals,'' based on the inquiries Moody's has received, Yvonne Fu, a managing director at the credit-rating firm, said in an interview. New York-based Moody's hasn't rated any new CDOs with investment in TABX contracts yet, she said.

    Moody's said it's acting to head off problems that could be caused by CDOs' interest in adding TABX contracts, which were introduced Feb. 14 and are ``trading at very wide levels,'' in either derivative form or through notes backed by the contracts.

    Low-Rated Bonds

    CDOs were the main buyers of low-rated bonds from subprime loan securitizations in 2006, according to investors such as Scott Simon, head of mortgage- and asset-backed bond investments at Newport Beach, California-based Pacific Investment Management Co., manager of the world's largest bond fund.

    TABX contracts linked to the safest parts of cash flows from subprime bonds with the lowest investment-grade ratings pay $675,000 per year to protect against losses on $10 million of securities, according to Deutsche Bank AG. Such bonds, which expose an investor to all losses, typically pay 8 percentage points over benchmark rates, or $800,000 in interest above some of the lowest financing cost, according to Wachovia Corp.

    Moody's said it was introducing ``guidelines'' that called for no more than 5 percent of the holdings for mezzanine structured-finance CDOs, which invest in low-rated asset-backed bonds, to be in ABX or TABX contracts and for them to represent no more than 2 percent of holdings of ``high-grade'' CDOs.

    The firm said managers should also label all exposures to bonds in ABX indexes when submitting deals for initial ratings.

    `Growth of Synthetics'

    Moody's also said it's concerned that the ``growth of synthetics,'' or credit swaps, may leave more CDOs invested in other CDOs exposed to the same bonds as they are.

    The company said its models ``were developed using the data that was available at the time,'' such as transactions backed by cash collateral. Moody's is now working on a research project to reassess the correlation between CDOs at time when exposures can be ``infinitely replicated,'' it said.

    Moody's sees ``increasing'' correlations in performance, which suggests it will require more protection for bondholders when the project is finished. ``We'll update the market with our final findings when we're done,'' Fu said.

    Having CDOs invest in other CDOs makes it difficult for investors to understand their exposures to, for instance, bonds from subprime lenders known to have made bad loans last year, said Janet Tavakoli, the president of Tavakoli Structured Finance Inc., a Chicago-based consulting firm. ``Sometimes it's just not worth it for what you're getting paid,'' she said.

    'Modest' Downgrades

    Mezzanine structured-finance CDOs generally contain less than 10 percent of their CDO brethren, Fitch Ratings said in a report yesterday. The only ``modest'' downgrades on the CDO securities held that Fitch expects as a result of downgrades on underlying bonds if loan performance is extremely poor means the effects on the CDOs holding them will be limited, it said.

    CDOs repackage loans, bonds and derivatives as new securities, some of which have higher credit ratings. Credit swaps on mortgage bonds offer payments to protect buyers if securities don't make payments as scheduled. The market for contracts linked to individual bonds began surging with the introduction of standard contract language in June 2005.

    New ABX and TABX indexes are created every six months by securities firms, including Deutsche Bank AG and Goldman Sachs Group Inc., and London-based Markit Group Ltd. They indicate prices for credit swaps on 20 bonds, not for contracts on each of the bonds. ABX contracts were first created in January 2006.

    About $59 billion of mezzanine structured-finance CDOs were created last year, up from $34 billion in 2005, according to JPMorgan Chase & Co. Another $120 billion of high-grade structured-finance CDOs were created.

    Structured-finance CDOs also may contain bonds backed by auto loans and credit-card payments.

    To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net .
    Last Updated: April 4, 2007 07:46 EDT
  2. Kalidane


    hmmm so that could be summarised as 'house of cards'?