Monday, October 22, 2007

Remember The Buckets

As the mortgage crisis unfolds, I think it is useful to remember that most mortgage-backed structured finance products use a cascade configuration. Practically, it takes some time until defaults are reflected in the cash flows of the AA and AAA tranches, because the first "hits" are taken against the lower-rated "buckets" and against whatever reserves were maintained as a cushion. From the perspective of the AA-AAA CDO holder, nothing has changed in his cash flow: he/she is still getting paid regularly.

What this means is that, absent a functioning secondary market, holders resort to mark-to-model to price their portfolios; since the cash flows are still unchanged for the AA-AAA tranches, models come up with high valuations. This explains why all concerned (banks, brokers and presumably hedge funds) took such relatively small write-offs on their CDO positions. But it also explains why holders of large positions in supposedly high quality bonds are in such a hurry to form the Super-SIV and get 'em off their balance sheets (but apparently no one else is biting). Because...

The big hits for the AA-AAA buckets are still in the future and they are not going to come from borrowers' missed monthly payments - that's just interest (mostly). As the process moves along from delinquency to default, repossession and eviction, the lower buckets may still be able to absorb some, if not all, of the losses stemming from lower monthly payments. The real crunch will come when REO auctions finally occur and the real estate is sold at prices significantly less than what is owed. That's when large principal losses will be realized, flooding the lower tranches and cascading in waves onto the AA-AAA buckets.

The sad truth is that there are no AA-AAA CDOs, not in the traditional corporate bond sense, anyway. Their structures make them inherently unstable past a critical point, after which their performance becomes non-linear on the downside. The banks know this very well (they engineered them, after all) and that's precisely why they don't want to hold them - it has nothing to do with lack of transparency or liquidity. Such products are large ticking bombs; their manufacturers can calculate with relative accuracy when they will explode, given timely data on delinquencies and defaults. As in any bankruptcy, how much money will be recouped will depend on the prices realized from the auctions, minus costs and fees.

That's why hedging via the ABX indices is becoming rapidly more expensive, even for the AAA tranches, and also why the rating agencies are finally starting to downgrade such issues by the tens of billions.
Chart: Markit


  1. But it also explains why holders of large positions in supposedly high quality bonds are in such a hurry to form the Super-SIV and get 'em off their balance sheets...

    No doubt. These people -- at least the 'financial engineers' who put the CDOs together -- are not stupid; they've seen the ARM reset schedules and the data on accelerating delinquencies and foreclosures and know about the firesales. They are ruthlessly self-interested, and capable of the worst kinds of moral and criminal malfeasance. When I saw a news story about the M-LEC stating it was to be an entirely new corporation, I knew then what the plan was: dump all this stuff onto this new company at very favorable prices, and after that who cares what happens? The paper was sold at a fair price at the time. It would then be a problem for the Fed and/or the government, e.g. to perhaps coordinate an LTCM-like bailout.

    The problem with this plan:

    ... (but apparently no one else is biting).

    Potential M-LEC investors have smart people working for them too.

    Another good post.


    P.S. A useful link.

  2. Great site, Hellasious. I'd like to contact you - could you drop me a line via ? thanks and best wishes tim.


  4. People who put together CMOs, CDOs, CDSs, hubrid CDSs and CPDOs, etc responded to the supply and demand.
    Similarly, home owners can choose not to buy the homes or take up mortgages when prices or interest rates are high.

    Maybe some push factors were around, but no one took a gun pointing at your head to get you to sign on the dotted line.

    My point is because when things were fine, and everyone is reaping loads of money, nobody said anything and hoping that good times never end; but when the music stops, people start to look for someone to blame.

  5. No one put a gun on peoples' heads.


    So don't rob ME at the point of a gun to bail out those that chose freely to issue and buy CDOs, etc.

    Private profit = private loss.

    We cannot have private profits for the very, very few and socialized losses for everyone; that's the very definition of fascism.

  6. "We cannot have private profits for the very, very few and socialized losses for everyone; that's the very definition of fascism."

    Great point helacious. I think we'll all see how far along in fascism we are shortly.

    My feeling is the trickle down theory will be enforced for losses also.

  7. My feeling is the trickle down theory will be enforced for losses also.

    Except that the losses will probably be "trickle up," I bet.

  8. But an AAA tranche is typically set with an attachment point over 60%. Given a 'recovery rate' of, say 80% (being the average difference between the value of the defaulted mortgage, and the value the house is sold at on foreclosure), it is difficult to see how, even in the case that every mortgage is in default, and every house sold at a whacking great loss, the AAA piece can be burned through. That is why people bought these securities in the first place.

    It is possible to envisage scenarios where this does happen (housing prices collapse to 1990's values, say). A more plausible explanation is that this really is a liquidity thing, and that the fair value of these securities is not at the level that the market is currently marking them to. Or something in between.

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