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