Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. Carina: CD-Oh-No
Standard & Poor's said a collateralized debt obligation managed by State Street (STT) began liquidating its assets, prompting the ratings firm to slice the investment vehicle's ratings as much as 18 levels, according to Bloomberg.
- It's an important story.
- Carina CDO Ltd., the CDO in question, is the first CDO to begin unwinding.
- According to S&P, the ratings on the most senior class of Carina CDO Ltd. were lowered to BB, two levels below investment grade, from AAA, while another AAA class was slashed 18 steps to CCC-.
- For all intents and purposes that means it is practically bankrupt.
- "The chance of material losses to noteholders is high, New York-based S&P said," according to Bloomberg.
2. What Is a CDO?
Ok, something called Carina CDO Ltd. has been downgraded by S&P and may begin liquidating assets, but what does this mean for me?
- Carina was originally a $1.5 billion CDO issued in September 2006.
- A CDO, collateralized debt obligation, is a type of asset-backed security, sometimes called a "structured security product."
- That's a fancy way of saying it is something you can invest in that generates cash.
- How does that "cash flow" happen?
- First. the CDO "creator' buys an inventory of asset-backed securities.
- Asset-backed securities are finance-geek speak for a bond or a note that is "collateralized" by the cash flows generated.
- If you buy a bond, you are loaning the bond issuer money in return for regular interest payments.
- So, for simplicity's sake, a CDO creator buys an inventory of asset-backed securities and then sells the rights to the cash flows generated by the inventory to investors.
- These rights are called tranches.
- Because not all bonds and notes have equal risk, some are riskier than others, the tranches are rated accordingly.
- The highest rated tranches are Senior (rated AAA, the most creditworthy), followed by Mezzanine (rated AA to BB) and the lowest rated Equity level (which are unrated).
- Theoretically a CDO makes it possible to "spread the risk" among different investors, and this spreading of risk serves an important economic function by enabling ventures that might otherwise seem to risky to one party to obtain financing from a pool of investors.
3. Down In the Tranches
What has happened is that the most senior tranch of the Carina CDO (the highest rated tranch) was downgraded two levels from AAA to BB, two levels below investment grade, while another AAA class was downgraded an astonishing 18 levels to CCC-.
- Why does the downgrade matter?
- Sometimes holders of the CDO are required to liquidate if a downgrade takes place, which is called an "event of default," below a pre-determined level.
- In this case the senior noteholders may have decided on their own to liquidate following the downgrade.
- What is also unique about this downgrade is that a AAA rating, the highest rating offered by S&P was overnight lowered to CCC -.
- The CCC- S&P rating means the financial security characteristics are very weak and the issuer is dependent on favorable business conditions to meet financial commitments.
- In other words, the cash flow kicked off by the tranch in question is in jeopardy.
The liquidation of the Carina CDO was one of the issues Citigroup (C) was concerned about in their conference call this week; the point at which holders of senior notes say they are no longer willing to risk the fact that the current cash flows will continue on without impairment.
- In the conference call Citigroup Chief Financial Officer Gary Crittenden said that although the ABX Indices were implying serious value declines in real estate and ultimately cash flow impairment, Citigroup is not yet seeing these cash flows impaired.
- The key is "not yet."
- As Crittenden said, "Now, when we have thought about taking these marks we have obviously if you look at what the ABX would imply in terms of real estate price reduction it starts to imply very, very high numbers of price reduction in real estate."
- Crittenden was referring to the ABX Indices and the fact the firm is not yet seeing cash flow impairment that the indices are implying.
- As a result, they are not yet conceding defeat to the ABX Indices and not yet willing to mark accordingly, opting instead for a projected range.
- Crittenden put it like this: "I guess our view is that it's unlikely that those very high levels of price reduction in real estate will take place so what's actually happening is implicitly the market is saying that the cash flows associated with those securities have become more risky and so as we have thought about valuing those cash flows we have put different discount rates on those cash flows and that's reflecting the range that you see in the estimate here and we'll see obviously how that actually plays out over time."
- It took less than a week for the first move in this waiting game to play out.
- The forced liquidation of the Carina CDO will likely have a domino effect, spreading into the pricing and ratings of other CDOs.
- At this point it's a game of faith.
- Once investors lose faith the "reality of pricing" detaches itself from tangible meaning, creating a new world with different rules.
- Citigroup, and other firms, have been hoping to ride out the irrationality of the ABX Indices.
- They haven't counted on the fact that what once appeared irrational might soon dissolve into reality.
5. Capitulation vs. Kickoff
For equity market participants liquidation events are typically hallmarks of capitulation. In credit markets liquidation events are more often kickoffs, triggers to other liquidation events.
- If equity markets are grounded in a fundamental reality of price discovery that only temporarily overshoots on the upside or downside, credit markets live on a more slippery plane, one based on trust and faith that, despite all the fancy nomenclature, still carries the backing of little more than a handshake.
- How do we "know" the borrower standing before us is legitimate?
- We don't. We do the best we can hedging away as much risk as we can, although forgotten in the shuffle is the implicit acknowledgment that all speculation carries risk.
- One of the issues Citigroup was concerned about in their conference call this week; the point at which holders of senior notes say they are no longer willing to risk - important word - risk the fact that current cash flows will continue on without impairment.
- Consequently, the Carina CDO Ltd. liquidation event is a hallmark move toward risk aversion where the holders are saying We no longer are willing to accept the risk of potential cash flow impairment.
- They are saying We just want to get whatever price we can get for the securities.
- Now, the important risk for us going forward is that this is not a capitulation event, as equity market participants perceive, but a kickoff event precipitating increased risk aversion across the spectrum, not to mention the creation of "observable inputs" in pricing.
- As noted in yesterday's Five Things (No. 2, November 15), the new SFAS 157 provisions that firms have implemented require firms, whenever possible, to use "observable inputs" in pricing their Level Three assets.
- Forced sales, at distressed prices, create "observable inputs"; the result will be revaluation down the line and risk aversion that begets still more risk aversion.
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