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Bear Stearns Fund Reveals Tip of the CDO Iceberg


If the market continues to deteriorate, the agencies at some point will be forced by the cumulative losses to acquiesce.


The Wall Street Journal yesterday reported two Bear Stearns (BSC) hedge funds that invested heavily in securities backed by subprime mortgage loans are close to being shut down. This is not surprising given the reality (which no one seems to recognize) that the market in credit derivatives is far from liquid.

In times of stress, the seemingly tight spreads that exist when the market is going up and everyone is seeking risk, rapidly disappear and disintegrate into vapor. Even those who own the protection and are seemingly in the driver's seat will quickly find out monetizing gains will be difficult, if not impossible, as dealers significantly widen their markets (if they are making them at all) and those trying to cover their exposure will be paying prices only the brokers see and not the customers monetizing.

In light of these developments, I wanted to revisit and update something I wrote about a little over a month ago. Earlier this year I was struggling to figure out exactly what I was missing with respect to Collateralized Debt Obligations (CDO) structuring. Specifically, I wanted to know why is the market so sanguine in the face of deteriorating collateral values in the mortgage market? One of my firm's theses has been that as the mortgage market deteriorates, investors holding CDO as an investment would realize losses and this would feed into other risky asset classes. Why aren't losses being seen when the market is so clearly deteriorating?

So I asked a large broker firm to send over its smartest math person on CDO structuring. The team that came over was headed by a very smart gentleman. He was very good at math and very straightforward. Working for a broker, I was prepared for some sugar coating. I didn't get any.

The answer is simple and scary: conflict of interest.

He explained that due to the many layers of today's complicated credit products, the assumptions used to dictate the pricing and outcome of CDO are extremely subjective. The process is so subjective, in fact, that in order to make the market work, an "impartial" pricing mechanism must exist that the entire market can rely upon. Enter the credit agencies. They use their models, which are not sensitive to current or expected economic activity, but are based almost entirely on past and current default rates and cash flow to price the risk. This, of course, raises two issues.

First, it is questionable whether "recent" experienced losses over the last few years really represent the worst of the credit market (conservative). But, even more importantly, it raises a huge conflict of interest: the credit agency's customers are the very issuers of the tranches they rate. The credit agencies, therefore, need to compete for business based in part on the ratings they are willing to give these tranches. As a result, they will only downgrade when forced to by experienced losses; not by rising default rates, not a worsening economy, but only actual, experienced losses. Even more disturbing, they will be most reluctant to downgrade the riskiest tranches (the equity tranches), since those continue to be owned by the issuers even after the deal is sold.

So even though the mortgage market has deteriorated substantially, mark-to-market losses by those holding the CDO paper have generally not been realized, simply because the rating agencies have not changed their ratings for all of the above reasons. Accounting rules only require holders of the paper to mark prices according to the accepted model, not actual prices. For example, below is a chart of the actual BBB minus tranch of the mortgage-backed securities pool from November '06 to present. The actual prices where traders can buy and sell are substantially lower than where investors are marking their positions.

The levels at which investors are carrying the paper is not reflecting the underlying reality of the holders simply holding their collective breath and the rating agencies ignoring a worsening environment.

I asked them what would force the rating agencies to change their ratings. The response was, "it's just a matter of time. If the market continues to deteriorate, the agencies at some point will be forced by the cumulative losses to acquiesce." Because these losses have been compressed, any re-adjusting of ratings by these agencies is likely to result in a massive repricing of risk. We may be there now.

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