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Minyan Peter: The Ripple Effect of Collateralized Debt Downgrades

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The downgrading of one structured debt security could result in immediate ripples across a far larger universe of financial institutions.

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The following is the latest missive from Minyan Peter, author of popular articles like the Bank Earnings series.

As reported earlier today, Moody's (MCO) downgraded CDO's backed by $33 bln of subprime mortgages and suggested that further downgrades may be forthcoming.

One of the challenges that Moody's (and the market overall) faces is identifying who holds each downgraded CDO and whether or not those downgraded CDO's serve as the backing for other rated debt – such as the commercial paper or MTN's for SIV's or other structured vehicles – which may in turn need to be downgraded. And with the downgrading of structure debt accelerating, I expect that structured vehicle entities, whose ratings may have previously been stable, may soon be under review.

But beyond the obvious Merrill Lynch (MER)-like portfolio write downs, there are other implications to all of these structured asset write downs. For asset-backed commercial paper issuing vehicles holding downgraded debt, it may mean even greater and greater dependence on their short term liquidity lines provided by banks. (Which in turn puts the banks in the position of further on-balance sheet loans (all requiring loan loss reserves), which in turn requires the banks to issue more debt, which puts further pressure on bank leverage ratios – which ultimately reduces the availability of new credit.)

Also, and I think missed by many, Moody's put the market on notice today that future structured note downgrades may be immediate, rather than occurring following an announced review period. For holders of structured debt this further raises the risk of a forced sale, rather than orderly liquidation. In addition, given the ratings interdependence of billions of dollars of structured debt, the downgrading of one structured debt security could result in immediate ripples across a far larger universe of financial institutions.

How the banking system responds to the accelerating downgrading of structured debt remains to be seen. As I have written already, financial institution balance sheets are already getting stretched. And, from what I read today, Moody's is not making it any easier for holders of structured debt. If anything, at least to these eyes, the pressure tightened.
Position in SKF.
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