In Depth Analysis: CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Thursday, June 28, 2007

Subprime and CDOs: Illiquifying the Liquified

by Tanta on 6/28/2007 10:17:00 AM

Naked Capitalism has another great post up on the Sturm und Drang in the CDO market. It doesn't exactly answer the question that has been nagging at me, namely, to what extent this "CDO valuation" crisis is truly a "direct" consequence of subprime mortgage-backed securities melting down, or whether the latter is just one of a cluster of debt-binge problems that is being amplified by Wall Street's crazy leverage schemes, one that is "easy" for the mainstream press to see and politically palatable for everyone to "blame." Save for the potentially compensatory stories of predatory lending and steering of prime or near-prime borrowers to subprime, which erupt from time to time but never become the main story, the narratives in play today are that subprime borrowers are fraudsters and deadbeats, as are subprime lenders, and this makes the two fine candidates for scapegoating.

What makes me think there might be some scapegoating going on? I'm not claiming that there are no troubles in Subprime City, of course. I am simply having a hard time reconciling the claim that there is a simple and uncomplicated relationship between these hedge funds' CDO asset valuation meltdowns, on the one hand, and deterioration in subprime mortgage performance on the other, when at the very same time this claim is made, we are informed that CDO portfolios are opaque, no one knows what's in them, and what we do know suggests that subprime ABS tranches cannot possibly be the largest share of their holdings:

And there are a few other barriers: you can't get the deal documents. No kidding. The Fed can't even get them because it isn't a "qualified investor." (Should the Fed start a hedge fund so it can study this problem?). From "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions," by Joshua Rosner and Joseph Mason (pages 83-4):

At present, even financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only “qualified investors” may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed “qualified investors.” Even after that designation, however, those regulators must receive permission from each issuer to view their deal performance data and prospectus in order to monitor the sector.

So if regulators can't get the description of the securities, market participants certainly won't. So what good is a price if you aren't really certain what is being traded?

In addition, the discussion in the FT article presupposes the CDOs are passive CDOs, meaning the assets are assembled and the CDO is structured before it is sold to investors. Yet many CDOs are "active" or "managed" CDOs, meaning blind pools. Blind pools that are tranched, often with leverage and often buying other CDOs or "CDO squared" (CDOs of CDOs). That means the investors pony up money before the fund (it is like a convoluted mutual fund) is formed, and the managed gets to trade it over its three to five year life. No CDO manager is going to disclose his holdings (it would put him at a competitive disadvantage) but how can you value it otherwise?

So how do we know these things are chock-full-o'-subprime paper? Well, Yves gives us this, from the Financial Times:

What makes the CDO sector unusual is that it has exploded at such a breakneck pace with bankers packaging bonds, loans and other debts into ever more complex structures. Last year alone, about $1,000bn (£500bn, €745bn) in cash and derivatives CDOs was issued in Europe and the US, according to data from the Bank for International Settlements. More than one-third was composed of asset-backed securities, often including low-grade mortgages.

Let us first note that the term "asset-backed security" or ABS denotes a quite diverse set of instruments; "ABS" is not a synonym for "MBS." ABS issues can be and are backed by commercial loans, student loans, credit cards, auto loans, insurance premiums, aircraft leases, and probably a few dozen other asset types. When an ABS is backed by mortgages, it can, in fact, be backed by "high-grade" mortgages. (Remember the tranche versus pool problem: you can have a low-rated security tranche that is backed by a pool of very high-rated mortgages; the rating on the tranche is due to its subordination in payment priority within the security, not the quality of the collateral, since it's backed by the same collateral as the high-rated tranches.) So BIS tells us that "often" there are low-grade mortgage securities in the one-third of CDO collateral that is ABS. If you wish to claim without reservation that subprime mortgages are driving this dog cart, you're braver than I am. We just got told that not even the regulators get to see the prospectuses.

Of course the fearless reporters of the New York Times and its friends are getting on- or off-the record quotes from industry insiders claiming or implying that the CDOs and hedge funds under pressure right now are the ones heavily invested in subprime. I am only observing that not every industry quote-bot knows what it is talking about and it is quite possible that some participants have an interest in exaggerating the "subprime" part.

The curious part of it all, for me, is this question of "liquidity." Or, more properly, "illiquidity":

As this explosion has occurred, some corners of this universe have already become relatively widely traded and transparent. Every day in the London and New York markets, for example, billions of dollars worth of deals are struck involving indices of derivatives on well-known corporate bonds – making it easy to obtain prices.

However, many other such products are created by bankers directly with their clients and then simply left to sit on the books of an investor. Since such instruments typically last three to five years – and the CDO boom is so recent – many have not come to the end of their life. Nor have they been traded. Christopher Whalen of Institutional Risk Analytics, a consultancy, says: “The lack of a publicly quoted market for CDOs and like assets is exacerbating the liquidity problems for these assets beyond the underlying economics, for example, in subprime real estate.”

As Yves notes, it sounds as if Mr. Whalen is suggesting that the illiquidity of CDOs is exacerbating the illiquidity of CDOs (maybe that's the "squared" part?). But you can see why some mere mortgage punk like me gets puzzled here: was there any asset created in the last five years or so that was more liquid than mortgages? Anyone remember that part about how the investment community was beating our doors down and in fact buying up us mortgage originators as a package in unquenchable thirst for product? How liquid can you get? It wasn't quite as bad as the day-trading thing--you probably didn't get subprime whole loan bid color from cab drivers--but I'm having a hard time remembering the secretive part of the whole thing.

I can't be the only one who suspects that "illiquidity" is in some quarters the new term for "I don't like the bid." Remember all the uproar in March and April about the deterioriation of the whole-loan market for Alt-A and subprime? I can say from personal experience that nobody likes being offered par when your profitability requires you to get bids of 102.50, but that doesn't make the market "illiquid." It does suggest to me that someone has some explaining to do, not about subprime mortgages, but about these CDOs. How did we get "illiquid" securities backed by "liquid" assets? That's some impressive financial magic.

Ponder this, as well:

Some bankers and policymakers argue that this is simply a teething problem that will fade as structured finance becomes more mature. History suggests that most opaque, illiquid markets eventually become more transparent when they grow large enough – and behind the scenes, the Bear Stearns hedge fund problems are prompting bankers and investment managers to re-examine their valuation techniques. . . .

I am not a historian of financial markets, so perhaps it is true that the Whigs always win in this regard. But I would be inclined to think that perhaps it is true that in some cases "opaque, illiquid markets" become large enough to implode spectacularly before they ever get around to becoming "transparent." In fact, I wonder if in certain cases "opacity" is a feature, not a bug.

I do know enough of the history of the mortgage market to be willing to claim that it was, once upon a time, an opaque and illiquid market that did indeed become both very large and highly transparent for quite a while there. You can get an amazing amount of information about one of those nice low-yield boring vanilla GSE MBS, you know, not to mention a price right off the old Bloomberg terminal. Now, you might want to say that in the last few years somehow that famous liquidity and transparency of the residential mortgage market has largely evaporated on us, right at the time that tons of unregulated private money started pouring into it and yields of 12-18% became just not good enough. You might observe that right about the time, historically speaking, when we'd managed to accumulate giant performance databases about mortgage loans, we started offering "low doc, no doc and snow doc" deals with drive-by "appraisals" and automated underwriting and tiny due diligence sampling and every other mechanism we could think of to assure that there was, in fact, no data to be "transparent" about.

So now that we've "innovated" our way into a situation in which nobody has the first bloody idea what's going on with a huge portion of recently-originated mortgage loans, we've noticed that we've innovated our way into a situation in which nobody has the first bloody idea what's going on with the securities they're in or the CDOs that buy the tranches of the securities or the hedge funds that buy the tranches of the CDOs of the securities of the mortgages that were written on a hope and a prayer and a FICO. And this is a "teething" problem? Holy Mastication, Batman, you think this thing will improve if it grows some fangs?

Perhaps certain market participants need to be reminded why we call some of this stuff "nuclear waste." Generating a jillion-gigawatts of power is always a blast. Figuring out what to do with all the leftover plutonium-239 is a drag. How that only just got to be a problem of an "immature market" is beyond me.

And while we're on the subject of revisionist history, note this little gem courtesy of naked capitalism:

See that little footnote? Alt-A is "slightly less risky than subprime"?

Except for Calculated Risk and a few other cantankerous contrarian cranks, do you remember anyone in the last five years describing Alt-A as "slightly less risky than subprime"? My, my. How the worm turns.