Friday, February 27, 2009

Oh God, I'm Fucking Blegging...

Not MM again, but I have a question. From a Financial Times article (via Balloon Juice):

The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32 per cent for the high grade CDOs. With mezzanine CDO’s, though, recovery rates on those AAA assets have been a mere 5 per cent.
How is it even possible to have an investment that is backed by collateral fall to 5% of it's original value. Housing prices have gone down, but not by 95%!

I asked this in comments at BJ (titter) and someone replied that it was because of leverage. That doesn't make sense to me. I thought institutions were leveraged, not assets. What am I missing?

16 comments:

Dhalgren said...

From a discussion on Yahoo Answers:

The problem last fall was that few large banks or investment houses had any cash to invest; ergo, the credit seizure. Banks need liquid capital for continuing operations. CDOs are no longer liquid and when banks cannot unload them, they get sold at a great discount.

NutellaonToast said...

So CDOs are selling for 5% of their value despite the fact that they could have lost no more than, what 50% (What are the worst numbers for declining housing prices?)

You can make 10:1 if hyou have a penny, then? Couldn't you?

Anonymous said...

Why are you asking this here?

Surely there's a prominent economics blogger at The Atlantic who would be happy to shed some light on your query.

I've noticed this blog drift off into irrelevancies (e.g., cat porn), but I can't imagine that The Atlantic would hire somebody who'd waste their time blogging about such trite matters.

Susan of Texas said...

The CDOs are bundled loans (very basically), split into three catagories. The super-safe loans with the lowest return are paid first, then the mezzanine, then the last catagory which is basically junk. They are getting so little money for the CDOs that after the top-rated catagory is paid there is only 5% left for the next level, and of course nothing for the riskiest level.

The ratings firms have been handing out dubious ratings for some time.

I think that's right.

Susan of Texas said...

Never, anon. In fact, Megan McArdle was split into a AAA economics tranche, then BBB politics tranche, and finally an unrated food tranche. (I wouldn't invest in the Food Channel if you have cholesterol problems.)

Her ratings were fixed too.

NutellaonToast said...

No, because the higher tranches were the only ones rated AAA and they should be paid first, but this article is saying that AAA rated investments are now down to 5%!

Marshall said...

My sense of the issue for CDO's is that first there wasn't that great of a market for the damn things anyway. Second, you make a CDO by throwing a lot of debt into a trust and selling credit default swaps on the riskier pieces of debt. Then you package the entire thing and sell the tranches.

The problem is that it is very, very hard to price these things at this point because, 1) no one really knows what the hell these CDO's are composed of, and 2) their probably isn't a hell of a lot of historical knowledge about these things.

In the aggregate their isn't a lot of demand, the banks need money, people are buying them at fire sale prices.

Anonymous said...

Ok I think it's more complicated than this, but to start typical recovery on an asset backed loan is nowhere near full value of the underlying asset. You have legal fees etc. that eat into your recovery, and in the case of houses the asset typically gets sold at sherriff's auction, which is hardly a good way to get a good sales price. Also, in this case, many of the appraisals were deliberately inflated so the loans could be closed.

NutellaonToast said...

I understand that, but how does that get to 95% off? That's not a mistake, that's fraud! If the assets underlying your CDO are worth 1/20th what you say... that doesn't make sense.

I dunno, maybe I'm just being naive, but it seems to me like something isn't adding up...

The Ignorant Investor said...

These instruments probably aren't vehicles for interest payments from the mortgage payments alone. There's probably some form of additional action in there in which one party promises to pay the holder money if X happens, but now that X has occurred that party is non-performing and the payment isn't coming. So the value of the instrument drops like a stone.

Marshall said...

The underlying asset isn't necessarily worth 5% but that's all anyone's willing to pay. The market makes no sense because there isn't any information on this shit.

The whole rational market theory is bull because it thinks that the market runs on information priced in. That's true except for the fact that the information is generally people's opinion (there is a reason that MM is considered intelligent in these circles) without a hell of a lot of real fact foundation.

NutellaonToast said...

Marshall, so you're saying that the assets behind the CDO may or may not be worth 5%, but since no one has any frickin' idea, that's all they're willing to pay?

I'm a pretty cynical fucker, but I have a hard time believing that even the must scrupulous broker would create a CDO whose actual worth could ever get to 5% it's original worth. If I were a gambling type, I'd get a few of the lower priced ones on the assumption that people are over reacting too far in the negative end.

Then again, I don't actually know anything so don't listen to me. (Some of us are aware of our limitations, MEGAN!:))

Marshall said...

Well if everyone is saying on general principles that a particular class of assets isn't worth shit then there is almost no market for it. If there are a couple of people who are willing to buy them then they will take them for the lowest price possible.

It doesn't matter what these things are worth. Hell people where buying these things when the they thought they were worth something for more than what they were actually worth due to an idiotic idea of the actual default rates of the underlying loans.

Now that no one knows what the actual default rate will be even for what is generally considered prime paper then I'm not surprised that this stuff is selling for 5%.

Now to give my disclaimer. I read very widely and this is my sense of what is happening. I don't have any first hand knowledge nor have I personally talked to any body who actually invested in this stuff. I have talked to people who know people but that could mean anything.

Anonymous said...

Following up on my post from before, the fraud explanation is almost definitely part of the equation, especially in the subprime area. The "tranching" also contributes to the almost total losses though. Since the losses are assigned to the securities by tiers, it was assumed that with a 5% default rate only the lower 5% tranches would take any losses. With default rates on some really bad stuff at 25% and climbing, the tranche representing the 5-25% seniority is now almost totally wiped out. This causes further problems, because now the holders of say the tranches representing 25%-50% are worried that they are also going to get wiped out. So what to pay for a bond which may be worth almost full face value, or may get completely wiped out? It's not really a situation where you get partial recovery, you are either assigned defaults, with next no recovery, or you are not assigned defaults, and you get all your money back. Hence the problem with valuing the "toxic" stuff. FYI, I'm not a professional or anything, so I may be completely wrong on this, but this is my understanding from reading other blogs.

NutellaonToast said...

Yeah, I've read all that stuff, too. It's just that, I thought there was some REAL value to these CDOs, that is, the incoming money from the people paying the loans the CDOs are based on. Unless you believe that 95% of those loans will default, why would you value the CDO at only 5%?

I understand why the price would change. What no one has satisfied me of is how it could possibly change SO EXTREMELY. I mean, that's like telling me that houses are selling fro 5 bucks. You can't even BUILD a house for 5 bucks so it'd be impossible to sell one for that. Something isn't adding up to me, as I keep repeating over and over. Maybe I'm just dense...

Karl Hungus said...

Marshall, so you're saying that the assets behind the CDO may or may not be worth 5%, but since no one has any frickin' idea, that's all they're willing to pay?

Yes. That's exactly it. No due diligence was done when the CDOs were packaged and sold, and no due diligence was done by the bond rating agencies. In fact, there are documented cases of some CDO pools not being downgraded from AAA until over a third of their constituent subprime mortgages had gone delinquent.

Consequently, since no one knew exactly what went into the CDOs, no one is willing to pay more than pennies on the dollar to buy them now. This is why the financial industry is so desperate to defer or cancel entirely the implementation of mark-to-market accounting for these assets. They much prefer the mark-to-make-believe system they have now, wherein they can pretend that these "assets" still have some value in the marketplace.