CDOh no!

This Economist article summarizes the current situation nicely. Notice the doomsday scenario in which bond insurers suffer a ratings reduction, which has spillover effects in the muni and state bond markets. This was mentioned previously in a comment here but I hadn't appreciated the seriousness of it before.

I suppose there is some muni-treasury spread index I should be betting on?

Over the years I've noticed a lot of my super-rich friends in fixed income keep a disproportionate (at least according to naive portfolio theory) fraction of their net worth in munis -- probably because of the tax benefit and because fixed income people always think equities are airy fairy overpriced and can never bear to place a big bet there. I'm going to see if any of them are worried about spillover into their personal portfolios if the bond insurers take a downgrade.

CDOh no!

Nov 8th 2007 | From The Economist print edition


With trades scarce and losses mounting, it is going to be a harsh winter.

IT WAS not a good omen. This week Lewis Ranieri, a pioneer of mortgage securitisation in his “Liar's Poker” days at Salomon Brothers, sold his property-financing firm because the subprime crisis had cut it off from fresh debt. If the industry's godfather can't navigate the storm-tossed markets, what hope its greedy children?

Banks that a few months ago were falling over each other to underwrite mortgage-backed securities and the labyrinthine pooling structures, known as collateralised-debt obligations (CDOs), that sit atop them, have admitted to more than $30 billion in losses. That figure is set to rise sharply as mortgage defaults in America climb. Citigroup estimates that big banks may be facing $64 billion in write-downs, excluding its own figures—and it was one of the top two underwriters of CDOs. Banks will be dealing with the pain for a lot longer than anyone imagined only a couple of months ago.

Most CDOs were engineered to provide both yield and safety, with a thick band of each rated AAA or even better, “super-senior”. Lower-rated tranches have been in trouble for months. But the prospect of a collapse in the value of the supposedly safe portions terrifies the banks—not surprisingly, since there is at least $350 billion-worth of such CDOs outstanding.

This looks all too possible now that rating agencies have started to downgrade AAA-rated CDOs, some of them by several notches (14 in the case of one notorious tranche). The agencies have given warning in the past month that they might downgrade another $50 billion-worth of top-rated CDOs, and that looks like the tip of the iceberg. One fear is that this leads to a wave of hurried sales, because many institutional investors are allowed to hold only AAA-rated paper. In addition, default notices have been issued on more than $5 billion-worth of CDOs, as senior investors try to grab what they can.

The uncertainty is compounded by the difficulty of finding a “fair value” for these complex instruments. The fall-back method recommended in a recent paper by the Centre for Audit Quality, an industry research body, is to employ “assumptions that market participants would use”, a technique known as “Level 3”, which becomes subject to strict accounting regulations in America on November 15th. But “Level 3 is not that useful,” confesses a risk controller at a big European bank. Banks have tended to use it as a bucket into which they throw any securities they find hard to value and then make an educated guess at the price. Among Wall Street firms, the soaring amounts of Level 3 securities now exceed their shareholder equity.

Finding a better indicator of market prices is no easy task, however. One measure, though an imperfect one, especially for CDOs, is the ABX family of indices. These relate to derivatives linked to subprime, which are traded even when the underlying bonds are not. The ABX indices are near record lows, having fallen precipitously in October. Even the top tranches are well below par value (see chart). According to Citi, some AAA-rated CDO tranches are faring even worse—at a mere 10 cents on the dollar.

Most banks are probably reluctant to mark down their assets that far. Citi and Merrill Lynch lead the list of shame, with combined write-downs of more than $22 billion. But others may just be slower in coming clean—even the teflon traders at Goldman Sachs. CreditSights, a research firm, estimates Goldman's potential CDO-related charges at $5.1 billion, for instance. On November 7th Morgan Stanley said it would write down its assets linked to subprime by $3.7 billion. For the first time, there is serious talk of banking giants running short of capital.

European banks can expect more grief, too. UBS, a Swiss bank, has reportedly been criticised for booking its mid-quality paper at twice the level implied by the ABX index. Marcel Ospel, its chairman, faces mounting pressure to resign after the bank reported big losses on fixed-income securities in the third quarter.

Banks are not the only ones who need to worry. Hedge funds hold more than 45% of all CDO assets, according to the IMF. Insurers are exposed, too; American International Group, the world's largest insurer, this week fell far short of earnings targets because of mortgage-related problems. In addition, one obscure but important corner of the industry faces a fight for survival over its subprime exposure: the specialist bond insurers.

In return for a premium, bond insurers guarantee repayment of interest on a variety of debt securities in case of default. Their mainstay used to be municipal bonds, but over the past decade they moved aggressively into structured finance. Before October, it was thought that the two biggest, MBIA and Ambac, would get away with losses in the low hundreds of millions. But the rating agencies' assault on high-grade CDOs, the bread and butter of the insurers' structured business, raises the prospect that they could run low on capital. Analysts at Morgan Stanley forecast combined losses for the two firms of up to $18.7 billion. Even the minimum expected loss, a much lower $3.3 billion, would be a huge blow for companies with combined equity capital of just $12 billion.

Some think the rating agencies will eventually have to strip the bond insurers of their cherished AAA ratings. They are loth to do this because it would “wreak havoc”, not only in structured products but across financial markets, says Andre Cappon, a consultant. New issues of municipal bonds could slow dramatically, since many borrowers rely on the insurers' top rating to enhance their own creditworthiness. Over $1 trillion of debt issued by American cities and states—much of it held by retired people through funds—might have to be downgraded. Public-private partnerships in Britain, which are also customers, would also be affected.

For those holding CDOs, things could get worse before they get better. Tim Bond of Barclays Capital points out that defaults on subprime loans are still accelerating in America, particularly on mortgages made since 2006. This will take time to feed through to CDOs, via mortgage-backed bonds, but feed through it will. A consumer-credit slump, which looks increasingly likely, would clobber securities backed by credit-card and car loans, which are also pooled in CDOs. That would be all the beleaguered banks need.

Yikes!

From the comments on the previous post More mark to model:

It’s worse than you think. Even the top brass at the big C (our nations largest) don’t know how much toxic waste sub prime CDOs they’ve got on book, and off book in siv s. C is not nearly alone. Your idea about GS...it’s is very unlikely to be a safe haven and the list goes on and on and on. The problem takes on new proportions of fugly when you realize that the monolines (bond insurers) are way in over their heads. Counter party trust is in bad shape. This mess cascades into a true shit avalanche by summer 09 during the next round of mortgage re-sets. The Dollar is being deserted like lifeboats leaving the Titanic. (Look what the dollar did at 9pm on the forex market this evening... a brief period of free fall during a long down trend.) Make no mistake about it this doesn't end pretty. The fed has a grim choice...save the dollar and plunge the country into depression or support the economy...as it appears to be doing with lower interest rates... and generate hyperinflation and a dollar crash. Suggested reading, Nouriel Roubini blog and Calculated Risk.

Funny story: my brother was at an event in Minneapolis about 10 days ago where Rob Rubin was the keynote speaker. During Q&A my brother asked him about subprime, SIVs, etc. and Rubin replied rather categorically that they weren't a problem for Citi. The local paper covered the story but not the national media.

StarTribune: Citigroup and other giant U.S. banks are not imperiled by subprime debt, despite the fact that they own tens of billions of dollars in debt linked to the deteriorating mortgage markets, former U.S. Treasury Secretary Robert Rubin said in Minneapolis on Wednesday.

Rubin, who was a Goldman Sachs executive before serving as President Bill Clinton's Treasury secretary, said the U.S. economy has bigger worries than subprime debt, ranging from the fear of consumer spending hitting a wall to the sagging international value of the dollar.

At a conference sponsored by the Dorsey & Whitney law firm, Rubin found himself answering questions about the growing troubles of the U.S. financial system stemming from the lax lending standards that prevailed during the housing boom.

The Bush administration has pushed the money-center banks to create a fund to avert a panic sell-off of subprime mortgages -- and the securities backed by those loans, often referred to as structured investment vehicles, or SIVs.

The efforts to create that $100 billion fund should not be seen as an effort by Citigroup and other major banks to protect themselves by propping up the subprime market, said Rubin, who is now a Citigroup director and chairman of its executive committee.

More than 95 percent of Citigroup's investments in SIVs are fully financed through the rest of 2007 and the bank has the money to cover losses if the value of subprime loans continues to fall next year, he said.

"I think the problem with this SIV issue is that it's been substantially misunderstood in the press," said Rubin, who has a considerable personal stake in the fate of Citigroup. The banking firm paid him $17.3 million last year.

"The banks appear to be in fine shape," he said. "That's not a problem."

The SIV issue isn't critical for the economy, he insisted.

"It's massively less important that it's been presented," Rubin said. "It's been presented as a sort of centerpiece of what's going on. I just don't think that's right."

More mark to model

Exactly what will certified accountants say about the balance sheets of Citi, Merrill, et al. at the end of the year? We may need a modification of financial accounting rules that allows for error ranges and Monte Carlo simulation in the reported results :-)

Can anyone guess when financials as a group will be oversold and I can go bargain shopping? Anyone recommend a good ETF for this purpose? (IYF, IYG, VFH, ...)

Earlier I had heard about foreign banks (e.g., in Germany) as big buyers of toxic CDO tranches, but now I learn that our sophisticated investment banks are also on the hook! (Goldman, perhaps, excepted?)

WSJ: Citigroup Acknowledges
It Can Only Estimate Write-Offs

By MICHAEL CONNOLLY
November 6, 2007

How much more will Citigroup Inc. and other banks end up having to write off? It's still anyone's guess. In a Citigroup conference call Monday, a day after the bank said it expects it might have to record losses of $8 billion to $11 billion this quarter, likely wiping out net profit, Chief Financial Officer Gary Crittenden acknowledged that these numbers are an estimate of the write-downs the bank may need to take on $55 billion in subprime securities and collateralized debt obligations. It "can't give any assurance" that the loss won't grow worse, or perhaps shrink, as the quarter progresses, he said.

Our reporters write that investors were especially unnerved by the fact that the big U.S. bank announced the additional write-downs just weeks after saying third-quarter losses due to the bank's subprime exposure would be $1.56 billion. The new, vastly bigger losses calls into question Citigroup's ability to measure its holdings, while sparking wider fears that the credit crunch is continuing unabated. Citigroup officials said it will take the bank until the middle of next year to iron out the mess created by the recent credit-market turmoil.

Investors voted with their pocket books, sending Citigroup shares down 6.2% in New York Monday after the bank said it will need much longer to dig itself out of a hole that has deepened dramatically in recent weeks. The steep share drop showed that any relief among investors' over Chief Executive Charles Prince's departure was quickly eclipsed by concerns about continuing losses the bank may face due to securities underpinned by subprime mortgages.

The crows come home to roost? Recall that financial firms have posted record profits in recent years, accounting for a larger and larger fraction of all S&P 500 earnings.

Will super senior tranches suffer losses, or are they merely suffering from contagion?

WSJ: Why Citi Struggles to Tally Losses Swelling Write-Downs Show Just How Fallible Pricing Models Can Be

By CARRICK MOLLENKAMP and DAVID REILLY
November 5, 2007; Page C1

When the market for mortgage securities entered a meltdown over the summer, financial firms holding billions of dollars of hard-to-trade assets used mathematical pricing models that were heavily dependent on credit ratings. When the credit-rating firms began a massive downgrade campaign last month, firms such as Citigroup Inc. and Merrill Lynch & Co. saw the value of their holdings plummet.

Citigroup's struggles to put an exact number on its losses demonstrate just how fallible the models can be, and how serious the consequences. Last night, Citigroup said that the downgrades will result in a reduction of fourth-quarter net income of $5 billion to $7 billion. That follows a third quarter when Citigroup recorded mortgage-related write-downs of $2.2 billion, including losses on subprime securities and fixed-income trading.

The latest update, much of it involving securities linked to subprime mortgages, follows a revision made late last month by Merrill Lynch that increased third-quarter write-downs to $7.9 billion from an earlier estimate of about $4.5 billion for exposure to debt pools and subprime loans. As a result, analysts are beginning to see Merrill's big hit as less of an anomaly than originally thought.

"We estimate that there's over $10 billion of write-downs in the fourth quarter for the industry for banks and brokers," said analyst Mike Mayo, who covers financial firms for Deutsche Bank. Mr. Mayo said his estimate is based on exposure to debt pools and mortgage securities and includes Citigroup, Bear Stearns Cos., Morgan Stanley and Bank of America Corp. Citi's updated write-downs could be included in its coming quarterly filing with U.S. securities regulators.

The source of Citigroup's write-down is at least as significant as its size. The bank's estimate of its losses has changed so rapidly in large part because the models it used to value hard-to-trade securities relied heavily on credit ratings, according to people familiar with the models.

That made the bank highly vulnerable when, in October, ratings firms Moody's Investors Service and Standard & Poor's slashed, or put on watch for downgrade, the ratings on tens of billions of dollars in securities.

It is unlikely that Citigroup is alone. Ratings play a big role in valuation models used by many banks, investment funds and insurance companies. Meanwhile, the market for securities linked to subprime loans has deteriorated in recent weeks as defaults have confirmed some of analysts' most dire forecasts, increasing the likelihood of further ratings downgrades.

Citigroup's subprime exposure -- and source of its problems -- is found in two big buckets that together total $55 billion in its securities and banking unit, the bank said. The first bucket totals $11.7 billion, including securities tied to subprime loans that were being held, or warehoused, until they could be added to debt pools for investors. The second, totaling $43 billion, covers so-called super-senior securities.

These highly rated super-senior securities are portions of collateralized debt obligations, or CDOs. CDOs are repackaged pools of lower-rated securities backed by subprime loans into pieces with different levels of risk and return. Analysts estimate that $60 billion in such super-senior tranches are sitting on the books of banks, insurers and investment funds.

The troubles stem back to the heyday of the U.S. housing boom, when Citi became one of the biggest players in the lucrative world of CDOs backed by subprime-linked bonds. Overall, Citi was the second-largest underwriter of CDOs in 2006, doing $34 billion in deals, according to data provider Dealogic. ...