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House of Cards

Written By Brian Hicks

Posted December 8, 2007



Still having trouble getting your head around exactly what a collateralized debt obligation is?

Well, on that score you’re hardly alone.

CDO’s after all are rather arcane and complex products of financial engineering. That makes understanding them and the dangers that they pose difficult for most folks.

That’s why if you’re still not real sure about how these investments work I urge you to click this link to piece by Felix Salmon at entitled: What’s a CDO? It’s a great visual explanation of how a CDO works and it’s 100 times better than anything that I’ve read so far on the subject.

It paints the picture in ways that words never could. And it shows exactly what one of these bits of financial engineering needs in order to stay completely solvent.

I say that because what most people don’t seem to get about CDOs is that they are essentially paper derived from other paper. As such, their cash flows are not at the top of the money funnel by a long shot.

That’s the reason why these CDOs are so troubled in the first place, and why the bottom tranches of them have essentially become worthless.

Now is that one great visual or what?

Of course, it would have all worked out just fine if mortgage defaults stayed within their historical norms –but they haven’t by a long shot. That has blown those models completely out of the water and out of the money thanks to all of that "easy" mortgage money.

So how big in dollar terms are these troubles? Well, that’s the $1.3 trillion dollar question for everyone that is holding CDOs.

In short, it’s a "how low can they go?" deal, and so far the hopeful thinking is that it’s somewhere north of 70 cents on the dollar.

That’s why various "back of the envelope" estimates have pegged the losses at somewhere between $250 and $400 billion dollars.

But a hint at the actual numbers came in a report by Barclays on Thursday. Here’s what they think.

From Bloomberg by Jody Shenn: Top CDO Classes May Lose 80 Percent, Barclays Says.

"U.S. mortgage assets in collateralized debt obligations have lost so much value that the top classes of the securities may be worth as little as 20 cents on the dollar in a liquidation, Barclays Plc analysts said in a report.

"About 20 percent to 30 percent of principal would be covered for the ‘super senior’ portions of mezzanine asset-backed bond CDOs, which mainly contain mortgage bonds and other CDOs initially assigned low investment-grade ratings, Barclays said in the report yesterday. The senior-most classes of CDOs containing highly rated asset-backed bonds would recoup 30 percent to 65 percent, it said.

"Determining accurate prices for the collateral is hard to do, the New York-based analysts, Joseph Astorina, Elena Warshawsky and Wei-Ang Lee, said. ‘We believe our methodology is analytically rigorous and represents a good jumping off point,’ they wrote.

"The Barclays analysts based their estimates partly on prices implied by the various series of the benchmark ABX and CMBX credit-default-swap indexes, on Nov. 30. The method has some ‘significant limitations,’ they wrote. Mortgage-bond credit-default swaps offer payments to buyers of protection when the securities aren’t repaid as expected."

So there you have Barclays’ take on the matter, and it’s a lot less than that 70 cents on the dollar everyone who holds these CDOs is still talking about.

And given what we witnessed with an E*TRADE fire-sale of these things last week, Barclay’s analysis is pretty much spot-on. E*TRADE got a whole 27 cents on the dollar for their CDOs when push came to shove.

So that’s why the banks are now doing everything in their power to keep these securities from being accurately priced in a "marked to market" sale. The losses would be huge.

Heck, even at 50 cents on the dollar those losses would be as high as $650 billion according to the back of my envelope.

The problem for the markets, of course, is that they can’t keep these toxic CDOs buried forever, since ratings downgrades and proper valuations will force their sale through various triggers within the contracts. That’s the domino effect that so many fear.

So what does it all mean?

It means that there is quite a bit more bad news out there since the banks have only confessed to a very small part of these losses.

It also means that you can practically kiss the structured investment vehicles good bye.

Because not only will this process destroy the value of the CDOs themselves, but it will also make the SIVs essentially worthless too since in many cases they used these same CDO’s as collateral for other borrowing.

In short, it’s a total house of cards. Or better yet picture this….the biggest snowball you’ve every seen rolling down a hill.