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Sunday, July 01, 2007

The 100 Year Storm Part II

Yesterday we pointed enquiring Naybob readers to MSN's Jim Jubak re: the 100 year storm hitting derivatives.

Today we followup with Yve Smith at
The Naked Capitalist's take: "so far, this appears to be merely an embarrassing one-off. However, were another sizeable fund in this sector be forced to liquidate, the perception of risk could change dramatically.

...the only natural buyers of the riskier Bear assets are likely to be actively managed CDOs and hedge funds.

One mortgage investor said that while the CDO assets for sale carried high credit ratings, they were backed by such risky mortgages as to be “junk in investment-grade clothing”.

While quite a few subprime-related CDOs have clearly been carried at considerrably higher values than they were worth (and therefore also overvalued as collateral),

there is now actually an open question as to whether the recent sales represent fair value or not.

But given the severity of the move down, no one is likely to step forward to buy in meaningful amounts until they have some confidence that another shoe isn't about to drop.

In the wake of the LTCM failure, swap spreads took a full year to return to historically normal prices...

Now I happen to be pretty negative on the prospects for housing, so I'd bet on paper in this sector deteriorating in value regardless.
"

Well put and now the Nattering One pours a little of his own kerosene on this fire...

The tasty morsels from Jubak's missive are regarding price and liquidity:

"Merrill Lynch succeeded in auctioning off some collateral at 90 or 95 cents to a dollar, but other collateral didn't sell at all, even at discounts of more than 50%."

and who's holding the bag...

"Hedge funds bought about 10% of equity tranches in 2006, according to Bear Stearns. But pension funds bought more -- 18%. Insurance companies bought even more -- 19%. And asset managers bought even more -- 22%."

From the
Financial Times: global sales of CDOs hit $503 billion in 2006 and a record $251 billion in Q107.

Synthetic CDOs accounting for $121 billion in Q107 up from $92 billion in Q406. The AA & AAA tranches represent 80% of all CDO deals.

Half of all CDOs sold in the U.S. in 2006 were loaded with subprime mortgage debt, according to Moody's and Morgan Stanley.

The bulk of suprime collateral is in Mezzanine CDO's of ABS which invest heavily in BBB tranches of MBS.

New market Mezzanine CDO's issued in 2006: $200 Billion. Whats the exposure to subprime in this $200 Billion issued? 70.6%!!!

How bad could it be? Average Collateral Pool Exposure To Subprime RBMS by vintage:

Cash Flow & Hybrid Mezzanie CDO of ABS by year 03:41.2%; 04:44.5%; 05:52.4%; 06:70.6%

Synthetic Mezzanine CDO of ABS by year 03:37.1%; 04:48.5%; 05:64.5%; 06:77.1%

See March 29, 2007
The Subprime Market:Housing & Debt pg 25 for all the gruesome details.

Any tranche of a CDO with underlying collateral that is defaulting can be wiped out.

The BBB & BB tranches of subprime bonds that are serving as collateral for Mezzanine CDOs need 8% to 10% credit support; and that support is already being seriously tested.

AAA tranches also require cash flow producing collateral and can withstand up to 20% losses.

From
Accrued Interest re "advertised" equity return:

"
For Mezz Structured Finance (which are mostly residential MBS), the 2006 average was 11.6%. Today it is 65.4%. Let me say that again.

Today it is 65.4%.

By demanding such an outrageously high base-case return, the market is saying they expect defaults and recovery to be substantially worse than historical norm
."

Remember that most of the ARM resets on these no down, low down, interest only 2/28 loans have yet to occur, and as the emasculated economy weakens, unemployment worsens, housing prices decline and foreclosure rates rise, the worst is yet to come.

American Theocracy: The Perils and Politics of Radical Religion, Oil, and Borrowed Money in the 21st Century; Viking, 2006, p. 384-87

"The religiosity of the American public... is associated with misinformation about the world, policy sclerosis, and complacency, features that historically have tended to lead to mediocre leadership."

Our pathetic political and mediocre business leadership has picked finance (money shuffling and greedy yield chasing) to be the ascendant economic sector in today's economy.

Given that historically, unlike what elite's believe, the ascendancy of finance leads to neither strength, nor progress, but vulnerability as debt breeds multiple crise's.

It will be interesting to see what unfolds, how the "leadership" reacts and what the gullible complacent publics just desserts will be.

The 9-11 crisis landed us in Iraq for Bush, Oil & Halliburton, eroded our civil rights & liberties (Patriot Acts I & II) and gave further rise to a neo con police state (Homeland Security).

The Nattering One muses that the sub prime crisis fallout will further yoke the middle class debtor to quasi indentured status, AKA "
The Sharecropper Society".

On that note, have a happy "Independence" Day.

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