Subprime shakeout could hurt CDOs
Complex structures helped fuel mortgage boom, but may suffer losses
By Alistair Barr, MarketWatch
Last update: 6:38 p.m. EDT March 13, 2007
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SAN FRANCISCO (MarketWatch) -- After a mortgage is sold, it's usually packaged up with other home loans into a mortgage-backed security, or MBS.
But who buys the riskier parts of these derivatives -- the bits backed by subprime mortgages offered to poorer borrowers with lower credit scores? The answer may be collateralized debt obligations, or CDOs.
These complex structures, which are similar to a mutual fund that buys bonds, helped fuel the U.S. mortgage boom in recent years by purchasing some of the riskier parts of MBS that other investors didn't want.
They could now do the reverse, according to a recent study by Joseph Mason, an associate finance professor at Drexel University's business school, and Joshua Rosner, a managing director at research firm Graham Fisher & Co.
By exiting in search of more attractive assets, CDOs could limit the supply of money to the mortgage market, making home loans more expensive and reducing the availability of subprime loans, Mason said in an interview this week.
"We started out a few months ago trying to find out who is investing in the riskiest portions of these MBSs," Mason said. "We found the answer to the big question: the CDO sector."
"CDOs are providing the primary liquidity at this level, but they're hot money that will jump in and out of sectors," he added.
The growth of CDOs has been explosive during the past decade. In 1995, there were hardly any. Last year, more than $500 billion worth were issued, according to the study by Mason and Rosner.
About 40% of CDO collateral is residential MBS. Almost three quarters of that is in subprime and home-equity loans, with the rest in higher-quality, prime home loans, the study estimated.
CDOs have become an important part of the mortgage market because they buy the riskier parts of MBS that others don't want. The higher-rated portions, or tranches, of MBS are sold to pension funds and insurers. But if the riskier tranches aren't sold too, the whole deal is off, Mason explained.
Jim Grant, editor of Grant's Interest Rate Observer, called CDOs "the power packs of the late housing boom" earlier this month, and said they've partly replaced the old banking system in which lenders kept mortgages on their own balance sheets.
"You may remember the phrase 'banking system,'" Grant wrote on March 9. "Today, in residential mortgage finance, there is a CDO system."
Stagnant home prices and rising delinquencies on subprime mortgages have sparked concern that some riskier MBS tranches could suffer losses. That, in turn, could hit CDOs.
"Even investment grade rated CDOs will experience significant losses if home prices depreciate," Mason and Rosner said in their study.
If CDOs take some of the hit, they could exit the residential mortgage market, Mason warned.
Something similar happened several years ago. During the late 1990s, CDOs invested a lot in asset-backed securities backed by manufactured housing loans and aircraft leases. After suffering losses, CDOs got out of those sectors, Mason said.
Even today, the manufactured housing and aircraft leasing industries still feel the effects of that shakeout when trying to borrow money via the asset-backed securities market, Mason said.
These older CDOs over-estimated the benefit of diversification, Mark Adelson, head of structured finance research at Nomura Securities International, said in a 2004 report on the sector.
"Now, however, newer computer models for creating CDOs attempt to reflect diversification more accurately. The jury is still out on whether the newer models actually work better," he noted.
The implications of CDOs withdrawing from the residential MBS market could be far-reaching, Mason said.
The bottom line here is that though the chain of mortgage originations millions of dollars of leveraged securitized money can be created from a loan
that was leveraged in the first place and collateralized by the borrower through the standard 8-1 fractional reserve lending sytem. So irrationally these crooks and gangsters have figured out how to steal potentially several million from a borrowers downment of few thousand or tens of thousands of dollars. The borrower provides the only real assets our labor which was traded for the downpayment.
The sytem has collapsed on itself and the government and lenders will use the hysteria of the bogus losses to seize power and trap us in debt slavery, unless we expose them and stop them that's why it's critical to asign blame before taking any action at all.