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Risks in the CDO Market

Felix Salmon:

Finance Blog - Market Movers by Felix Salmon: Unpacking the Risks in the CDO Market - I think it's worth teasing out exactly what the different risks in the CDO market are...[:]

First, there's the risk that holders of subprime mortgages will default on their loans. This is a known and relatively easy to quantify risk. Subprime mortgages issued in 2005 and 2006 already have high default rates, and those rates are likely to rise even higher when the mortgages reach their second birthday and higher adjustable rates start kicking in.... [T]he key risk in the market for any mortgage-backed security is not default risk but prepayment risk, and that a high mortgage default rate, in and of itself, is not necessarily particularly worrisome from the point of view of a CDO holder.

Second, there's the risk that CDO tranches, especially the riskier equity tranches and the ones with relatively low credit ratings, will start to default.... A key problem here is one of transparency: with many CDOs investing largely in other CDOs, it's very difficult often to get a handle on what the underlying cashflows are and how likely they are to be impaired.

Third, there's the discount which investors are currently demanding in order to buy illiquid securities with precious little transparency. There's talk in the market that triple-A rated CDO tranches – which, we can reasonably assume, are very unlikely to actually default – are getting bids at 270 basis points over Treasuries, or more. That huge spread is not a credit spread; rather, it's a good old-fashioned wide bid-offer spread on extremely illiquid securities. CDOs are similar in some ways to private equity, in that they tie up money for a long period of time and hope to provide excess returns over that time. They're not designed to be instruments which can be liquidated easily or quickly. If investors start being forced to liquidate their CDOs, then the price they receive might well be much lower than the actual credit risk on those CDOs might suggest.

Fourth, there's what used to be called rollover risk. If investors start liquidating their CDOs, that means there's going to be a pretty large supply of cheap CDOs on the secondary market. In turn that means that there's going to be much less demand for expensive CDOs on the primary market.... This is the credit crunch that many people are so worried about.... These four risks form a nice little circle.... But while all the risks are real, the linkages between them all are far from clear, and the different risks don't necessarily cascade onto and exacerbate each other in this way. They might – or they might not. If investors turn out to have reasonably strong stomachs, they might not want to liquidate at prices well below their entry points. And CDOs themselves, even the ones based on subprime mortgages, might not default nearly as much as homeowners. And without the passthrough mechanism of risks two and three, the vicious cycle loses a lot of its teeth.

So there is cause for concern, to be sure. But there isn't cause for panic.