Magazine

A Chain Reaction in Shaky Debt?


The fate of one exotic security may signal more trouble ahead for the credit markets. In early November, a collateralized debt obligation called Carina CDO apparently started liquidating its $450 million portfolio filled with bonds backed by subprime mortgages and pieces of other CDOs. These sales prompted credit rating agency Standard & Poor's (MHP) to downgrade Carina's bonds from AAA to junk in a day.

The fear is that more dramatic downgrades could follow, perhaps setting off a chain reaction that might trigger further fire sales, extend the credit meltdown, and threaten the economy. "Systemic risk is sky high," says Morgan Stanley (MS) strategist Gregory J. Peters.

The complexity of such structured finance deals as Carina, which piled one esoteric bond upon another, have amplified threats in the credit market. In the housing- market heyday, investment firms packaged subprime and other risky loans into investment pools that issued bonds. Those securities were then grouped together into CDOs, whose own bonds were sometimes sold to other CDOs. Credit-rating agencies graded securities all along the chain.

But when home prices started to sink and troubled borrowers stopped making payments on their loans, the pyramid began to crumble. First the ratings on mortgage-backed securities took a hit. Moody's Investors Service (MCO), for example, has downgraded $56 billion of such bonds, creating problems for the CDOs that own them. In turn, Moody's has cut the ratings on 338 CDO-related bonds this year and has another 734 under review for downgrade.

Such rating changes create a particularly dire situation for some CDOs. The rules governing Carina and many others dictate that certain events can put a CDO into technical default. In the case of Carina and at least 13 other CDOs, technical default occurred because the ratings on underlying holdings dropped too far. With more securities under review by the rating agencies, dozens of additional CDOs may be headed for the same fate, according to research by Citigroup (C) strategist Ratul Roy.

FEEDING ON ITSELF

More defaults would have serious implications for the already troubled credit markets. When a CDO falls into technical default, investors in the top tier of bonds usually get additional rights. They can collect all the interest payments for themselves, leaving other investors with nothing. So investors in the lower part of the food chain, including hedge funds, investment banks, and other CDOs, take a big financial loss.

In the worst-case scenario, the top-level bondholders can force the CDO managers to dump assets. Only investors in Carina's bonds are believed to have done that so far. If more do, additional fire sales could depress prices further and create more panic in the markets.

Making matters worse, another wave of mortgage delinquencies might be on the way. Some $362 billion worth of subprime loans are due to reset to higher interest rates in 2008, according to Banc of America Securities (BAC).

Rating agencies are also looking at another segment of troubled bonds, those backed by Alt-A mortgage loans; some $675 billion of Alt-A bonds were issued in 2005 and 2006. They're considered less risky than subprime ones, but the underlying mortgages often came with teaser rates that will jump higher soon. On Nov. 9, S&P, which like BusinessWeek is owned by The McGraw-Hill Companies (MHP), put $2.1 billion of bonds backed by Alt-A mortgages on watch for downgrades.

If such downgrades occur, billions worth of CDOs holding the bonds could get hit. That would keep the vicious cycle going, making it harder for borrowers to find loans and threatening all manner of mortgage-related investments.

By David Henry


Silicon Valley State of Mind
LIMITED-TIME OFFER SUBSCRIBE NOW

(enter your email)
(enter up to 5 email addresses, separated by commas)

Max 250 characters

 
blog comments powered by Disqus