Wednesday, June 27, 2007

Where's The Paper?

We are now a full week into the Bear Stearns mortgage debacle and, after big press coverage, a sizable pull back in the equity markets worldwide and a small unwind of the global carry trade, we still have little information concerning the CDO risk. And it's quite possible the markets will pretend that we really don't need to know much more.

We don't know actual pricing for a lot of the paper because no one wants to trade it, and we don't know who owns it, because no one wants to fess up. There are articles that suggest it's the hedge funds, some say it's the insurance companies and endowments, maybe some sovereign funds and maybe, god forbid, the commercial banks. But no one knows. Where's the paper?

Meanwhile, Moody's continues downgrading mortgage focused CDO's (basically corporations that hold the underlying mortgages - usually subprime - as assets and finance these assets with debt and equity; the debt is issued in tranches that get rated from AAA on down and the equity becomes the most toxic part of the capital structure) because the collateral itself has deteriorated. This means that at some point, assets will have to be shuffled - bought and sold by the CDO manager - finally setting prices for these things.

The quality of the paper is unlikely to improve in the near term. Subprime defaults continue to rise and as the CDO managers try to maintain credit ratings for their debt issues, who's going to step up and buy the low grade paper and the toxic equity as they drop like a stone? We also have a big ARM reset comming over the next few months that will affect the higher grades of mortgage paper, adding even more pressure.

There is a sizable chunk of CDO paper that will tank. A lot of capital will be wiped out. It might look like the savings and loan game all over again. We assume this isn't the case because derivatives have allowed a very broad distribution of this paper and the ability to hedge the paper's risk; but what do we really know? It sounds good, but it is quite possible that some big, well regarded institutions, in a desperate reach for yield, have built up large positions of unhedged CDO's. This is, after all, why the banks invented this product - AAA paper with a better yield. And we haven't even started talking about the overlevered, no-covenant, PIK paying LBO - I'm sorry, private equity - deals out there.

I know when my stocks are working against me, I have a tendency to avoid the truth and not look at my trading account. We all know what the elephant in the living room is all about. We'd like to think that the $10 million men running some of the world's largest financial institutions are above this kind of human behavior. I'm gonna guess they aren't. We have heard from the CEO's of UBS, BofA and CD&R; they are concerned. Concerned enough to start building up big distressed asset teams to buy all the crap they issued over the years. At a nice discount, of course.


Post a Comment

<< Home