I continue my search
for someone who can shed light on exactly what happens to the alphabet soup
of MBS and CDO and CDS when subprime default rates rise. I briefly thought I’d
hit paydirt when Alea blogged a
February paper
by Joseph Mason and Josh Rosner, with a very
enticing abstract:
The authors go on to measure the efficacy of ratings agencies when it comes
to assessing market risk rather than credit risk. They determine that even
investment grade rated CDOs will experience significant losses if home prices
depreciate…
Was this what I’ve been looking for, an explanation of the link between home
prices, mortgage-backed bonds, and CDOs? Alas, it was not to be. I’ve scoured
the whole paper two or three times now, and – well, I just can’t find
their finding. Home prices are barely mentioned in the report, and not at all
in the part of the report which deals with CDOs. I also can’t find any mention
of losses in investment-grade CDOs for any reason at all. So I certainly
can’t find any link between home prices and losses in investment-grade CDOs.
The closest thing I can find is this:
Given recent events, we now know the defaults are in the mortgage pools and
it is only a matter of time before they accumulate to levels that will threaten
rated mezzanine RMBS. Given the high proportion of CDO investments in mezzanine
RMBS, the questions therefore become: (1) when will the defaults hit CDO returns
and (2) what will be the effect when CDO investors react, as they did with
previous sectoral difficulties, by divesting the sector and moving on to new
forms of collateral?
The statement that "it is only a matter of time" before losses hit
the MBS market is especially weird in light of the fact that they haven’t mentioned
this before, and that they say earlier on in the paper that as far as the MBS
market is concerned, "prepayment risk is an entirely different order of
magnitude than default risk". It’s as though they can’t make up their mind
about default risk, and whether it’s a tiny problem or a massive one.
But in any case, all of the authors’ discussion about risks in the CDO market
centers on the probability that CDOs will move out of subprime mortgages and
into some other asset class, reducing liquidity in the MBS market and ultimately
hurting the housing market as a whole. That’s all perfectly reasonable –
but it doesn’t even come close to demonstrating that existing CDOs with investments
in the MBS market will suffer significant losses on their rated tranches.
So, the search continues. In the meantime, there do certainly seem to be winners
as well as losers from the current mess: a $2 billion fund run by John
Paulson returned
40% in June alone – and that’s after fees. I guess that losing
his fight
against Bear Stearns didn’t do him any harm at all.
And I hasten to add that I’ve nothing against commenter jck,
who runs the Alea blog and who left a very handy comment on my last subprime
post. According to him, the implied spread on BBB- rated bonds, if we can trust
the ABX index, is about 2500 basis points. That’s huge: debt securities very
rarely trade at that sort of level without defaulting. On the other hand, securities
at the bottom of an asset-backed waterfall do exhibit a huge amount of price
volatility, since a small change in the structure’s total cashflows can mean
a huge variation in recovery value.
Update: jck emails me to point out that a later
version of the paper has more detail – although it still doesn’t draw
any connection between house-price declines and CDO defaults. He adds:
I think they are misguided if they think downgrading the asset side automatically
implies downgrade of the liability side of the CDO, for example if there is
a general credit degradation with increased correlation, the junior tranches
will actually gain against the senior tranches i.e spreads will contract,
but this a draft so I will wait for the final print before getting more critical.