When CDOs Trump Paris Hilton, There's a Problem

Repeat after me: CDO's could be the next "bad thing" in the history of bad investments. People have heard of "Pyramid Schemes", "Junk Bonds", "S&L Crisis" and more recently, "Sub-prime mortgages" but it's time for the general public to get ready for CDO's.

June 27 (Bloomberg) -- If you're like me and can't seem to get your arms around the concept of home loans pooled into mortgage-backed bonds packaged into collateralized debt obligations carved up into tranches combined to form other CDOs (CDOs-squared), you may wonder what all the hullabaloo has been about these past few weeks.

Unless you're a Bear Stearns Cos. stockholder or an investor in a hedge fund that owns the riskiest piece of a CDO (the equity tranche), the owners of which line up behind everyone else when it comes time to get paid, why should you care about complex Wall Street structured-finance products designed to turn a hefty profit without landing the issuer in jail?

Answer: Because losses in one area have a way of rippling through to others; because risk is a four-letter word, especially if priced improperly; because uncertainty about the value of illiquid, opaque securities backed by home loans breeds risk aversion on the part of mortgage lender and CDO investor alike; because the lightly regulated derivatives market has become so big and so diffuse that some out-of-nowhere event may bring the domino theory back for a retest; and because each of us, directly or indirectly, owns a small piece of the rock.

When he was Federal Reserve chairman, Alan Greenspan extolled derivatives as a way to unbundle and transfer risk to those willing to assume and manage it.

But first the risk has to be identified and priced as such. Many CDOs were considered practically risk-free, with their ability to deliver a steady, reliable return month after month.

Safety in Numbers

It's true there's safety in numbers. Put enough junk bonds or subprime mortgages into a composite entity, and a default here or there isn't going to matter.

It may be easy, with the benefit of hindsight, to say ``there was insufficient capital at the very beginning, but it was not impossible to determine it at the closing date based on the underwriting characteristics of the loans,'' says Sylvain Raynes, a principle at R&R Consulting, a structured valuation boutique in New York, and author, with Ann Rutledge, of ``The Analysis of Structured Securities.''

The delinquency rate for subprime loans rose to 13.8 percent in the first quarter, according to the Mortgage Bankers Association. It was 11.5 percent a year earlier.

When the collateral in residential mortgage bonds is impaired, ``nothing will undo the losses,'' says Joseph R. Mason, associate professor of finance at Drexel University in Philadelphia. ``It's a static pool of investments, a brain-dead trust.''

Buying Time

With the residential real estate market continuing to deteriorate, mortgage-related derivatives aren't only a concern for sophisticated investors, rating companies and regulators. Subprime delinquencies may cause problems for everyone from potential homebuyers to small investors to the Federal Reserve to the man on the street. It's something everyone should care about.

If you are a Bear Stearns shareholder, you should care. The securities firm will inject about $1.6 billion into one of its failing hedge funds to prevent a fire sale of illiquid assets, including CDOs, by creditors. The stock has lost $6.46, or 4.4 percent, since the announcement.

In becoming its own lender of last resort, Bear Stearns bought itself some time. If neither housing nor market conditions improve, time may not be on its side.

Hedge funds should care. The over-the-counter CDO market is opaque. The value of any CDO is primarily model-determined. There is no active market and no fair market value. It's a kind of don't-ask-don't-tell-'til-you-gotta-sell system.

Making a Mark

Once a CDO is sold, it forces other investors to revalue, or mark to market, that security. Last week, creditors of Bear Stearns's hedge funds seized collateral to cover the funds' losses and ended up selling only a small portion of the assets. It's not far-fetched to think other lenders to other hedge funds will come a knockin', forcing liquidations into a poor market.

The small investor, who may have no idea what a CDO is, should care.

``We should care because our money market account, pension account, insurance company all may be invested in these securities, which have not been tested in a down cycle,'' says Joshua Rosner, managing director at Graham Fisher & Co., an independent financial-services research firm in New York. ``We should care because as we saw last week, an asset carried at a value determined subjectively maybe be worth a lot less when it's traded.''

S&L Crisis

The Federal Reserve should care. While Bear Stearns's bailout of its hedge funds is being compared to Wall Street's rescue of Long-Term Capital Management in 1998, a better paradigm might be the savings and loan crisis in the early 1990s. Insolvent thrifts saddled with -- guess what? -- bad real estate loans depleted the now-defunct Federal Savings and Loan Insurance Corp., which provided deposit insurance to S&Ls. The U.S. government created the Resolution Trust Corp. to dispose of bad loans, auction off the underlying properties, shut insolvent thrifts and arrange for solvent institutions to assume the performing loans of insolvent ones.

The result was a true credit crunch, with banks unable to make new loans until they repaired their balance sheets. The economy hobbled along until the process was complete.

Nowadays banks are only a small part of the home-loan market. Outside the banking system, the situation is worse. Rising defaults on subprime mortgages have forced some 60 mortgage companies to close or sell their operations since the start of 2006, according to Bloomberg data.