CDO Liquidation - Splatter zone being defined?

[GRG55]

OK folks, it looks like the solid matter is hitting the blades now...

I'm no expert on all this credit derivative financial stuff, but if I've paid attention properly to what I've learned on this site, it would seem an 11 notch downgrade from AAA to junk in one move is a serious matter. :eek:



S&P says State St-managed CDO liquidating assets

Fri Nov 9, 2007 6:48am EST
By Eric Burroughs
TOKYO, Nov 9 (Reuters) - The trustee of a $1.5 billion collateralised debt obligation (CDO) managed by State Street Global Advisors has started selling assets, apparently starting a process of liquidation, Standard & Poor's said late on Thursday.

The news from the ratings agency raised worries of similar action on a wider array of structured securities, and stirred more fears about the exposure of U.S. financial institutions to credit markets.

It helped drive the dollar to a fresh record low against the euro in Asia trading and hit regional equity markets, traders said.

S&P said it slashed its ratings on Carina CDO Ltd's top tranche of securities by 11 notches to the junk level of BB from the top-notch triple-A after it received a notice on Nov. 1 saying that the controlling noteholders had told the trustee to liquidate.

S&P also chopped its ratings on the subordinate levels of the CDO, with two falling to CCC- and eight to CC. The ratings were first assigned in November 2006.

The trustee of the Carina CDO has started selling the asset-backed securities -- residential-mortgage backed securities and CDOs -- making up the CDO at the direction of the structure's noteholders, S&P said.

"We believe the liquidation process has begun," S&P said in its statement.
CDOs repackage assets ranging from mortgages and credit-card receivables to corporate bonds into securities. The tranches of a CDO are divided so returns depend on credit risk, with the lowest tranches the first to suffer from any asset defaults.

State Street declined on Friday to say whether the CDO it manages is being liquidated. However, the bank's spokeswoman said any decision to liquidate the CDO and the financial liability from that lie with the principal note holder, not State Street.

Ratings agencies have slashed the ratings of many CDOs and structured securities this year as surging defaults in U.S. subprime mortgages and the resulting credit crunch have hit the value of their underlying assets.
Last month, S&P put 590 ratings on 176 CDOs -- including those on Carina -- on watch for a possible cut, affecting $20.6 billion in debt.

The ratings cut on the Carina CDO is more severe than would be justified by the deterioration of the underlying assets because a decision to liquidate would depress prices and affect all notes that were issued, S&P said.

S&P said the ratings on the top two parts of the CDO would only be trimmed by one or two notches if the liquidation notice were withdrawn, but any selling will lead to material losses and market prices may not recover during the liquidation period.

The liquidation notice follows an event of default notice on Oct. 22, which occurred after a collateral trigger in the structure was tripped. That notice led Moody's Investors Service to slash its ratings on Carina on Oct. 30.

S&P said 14 CDOs have received such default notices, twice as many as the agency said had received the notices a week ago. But it said it had only received a notice of liquidation for Carina, not the other 13.

Credit analysts at Bank of America Securities said in a note to clients this week they expect more hefty asset write-downs tied to CDOs as "valuation uncertainty and further market erosions will imply continued increased losses."

Link:
http://www.reuters.com/article/bonds...071109?sp=true

[jk]

Re: CDO Liquidation - Splatter zone being defined?

the real fallout is that now there are [low] market prices that should be used to price a lot of other similar instruments. this drags a lot of material from level 3 [no market info, mark to myth] to level 2 [some relevant market info for related instruments, mark to modeled relationship].

[GRG55]

Re: CDO Liquidation - Splatter zone being defined?

the real fallout is that now there are [low] market prices that should be used to price a lot of other similar instruments. this drags a lot of material from level 3 [no market info, mark to myth] to level 2 [some relevant market info for related instruments, mark to modeled relationship].

Isn't that the "nightmare scenario" for Citi, Paulson and the other Super SIV promoters?

[jk]

Re: CDO Liquidation - Splatter zone being defined?

Isn't that the "nightmare scenario" for Citi, Paulson and the other Super SIV promoters?

i think so. of course someone could argue that state street's stuff is so different than their stuff that the prices state st. gets are irrelevant. the question is whether the auditors will buy it, esp. in light of the new fasb157 and the knowledge that arthur anderson is no more.

[WDCRob]

Re: CDO Liquidation - Splatter zone being defined?

If this liquidation is going to force a lot of stuff to be repriced (or 'priced') is there an incentive for everyone with this Level 3 garbage to be the first out the door?

i.e. if one of the big players starts to sell this stuff off is there the liklihood of a panic?

[GRG55]

Re: CDO Liquidation - Credit crisis worse than LTCM - Lehman's Malvey

And just so everyone heads into a nice weekend, here's a real bit of sunshine...

Credit crisis worse than LTCM - Lehman's Malvey
Fri Nov 9, 2007 12:36pm EST
By Walden Siew
NEW YORK, Nov 9 (Reuters) - The U.S. credit crisis is now worse than the crisis of confidence following the collapse of Long-Term Capital Management in 1998 and recession risks are growing, said Jack Malvey, chief global fixed income strategist at Lehman Brothers.

In 1998, investor confidence was shaken after deep losses resulted in the collapse of Long-Term Capital, which spurred the Federal Reserve to initiate a bailout of the hedge fund to avert a wider financial collapse.
"This is the deepest correction we've ever seen in structured finance," Malvey said in an interview on Friday. "This is now worse than Long-Term Capital."

"This is so dispersed, so interlocked and the relationships among the various entities are not as evident," Malvey said in New York. "This is a painful lesson in financial engineering." [Ya figure]

U.S. Treasury debt prices rose for a fourth day, while stocks fell on Friday after Fannie Mae, the biggest U.S. mortgage finance company, said its quarterly net loss doubled, and Wachovia Corp, the No. 4 U.S. bank, warned of losses.

One-month dollar/yen implied volatility, a gauge of investor fear about greater risk in the foreign exchange market, is on pace for the biggest weekly increase since early October 1998, when LTCM was blowing up and the global economy was still reeling from Russia's sovereign default.
While Lehman now assigns a 30 percent probability of the U.S. falling into recession next year, risks may be growing, Malvey said.

"There's a lot of recession risk denial in the marketplace," Malvey said. [Evidently he hasn't been hanging around these parts] "We will find out over the next three to six quarters if we are coming close to recession or may cross over the recession line."

The collapse of Bear Stearns hedge funds in July has been followed by massive bank write-downs that have even surprised veteran bond and market analysts.

Losses are so bad that many firms are reporting additional losses just a few weeks after publicizing huge write-downs. Citigroup said this week it expects as much as $11 billion in losses from its exposure to bad mortgages tied to collateralized debt obligations, or CDOS. A month ago Citi said it cut the value of those assets by $5.9 billion.
Merrill Lynch & Co. last month announced a $7.9 billion write-down, up from $4.5 billion just a few weeks earlier.

"This sort of staccato reporting of write-downs is something with financial services that we haven't seen in quite a while, not since the S&L crisis," Malvey said, referring to a wave of U.S. savings and loan association failures in the 1980s, which were followed by a U.S. recession.

Link:
http://www.reuters.com/article/bonds...071109?sp=true

[jk]

Re: CDO Liquidation - Splatter zone being defined?

If this liquidation is going to force a lot of stuff to be repriced (or 'priced') is there an incentive for everyone with this Level 3 garbage to be the first out the door?

i.e. if one of the big players starts to sell this stuff off is there the liklihood of a panic?

i don't think there's an incentive to sell first. right now no one knows what this stuff is really worth, and so there are no bids. i think the incentive is to hold it as long as possible, especially if you can make believe it's worth something. in fact it IS worth something, at least the value derived from the underlying foreclosed properties. the problem lies in the words "derived from." [these are derivatives] the process would involve an agent foreclosing on the homes, selling them and then parcelling out the proceeds according to the derivatives' structures. a mess.

[c1ue]

Re: CDO Liquidation - Splatter zone being defined?

I second JK's view, and add this: no one is going to sell first if they can help it because doing so means a significant possibility of bankruptcy.

I underline if they can help it because there are other factors at play also:

1) cash crunch: the general miasma of fear is likely leading many depositors to head for the exits. I'm one of them.

2) dollar crunch: foreigners who had invested in dollar assets previously are likely to start seeking cutting of their losses.

The euro/dollar cross is such that even a Google investment in the first half of this year would not have yielded quite such a good return; most any other stock would be seriously negative for a euro home zone investor.

[rj1]

Re: CDO Liquidation - Splatter zone being defined?

i think so. of course someone could argue that state street's stuff is so different than their stuff that the prices state st. gets are irrelevant.

Which is probably what will occur.

[jk]

Re: CDO Liquidation - Splatter zone being defined?

a backgrounder on the state st cdo sale- nothing that hasn't been said here, but of possible use for anyone not up to speed.

Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. Carina: CD-Oh-No
Standard & Poor's said a collateralized debt obligation managed by State Street (STT) began liquidating its assets, prompting the ratings firm to slice the investment vehicle's ratings as much as 18 levels, according to Bloomberg.

• It's an important story.
• Carina CDO Ltd., the CDO in question, is the first CDO to begin unwinding.
• According to S&P, the ratings on the most senior class of Carina CDO Ltd. were lowered to BB, two levels below investment grade, from AAA, while another AAA class was slashed 18 steps to CCC-.
• For all intents and purposes that means it is practically bankrupt.
• "The chance of material losses to noteholders is high, New York-based S&P said," according to Bloomberg.

2. What Is a CDO?
Ok, something called Carina CDO Ltd. has been downgraded by S&P and has begun liquidating assets, but what does this mean for me?

• Carina was originally a $1.5 billion CDO issued in September 2006.
• A CDO, collateralized debt obligation, is a type of asset-backed security, sometimes called a "structured security product."
• That's a fancy way of saying it is something you can invest in that generates cash.
• How does that "cash flow" happen?
• First. the CDO "creator' buys an inventory of asset-backed securities.
• Asset-backed securities are finance-geek speak for a bond or a note that is "collateralized" by the cash flows generated.
• If you buy a bond, you are loaning the bond issuer money in return for regular interest payments.
• So, for simplicity's sake, a CDO creator buys an inventory of asset-backed securities and then sells the rights to the cash flows generated by the inventory to investors.
• These rights are called tranches.
• Because not all bonds and notes have equal risk, some are riskier than others, the tranches are rated accordingly.
• The highest rated tranches are Senior (rated AAA, the most creditworthy), followed by Mezzanine (rated AA to BB) and the lowest rated Equity level (which are unrated).
• Theoretically a CDO makes it possible to "spread the risk" among different investors, and this spreading of risk serves an important economic function by enabling ventures that might otherwise seem to risky to one party to obtain financing from a pool of investors.

3. Down In the Tranches
What has happened today is that the most Senor tranch of the Carina CDO (the highest rated tranch) were downgraded two levels from AAA to BB, two levels below investment grade, while another AAA class was downgraded an astonishing 18 levels to CCC-.

• Why does the downgrade matter?
• Sometimes holders of the CDO are required to liquidate if a downgrade takes place, which is called an "event of default," below a pre-determined level.
• In this case the senior noteholders may have decided on their own to liquidate following the downgrade.
• What is also unique about this downgrade is that a AAA rating, the highest rating offered by S&P was overnight lowered to CCC -.
• The CCC- S&P rating means the financial security characteristics are very weak and the issuer is dependent on favorable business conditions to meet financial commitments.
• In other words, the cash flow kicked off by the tranch in question is in jeopardy.

4. Dominoes
The liquidation of the Carina CDO was one of the issues Citigroup (C) was concerned about in their conference call this week; the point at which holders of senior notes say they are no longer willing to risk the fact that the current cash flows will continue on without impairment.

• In the conference call Citigroup Chief Financial Officer Gary Crittenden said that although the ABX Indices were implying serious value declines in real estate and ultimately cash flow impairment, Citigroup is not yet seeing these cash flows impaired.
• The key is "not yet."
• As Crittenden said, "Now, when we have thought about taking these marks we have obviously if you look at what the ABX would imply in terms of real estate price reduction it starts to imply very, very high numbers of price reduction in real estate."
• Crittenden was referring to the ABX Indices and the fact the firm is not yet seeing cash flow impairment that the indices are implying.
• As a result, they are not yet conceding defeat to the ABX Indices and not yet willing to mark accordingly, opting instead for a projected range.
• Crittenden put it like this: "I guess our view is that it's unlikely that those very high levels of price reduction in real estate will take place so what's actually happening is implicitly the market is saying that the cash flows associated with those securities have become more risky and so as we have thought about valuing those cash flows we have put different discount rates on those cash flows and that's reflecting the range that you see in the estimate here and we'll see obviously how that actually plays out over time."
• It took less than a week for the first move in this waiting game to play out.
• The forced liquidation of the Carina CDO will likely have a domino effect, spreading into the pricing and ratings of other CDOs.
• At this point it's a game of faith.
• Once investors lose faith the "reality of pricing" detaches itself from tangible meaning, creating a new world with different rules.
• Citigroup, and other firms, have been hoping to ride out the irrationality of the ABX Indices.
• They haven't counted on the fact that what once appeared irrational might soon dissolve into reality.

5. Capitulation vs. Kickoff
For equity market participants liquidation events are typically hallmarks of capitulation. In credit markets liquidation events are more often kickoffs, triggers to other liquidation events.

• If equity markets are grounded in a fundamental reality of price discovery that only temporarily overshoots on the upside or downside, credit markets live on a more slippery plane, one based on trust and faith that, despite all the fancy nomenclature, still carries the backing of little more than a handshake.
• How do we "know" the borrower standing before us is legitimate?
• We don't. We do the best we can hedging away as much risk as we can, although forgotten in the shuffle is the implicit acknowledgment that all speculation carries risk.
• One of the issues Citigroup was concerned about in their conference call this week; the point at which holders of senior notes say they are no longer willing to risk - important word - risk the fact that current cash flows will continue on without impairment.
• Consequently, the Carina CDO Ltd. liquidation event is a hallmark move toward risk aversion where the holders are saying We no longer are willing to accept the risk of potential cash flow impairment.
• They are saying We just want to get whatever price we can get for the securities.
• Now, the important risk for us going forward is that this is not a capitulation event, as equity market participants perceive, but a kickoff event precipitating increased risk aversion across the spectrum, not to mention the creation of "observable inputs" in pricing.
• As noted in yesterday's Five Things (No. 2, November 15), the new SFAS 157 provisions that firms have implemented require firms, whenever possible, to use "observable inputs" in pricing their Level Three assets.
• Forced sales, at distressed prices, create "observable inputs"; the result will be revaluation down the line and risk aversion that begets still more risk aversion.

http://www.minyanville.com/articles/S-P-C-ABX-stt-Indices/index/a/14812