It was not a good omen. This week Lewis Ranieri, a pioneer of mortgage securitisation in his “Liar’s Poker” days at Lewis Ranieri, sold his property-financing firm because the subprime crisis had cut it off from fresh debt. If the industry’s godfather can’t navigate the storm-tossed markets, what hope its greedy children?
Banks that a few months ago were falling over each other to underwrite mortgage-backed securities and the labyrinthine pooling structures, known as collateralised-debt obligations (CDOs), that sit atop them, have admitted to more than $30 billion in losses. That figure is set to rise sharply as mortgage defaults in America climb. Citigroup estimates that big banks may be facing $64 billion in write-downs, excluding its own figures — and it was one of the top two underwriters of CDOs. Banks will be dealing with the pain for a lot longer than anyone imagined only a couple of months ago.
Most CDOs were engineered to provide both yield and safety, with a thick band of each rated AAA or even better, “super-senior.” Lower-rated tranches have been in trouble for months. But the prospect of a collapse in the value of the supposedly safe portions terrifies the banks—not surprisingly, since there is at least $350 billion-worth of such CDOs outstanding.
This looks all too possible now that rating agencies have started to downgrade AAA-rated CDOs, some of them by several notches (14 in the case of one notorious tranche). The agencies have given warning in the past month that they might downgrade another $50 billion-worth of top-rated CDOs, and that looks like the tip of the iceberg. One fear is that this leads to a wave of hurried sales, because many institutional investors are allowed to hold only AAA-rated paper. In addition, default notices have been issued on more than $5 billion-worth of CDOs, as senior investors try to grab what they can.
The uncertainty is compounded by the difficulty of finding a “fair value” for these complex instruments. The fall-back method recommended in a recent paper by the Centre for Audit Quality, an industry research body, is to employ “assumptions that market participants would use”, a technique known as “Level 3,” which becomes subject to strict accounting regulations in America on November 15th. But “Level 3 is not that useful,” confesses a risk controller at a big European bank. Banks have tended to use it as a bucket into which they throw any securities they find hard to value and then make an educated guess at the price. Among Wall Street firms, the soaring amounts of Level 3 securities now exceed their shareholder equity.
Finding a better indicator of market prices is no easy task, however. One measure, though an imperfect one, especially for CDOs, is the ABX family of indices. These relate to derivatives linked to subprime, which are traded even when the underlying bonds are not. The ABX indices are near record lows, having fallen precipitously in October. Even the top tranches are well below par value. According to Citi, some AAA-rated CDO tranches are faring even worse—at a mere 10 cents on the dollar.