Bear Stearns, CDOs and Default Probabilities
Until recently, the fall out from the collapsing US real estate sector has been limited to parties directly involved in this sector, namely mortgage lenders and builders. This column’s focus on the credit markets is now paying off in that third party effects are now appearing.
This month the aptly named “Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund” fell into difficulty after losing 23 per cent of its value in the first four months of the year. A fire sale of assets was adverted when Bear Stearns offered to place its own capital on the line to support the fund. These events illustrated that there is no liquidity for this type of Asset Backed Securities and Collateralized Debt Obligations (CDOs) during market stress. Even with numerous other hedge funds, holding similar assets in this instance there were few buyers at prices close to the assets face value. Lombard Street Research said, “We heard buyers were lobbing bids at just 30% [of face value].” Hence, the liquidity assumptions embedded within the pricing and risk management models of such assets are questionable to say the least.
Collateralized Debt Obligations (CDOs) are similar in structure to split-cap investment trusts where differing ‘tranches’ having different rights over the underlying assets. With CDOs, you typical start with a portfolio of mortgage-backed securities, which roughly speaking are pools of similar mortgages, and other loans. The first tranche of the CDO will typically own 5 percent of the portfolio and absorb the first 5 percent of the default loses. The second tranche will own 10 per cent of the portfolio and absorb the next 10 per cent of loses. The third tranche will own 10 per cent of the portfolio and absorb the next 10 percent of loses, and the fourth tranche will own 75 percent of the portfolio and absorbs the residual default loses. The fourth tranche will usually receive a triple A rating by rating agencies and pay a yield corresponding to similarly rated high-grade bonds or highly covered split-cap investment trust zeros.
In a typical CDO transaction, the bank who arranges the loans will retain the first tranche and a very high proportion of the default risk, and sell on the other tranches transferring only the extreme losses to other market participants. The size and yield of the first tranches is largely driven by the average default probability of the securitized assets. These default probabilities in the Bear Sterns case and across the US mortgage backed securities sector appears to have been greatly underestimated. Re-pricing these assets with respect to higher default probabilities, which now seems inevitable, will lead to a mark down of all similar instruments leading to large paper loses.
Web resource:
Queen’s Walk Investment Limited is a LSE listed closed-end fund which invests within the CDO market. Their web site (http://www.queenswalkinv.com/) contains presentations and reports detailing how the fall out from the mortgage markets during Q1 2007 has affected their portfolio.