CDOs Backed by Risky Mortgages now Worth 5% of their value

Remember those toxic assets and how the government was going to buy them up, sell them later to recover their value?

You must read this Financial Times article:

Here is the Magic Secret Decoder Ring to translate:

CDO - Collateralized debt obligations
Mezzanine - Underlying asset is subprime, "risky" mortgage
ABS - Asset backed securities
Tranche - Slices of risk levels within a bundled group of securities

From late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds (known as mezzanine CDO of ABS) and much of the rest from safer tranches (high grade CDO of ABS.)

Out of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi.

The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32 per cent for the high grade CDOs. With mezzanine CDO’s, though, recovery rates on those AAA assets have been a mere 5 per cent.

So, how to destroy all trust, credibility and confidence in a matter of a year? Rate risky assets as safe so people will buy them.

It looks like the global financial sector created a Second Life fantasy financial world and the Linden dollar wasn't even pegged to anything but a bad math base equation.

Hiding toxic waste and looking for a brighter day just ain't workin' here. Take a deep breath, pull the band-aid off in one jerk and get it over with. Open the hood to the public on these inane fantasy derivatives.

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The author offers an interesting idea.

The author of that Financial Times article suggests that the banks, probably with a push from Treasury, should do an open auction basically a fire sale. Her theory is that their models were terribly wrong and why keep lingering in limbo. Everybody needs a little price discovery. It doesn't even have to be an entire portfolio.

makes sense to me

Considering the "ultra safe" is worth 32% and the other is basically worthless what difference does it make at this point to hide these as well?

But my question, which I do not understand is through regulation somehow they plain need to get some of these new "vehicles" out of the market because they are based on inaccurate equations and methods...

so what percentage of this shadow banking system are these fictional mathematically based vehicles?

Part of the story?

I saw this article earlier today and my first thought was . . . . where is all the TARP money AND the Fed/Treasury guarantees going? The numbers mentioned in this article are a pittance when compared to the $7-$8 Trillion that has been given away or offered as security. And everywhere I read that number will go up substantially this year.

Then I realized that the article is only mentioning 2 institutions looking at 2005 to mid 2007. Geithner's planned "stress test" will be looking at 20 or so institutions and their holdings up to today. In various news articles over the past months I have seen estimates of the "asset" value of the total toxic derivatives being anywhere from $160 Trillion and up to $600 Trillion!!

Have I misunderstood something in what I've been reading? I mean, if the current value of this doodoo is 5% of that, there are not enough other assets on planet earth to offset that kind of write off.

Fed, $8 trillion

Yeah, that would make a great research post for I do not understand quite the difference between the Fed and it's $8 trillion obligations vs. TARP I of $800 billion and now this new TARP II in the recent budget of $750 billion.

I don't get quite how that works and I especially do not get these $8 trillion by the Fed....if banks are insolvent, how that is not major U.S. debt.

Your shadow banking system estimates seem off the planet so let's see how they are coming up with such numbers.

I've read $40 trillion to about $65 trillion estimates..

and yeah, if it's all fiction, well, the world is going to have to let all of that fictional economy and money disappear and it's going to really fuck things up.

But this 95% collapse of evaluation, i.e. discovery this crap is fiction and worthless is seemingly just these particular CDOs associated with the residential mortgage market, which I pray and hope doesn't mean the entire shadow banking system.

If you research out this relationship and how it really works I'd love to read it in a post.

I do not get it!

Thanks Robert

I will keep looking for sure. All of this CDS/CDO stuff has been like peeling an onion to me. As they said in Xfiles, the truth is out there!

$10 trillion

I think the Fed obligations along with TARP I are now $10 trillion. Yeah, if you find out a good bit of data, explanation on precisely how this doesn't count...
or does, I'd like to see it.

It seems the lesser the amount of money is involved, the more outrage it generates...i.e. private jets, junkets, CEO bonuses, TARP, then Fed...

where seeing $10 trillion is enough to make me think about digging a fox hole in the back and loading up with canned goods.

The gap explained.

While reading the article yet again, it occurs to me that the author is only talking about CDO's. The credit default swaps (CDS's) are the other, much larger component included in "toxic assets". Hence the higher values for toxic assets being estimated/reported.

From Economics Explained:

The first credit default swap was introduced in 1995 by JP Morgan. By 2007, their total value has increased to an estimated $45 trillion to $62 trillion. Although since only 0.2% of investment companies default, the cash flow is much lower than this actual amount.

The size of the credit default market dwarfs that of the stock market and the bond market they represent. Therefore, this shows that credit default swaps are being used for speculation and not insuring against actual bonds.

Credit Default Swaps are unregulated and because they get traded so frequently there is uncertainty of who owns them and whether the holders can actually pay in the event of a negative credit event.

Jeeeesh! It's no wonder so many people feel like they are going down the rabbit hole!

search on EP

There are a lot of posts on derivatives and the search (upper right hand corner) should pull them up. Also a site specific search on Google works too.

Yes, CDSes are different from CDOs and all of these derivatives, structured finance I have to look up and read constantly, still working on it. It's a maze of little investment vehicles and indexes, etc. seemingly built upon each other and it's confusing as hell!

It's no wonder that no one understands these things...and as noted on the baseline model, once I dug into the mathematics...uh, that sure as hell didn't appear valid either as a probability equation.

That's why I put the "translation tool" before the quote because the mnemonics become a flurry of snow upon which one can no longer see the shit on the ground underneath!

The Power of Zero

"Nothing from Nothing leaves nothing..." To build from the bottom-up, we must assume zero cost in many cases as a starting point. When Demand=0, Value=0, regardless of P (Price). A growing pile of manure in a season when fields are fallow is a good example. (It may have tons of nitrogen, but it's only value is relative to its utility.)
Another problem with most of these securities is...they have no comparables, so there's no possibility to ratiocinate their values. I once had a prof that used to say, "If I demand water, and quantity=0, then price=thirst." Absent a grasp of the ROI for these, the
natural valuation starting point should be zero.

that is why the author was recommending open market

kind of a "how worse can it get, you are internally evaluating these CDO ABS @ 95% loss and 78% loss".

I have to agree, if it's worthless, take the pain, deal with the disaster and at least move on to build.

I don't know the inner workings of structured finance but it's clear enough to know that unregulated markets do not work at all...

and it also appears there should be some serious monitoring on use of probability models of any kind! If the Fed/SEC/FDIC/Congressional experts on hand cannot understand the model....well, maybe it's not a good idea to create a new "market" based on it!