For Stop the Bubble Hype from SD Realtor

[Anonymous]

Aw, Allan, you mean the same ‘prospecti’ that lay out overstated values for CDOs and the like?

I’ve not seen ‘tranch’ before in regard to finance (only in regard to sturgeon slicing). But, I’m willing to learn; show me a definitive source, sir!

[stansd]

One thing that I think we are overlooking a bit on this site…Most folks around here understand, but the nuance seems to be getting a bit lost: The subprime CDO market is in a bit of a tailspin. That said, and undeserved AAA ratings notwithstanding, the majority of the subprime tranches will weather even a severe pop of the housing bubble.

This is a bit oversimplified, but Returns on a CDO roughly equal (Interest + repayment of principal – management fees -expenses for dispositions of defaults + collections from sales of defaulted properties)/(initial investment).

There will no doubt be a bloodbath in the “toxic waste” tranches (little interest, little repayment of principal, big disposition expenses, and sales on defaulted properties with a significant haircut).

Assume the following scenario, though: Market Dives 30%, and subprime REO’s go to 20%. Also assume it costs 10% to dispose of a property.

Let’s just talk principal (interest collected further reduces the impact): If you start with $100 of CDO, you still collect $80 (REO’s at 20%). Then, of that $20 you didn’t collect on, you can sell the houses in that $20 for $14 (30% market drop), and you have to pay $2 to dispose of the assets.

In this oversimplified Scenario, then, you still have $80 of principal + $14 from the REO’s – $2 from the REO expenses = $92. Now if the toxic waste segment takes that entire loss, you are probably looking at a complete wipeout of that tranche, and some creep into the tranches above. Not a good thing. That said, there are a lot of holders of the higher tranches still getting paid even in a pretty bad scenario.

This would still cause a substantial disruption; The higher rated segments aren’t so highly rated any more, pension funds have to drop them automatically raising the spread over treasures and decreasing the value. Hedge funds go belly up because of leverage, overexposure, fear. The cost of subprime mortgages skyrockets because banks have to sell that toxic waste tranche very cheaply, etc. Maybe the subprime market isn’t even viable for a time.

What doesn’t happen unless you consider the absolute worst, though is huge losses throughout all the tranches. There is a lot of money that will be lost here, but lets remember that when you hear that there were $300B in subprime originations, it’s only a small fraction of that where losses are actually likely to occur.

Stan

[stansd]

One thing that I think we are overlooking a bit on this site…Most folks around here understand, but the nuance seems to be getting a bit lost: The subprime CDO market is in a bit of a tailspin. That said, and undeserved AAA ratings notwithstanding, the majority of the subprime tranches will weather even a severe pop of the housing bubble.

This is a bit oversimplified, but Returns on a CDO roughly equal (Interest + repayment of principal – management fees -expenses for dispositions of defaults + collections from sales of defaulted properties)/(initial investment).

There will no doubt be a bloodbath in the “toxic waste” tranches (little interest, little repayment of principal, big disposition expenses, and sales on defaulted properties with a significant haircut).

Assume the following scenario, though: Market Dives 30%, and subprime REO’s go to 20%. Also assume it costs 10% to dispose of a property.

Let’s just talk principal (interest collected further reduces the impact): If you start with $100 of CDO, you still collect $80 (REO’s at 20%). Then, of that $20 you didn’t collect on, you can sell the houses in that $20 for $14 (30% market drop), and you have to pay $2 to dispose of the assets.

In this oversimplified Scenario, then, you still have $80 of principal + $14 from the REO’s – $2 from the REO expenses = $92. Now if the toxic waste segment takes that entire loss, you are probably looking at a complete wipeout of that tranche, and some creep into the tranches above. Not a good thing. That said, there are a lot of holders of the higher tranches still getting paid even in a pretty bad scenario.

This would still cause a substantial disruption; The higher rated segments aren’t so highly rated any more, pension funds have to drop them automatically raising the spread over treasures and decreasing the value. Hedge funds go belly up because of leverage, overexposure, fear. The cost of subprime mortgages skyrockets because banks have to sell that toxic waste tranche very cheaply, etc. Maybe the subprime market isn’t even viable for a time.

What doesn’t happen unless you consider the absolute worst, though is huge losses throughout all the tranches. There is a lot of money that will be lost here, but lets remember that when you hear that there were $300B in subprime originations, it’s only a small fraction of that where losses are actually likely to occur.

Stan

[Allan from Fallbrook]

Stan,

I agree on all counts. However, what is missing from your equation is the possibility of a severe credit contraction occurring within the short-term. If you have been following the volatility indexes, they have been curiously out of whack for quite some time (even puzzling the august Alan Greenspan).

We are essentially awash in cheap, easy money, fueled in no small part by Chinese central banks. If you look at the rash of over-priced LBOs and buyouts taking place across all industry sectors and juxtapose this with the same easy money that pushed air into the housing bubble, and then factor in the definite funkiness of the bond markets, a more serious picture starts to emerge.

Add to this the overall level of concern on the parts of the big investment houses, and this concern is not solely limited to the nonsense taking place in the sub-prime CDO market.

As I said earlier, I don’t think we are looking at a collapse, but rather a severe correction. However, if you are sitting up in Temecula in a $500k house that you put a HELOC and a 2nd on, and your 1st is about to reset to a significantly higher rate, well, your idea of collapse and mine might be considerably different.

Mr. JG, I will endeavor to find a spelling of “tranch” that I can pass along or will consider myself the gutted sturgeon in this instance. Sir.

Regards

[Allan from Fallbrook]

Stan,

I agree on all counts. However, what is missing from your equation is the possibility of a severe credit contraction occurring within the short-term. If you have been following the volatility indexes, they have been curiously out of whack for quite some time (even puzzling the august Alan Greenspan).

We are essentially awash in cheap, easy money, fueled in no small part by Chinese central banks. If you look at the rash of over-priced LBOs and buyouts taking place across all industry sectors and juxtapose this with the same easy money that pushed air into the housing bubble, and then factor in the definite funkiness of the bond markets, a more serious picture starts to emerge.

Add to this the overall level of concern on the parts of the big investment houses, and this concern is not solely limited to the nonsense taking place in the sub-prime CDO market.

As I said earlier, I don’t think we are looking at a collapse, but rather a severe correction. However, if you are sitting up in Temecula in a $500k house that you put a HELOC and a 2nd on, and your 1st is about to reset to a significantly higher rate, well, your idea of collapse and mine might be considerably different.

Mr. JG, I will endeavor to find a spelling of “tranch” that I can pass along or will consider myself the gutted sturgeon in this instance. Sir.

Regards

[Anonymous]

Wow, Allan, you are a measured, reasonable, even-keeled CFO, unlike the loose-cannon, religious zealot CFO that we’ve had running around on this site for a while.

Pleasant change.

[Anonymous]

Wow, Allan, you are a measured, reasonable, even-keeled CFO, unlike the loose-cannon, religious zealot CFO that we’ve had running around on this site for a while.

Pleasant change.

[DaCounselor]

Great points from Allan and stansd.

I would guess that most of the holders of investment-grade MBS tranches are going to be fine, depending obviously on the financial engineering employed in carving up the original pool. I do think it’s prudent to be mindful of the possibility of the defaults eating their way up into the highest rated tranches.

The fallout from wiped-out non-rated tranches has the potential to fantastically exceed the value of the original MBS tranch. This is where the most imminent problem lay. With each successive generation of derivatives, the risk increases greatly. This is why we must look beyond the market segment of the original MBS tranches that are in trouble.

It is an unbelievably thick wicket. Even street insiders don’t know who is holding CDO’s and how many generations of derivatives are out there. The behind the scenes manuevering has got to be incredible. Hopefully we’ll get a good book on this stuff down the road.

[DaCounselor]

Great points from Allan and stansd.

I would guess that most of the holders of investment-grade MBS tranches are going to be fine, depending obviously on the financial engineering employed in carving up the original pool. I do think it’s prudent to be mindful of the possibility of the defaults eating their way up into the highest rated tranches.

The fallout from wiped-out non-rated tranches has the potential to fantastically exceed the value of the original MBS tranch. This is where the most imminent problem lay. With each successive generation of derivatives, the risk increases greatly. This is why we must look beyond the market segment of the original MBS tranches that are in trouble.

It is an unbelievably thick wicket. Even street insiders don’t know who is holding CDO’s and how many generations of derivatives are out there. The behind the scenes manuevering has got to be incredible. Hopefully we’ll get a good book on this stuff down the road.

[stansd]

Totally agree, and have been watching the LBO market carefully through the same set of eyes (especially some of the failed issues in recent weeks)…The world is awash in liquidity. I tend to be a bit Austrian in my economic thought and the potential danger of this is not at all lost on me.

In my mind, this would be a big chunk of the fuel that causes a severe correction in housing…was just pointing out that even in a severe correction, the impact while severe on those holding the lower tranche bag (or the house owner losing her house) is likely more localized than we sometimes assume.

Stan

[stansd]

Totally agree, and have been watching the LBO market carefully through the same set of eyes (especially some of the failed issues in recent weeks)…The world is awash in liquidity. I tend to be a bit Austrian in my economic thought and the potential danger of this is not at all lost on me.

In my mind, this would be a big chunk of the fuel that causes a severe correction in housing…was just pointing out that even in a severe correction, the impact while severe on those holding the lower tranche bag (or the house owner losing her house) is likely more localized than we sometimes assume.

Stan

[lurkor]

Stan, unless I am misreading you, you seem to be assuming that $100 of CDO is backed by $100 of home equity. I don’t understand this to be the case at all-from what I’ve read a 30% decline in home prices would easily wipe out many CDOs in their entirety.

Unfortunately after googling for a few minutes I can’t find a definitive source on this. Anybody know where to find details on the typical debt to equity ratio of a CDO?

[lurkor]

Stan, unless I am misreading you, you seem to be assuming that $100 of CDO is backed by $100 of home equity. I don’t understand this to be the case at all-from what I’ve read a 30% decline in home prices would easily wipe out many CDOs in their entirety.

Unfortunately after googling for a few minutes I can’t find a definitive source on this. Anybody know where to find details on the typical debt to equity ratio of a CDO?

[Allan from Fallbrook]

JG, thanks for the compliment. I came up in a British owned insurance brokerage (Willis Group PLC) and they seemed to prefer low-key and even keeled to brash zealotry. We used to have an expression in insurance, “passing a burning match”, which referred to passing liability down the food chain. I think what is happening here in the derivatives market is exactly that, compounded by Stan’s observation that no one involved really has a complete picture of what is going on.

There is almost a willful ignorance on the part of analysts, commenters and observers as regards the true picture of how risky these instruments are and how much overall danger they pose.

I would think the gravest concern would be risk aversion overcoming greed (yes, it is possible when losses run high enough), combined with a credit crunch. The liquidity we are awash in can and probably will go away. If this contraction occurs, the severity of the downturn will be greatly amplified and the reverberations will be felt much more strongly and throughout the world.

Granted, this is somewhat Chicken Little, but not outside the realm of possibility. The more I watch the gyrations of Bear Stearns, and how quickly Merrill Lynch liquidated their sub-prime MBS position, the more I think Denmark is a lot rottener (sp?) than any of us realize.

JG: Are those your initials or do they correspond to a Navy rank? Please tell me the former, rather than the latter. The only thing worse than being upbraided by a Navy officer is being upbraided by a Marine officer.

[Allan from Fallbrook]

JG, thanks for the compliment. I came up in a British owned insurance brokerage (Willis Group PLC) and they seemed to prefer low-key and even keeled to brash zealotry. We used to have an expression in insurance, “passing a burning match”, which referred to passing liability down the food chain. I think what is happening here in the derivatives market is exactly that, compounded by Stan’s observation that no one involved really has a complete picture of what is going on.

There is almost a willful ignorance on the part of analysts, commenters and observers as regards the true picture of how risky these instruments are and how much overall danger they pose.

I would think the gravest concern would be risk aversion overcoming greed (yes, it is possible when losses run high enough), combined with a credit crunch. The liquidity we are awash in can and probably will go away. If this contraction occurs, the severity of the downturn will be greatly amplified and the reverberations will be felt much more strongly and throughout the world.

Granted, this is somewhat Chicken Little, but not outside the realm of possibility. The more I watch the gyrations of Bear Stearns, and how quickly Merrill Lynch liquidated their sub-prime MBS position, the more I think Denmark is a lot rottener (sp?) than any of us realize.

JG: Are those your initials or do they correspond to a Navy rank? Please tell me the former, rather than the latter. The only thing worse than being upbraided by a Navy officer is being upbraided by a Marine officer.

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