THE AAA MELTDOWN….At the heart of the subprime mortgage debacle is a financial instrument called a Collateralized Debt Obligation, or CDO. A CDO is a collection of bonds that’s divided into tranches and then sold to investors. Usually there’s a AAA tranche at the top (very safe, very reliable) and a garbage tranche at the bottom (pay your money, take your chances). In the middle is a mezzanine tranche.

It’s easy to understand why the garbage tranches have lost all their value: they’re garbage. But why are the AAA tranches also losing value? Aren’t the underlying securities still safe and reliable? Today, Steven Pearlstein puts in place a piece of the puzzle that I didn’t know about before:

The least sought-after tranches were those in the middle, the “mezzanine” tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same “tranching” process, they could use these mezzanine-rated assets to create a new set of securities — some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees….What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.

One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.

So if this is right, then the reason that even AAA tranches are in such trouble is basically twofold:

  • A lot of the AAA debt isn’t really AAA. It’s mezzanine debt that the rocket scientists and the rating agencies conned everyone into believing was AAA.

  • The mortgage meltdown is so widespread that even the legitimate AAA stuff is taking a beating.

Put these two things together, and the average AAA tranche is overvalued by, say, 10-20%. Add in the usual Wall Street panic whenever something goes wrong, and buyers are demanding discounts of 20-30% or higher.

There’s plenty more worth reading in Pearlstein’s column. But here’s the unsettling conclusion: “This may not be 1929. But it’s a good bet that it’s way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.”

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