Now That’s What I Call Toxic!

During the past year or so, I have sometimes wondered exactly how toxic all those toxic assets really are. It’s hard to tell, since they differ from one another, and are not traded that often. However, the Financial Times (h/t) has some answers:

“In recent weeks, bankers at places such as JPMorgan Chase and Wachovia have been quietly sifting data trying to ascertain what has happened to those swathes of troubled CDO of ABS. [Ed.: collateralised debt obligations of asset-backed securities.]

The conclusions are stunning. 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 CDOs, though, recovery rates on those AAA assets have been a mere 5 per cent.

I dare say this might be an extreme case. The subprime loans extended in 2006 and 2007 have suffered particularly high default rates and the CDOs that have already been liquidated are presumably the very worst of the pack.

Even so, I would hazard a guess that this is easily the worst outcome for any assets that have ever carried a “triple A” stamp. No wonder so many investors are now so utterly cynical about anything that bankers or rating agencies might say these days.”

If I’m reading this right, within four years of being issued, two thirds of these CDOs are in default, and their recovery rates are very, very low. That’s just staggering. It’s actually hard to understand how the banks managed to do this badly: you’d think they could have done better hiring people off the street and paying them to put all those nice little loan documents into piles at random, or tossing mortgages down the stairs and bundling them based on how they landed. They certainly didn’t need to hire people with advanced math degrees and pay them seven- or eight-figure salaries to get these kinds of results.

And how about those ratings agencies? They would have done a better job using a Magic 8-Ball to rate the CDOs. (“Signs point to junk!”)

I have been hearing for years and years about how the financial services sector pays such exorbitant wages because the people who work there are so immensely talented that they are cheap at $50 million a year. I never particularly bought that line before. But I never imagined that all those Masters of the Universe would do quite this badly. If we had paid them $50 million a year to go far, far away and leave our financial system alone, it would have been a bargain.

The column ends with a very important observation:

“Those American officials who are implementing flashy new “stress tests” of banks would do well to take note.”


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