Paul Krugman: Stress test this

[RedEarth]

February 27, 2009, 8:46 am
Stress test this
An important article by Gillian Tett about actual recovery rates on AAA-rated CDOs. (They’re worse than even the pessimists thought.)

Why is this important? A recurring theme of those who believe that the financial system can be rescued with fancy financial engineering — a group that, sad to say, apparently now includes the Obama administration — is that the losses on toxic assets aren’t really as bad as people say; that lack of liquidity and “irrational despondence” have led to an undervaluation of these assets, and that if we can just calm things down and get cash flowing again all will be well.

Not so much, it seems.

http://krugman.blogs.nytimes.com/2009/02/27/stress-test-this/


.........Article by Gillian Tett


Insight: Time to expose those CDOs
Published: February 26 2009 16:34 | Last updated: February 26 2009 16:34

Just how much should a debt vehicle backed by subprime mortgage bonds be worth these days? Two years ago, most banks and insurance companies assumed the answer was close to 100 per cent of face value – or more.

Since then, however, that “price” has clearly collapsed, triggering tens of billions of dollars worth of writedowns, particularly in relation to a product known as collateralised debt obligations of asset-backed securities (CDO of ABS.)

But as the zeroes relating to writedowns multiply, a peculiar – and bitter – irony continues to hang over these numbers. Notwithstanding the fact that bankers used to promote CDOs as a tool to create more “complete” capital markets, very few of those instruments ever traded in a real market sense before the crisis – and fewer still have changed hands since then.

Thus, the “prices falls” that have blasted such terrible holes in the balance sheets of the banks have not been based on any real market numbers, but on models extrapolated from other measures such as the ABX, an index of mortgage derivatives.

What has blown up the capital markets is thus a set of theoretical swings in prices that were always pretty abstract.

This takes the concept of virtual banking onto a whole new, terrible level.

But now, at long last, one shard of reality has just emerged to piece this gloom. 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.

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 CDO’s, though, recovery rates on those AAA assets have been a mere 5 per cent.

http://www.ft.com/cms/s/0/2970532c-0421-11de-845b-000077b07658.html

[ret5hd]

1. The way I understand things, $305bn of CDOs in a formal state of default...

roughly equals $3T of CDS that need to be paid.

Our bailout dollars are going to the hedge funds that bet our economy would collapse.