Wednesday, November 14, 2007

The Subprime Meltdown: For CDO Investors There is a Remedy

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While each CDO is unique, certain tendencies in the formation of both the rated and unrated tranches have emerged. By 2006, data was available showing a dramatic increase in the risk of subprime mortgages comprising many pools of CDO collateral. The quality of loans, the rate of default, the loan-to-value ratios, and the level of documentation were known to be in decline.

CDO issuers could have taken defensive steps, including rejecting risky loans, adding more loans to cushion against loss, and fully and timely disclosing declining creditworthiness of their CDOs. Rating agencies also could have demanded changes. But, as the market for CDOs expanded and financial institutions discovered that they could pass off mortgage risk to investors, underwriting standards collapsed to irresponsible levels--with the full knowledge of the rating agencies. Both groups reaped enormous profits.

Historically, Wall Street has responded to criticism of product sales with two powerful arguments, neither of which applies to mortgage-backed CDOs.

The first defense is that independent ratings agencies such as S&P, Moody's, and Fitch evaluated and blessed each CDO before it was sold. But in the past few years, rating agencies were paid only on condition that the CDO went to market, received large continuing fees for periodically re-evaluating the products, and also collaborated with managers in structuring many CDO investments. In short, the rating agencies were not independent, and now many 2006 and 2007 CDOs are facing defaults and downgrades, effectively an acknowledgment that the original ratings issued only months earlier were deficient.

The second defense typically offered is that CDOs were purchased by institutions and sophisticated individuals with access to their own financial professionals, who were fully capable of evaluating the risks. This isn't rocket science. Caveat emptor.

But structured investment vehicles are rocket science, and not just any institutional investor or high net worth individual has the capacity to engage the army of math Ph.D.s and MBAs that Wall Street employs to create and value these products.

In 2006, the Law Offices of Alan W. Sparer won an award of $5.8 million against Deutsche Bank for its role in connection with the sale of CLOs and CDOs.

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