Wednesday, November 14, 2007

The Subprime Meltdown: For CDO Investors There is a Remedy

Click here for full article.

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.

Florida Agency Holds $2.2 Billion of Debt Cut to Junk Status

November 14, 2007 - Bloomberg reports that the Florida agency that manages about $50 billion of short-term investments for the state, school districts and local governments holds $2.2 billion of debt that was cut below investment grade. Florida rules require the state's short-term investments to only be top-rated, liquid securities, so taxpayer funds aren't placed at risk.

Former SEC Chairman weigh in...

``Investment of public money needs to be carefully conducted and thoroughly researched,'' said Harvey Pitt, former chairman of the U.S. Securities and Exchange Commission. ``This is not the place for seat-of-the-pants judgments. It requires a lot more than jumping on the latest investment du jour to improve your results.''

Florida isn't the only government whose short-term investments have been affected by rising mortgage defaults in the U.S. and investors' diminished appetite for the securities tied to them.

``I think there are other communities that are going to follow, probably a lot of them,'' former U.S. Securities and Exchange Commission Chairman Arthur Levitt said today in an interview.

``I think we've got to pay more attention,'' Levitt said. ``They're playing with pensioners' money. That's serious. That's more serious than a brokerage firm or a bank losing money on a bad bet. We're talking about pension losses, and I think the fact that this is spreading is something that we've got to watch very, very carefully.''

According to the report, nearly 1,000 school districts, cities and counties invested in the fund, and have now been informed of its downgraded debt. Click here for full article.

"Breaking the buck?" Money Market Funds are Spending Millions to Ensure a Dollar is Still Worth a Dollar

Bank of America announced Tuesday, November 13, 2007 that it planned to set aside $600 million to cover potential losses in tis money market funds and an institutional cash management fund. This is the largest step by a financial institution to ensure that its money funds aren't forced to reduce the value of their shares. Click here for the full article.

"Money funds have long appealed to people as super-safe investments. And they've kept their share prices fixed at $1 a share. But unlike banks' money market deposit accounts, money funds are not federally insured. The crisis in subprime mortgages has jolted the market for the short-term securities that money funds invest in. Even so, assets in money funds recently hit a record $3 trillion.


Several other financial institutions have also bolstered their money funds:

- SEI, an insitutional money manager in Oaks, Pa., has set aside $129 million to support two of its money funds.

- Legg Mason, a Baltimore money management firm, has set up a $238 million line of credit for two money funds. It also invested $100 million to buoy an offshore money fund.

- SunTrust (STI) has received SEC permission to set up credit lines for two money funds.

Sunday, November 11, 2007


A report in the week-end edition of the Wall Street Journal dated Saturday/Sunday, October 27 - 28, 2007--that Moody’s, Standard & Poor and Fitch are being investigated in connection with potential antitrust violations--sheds light on potential abuses that may account for the recent precipitous round of rating downgrades by these same agencies. According to the REPORT, the Connecticut Attorney General’s office has issued subpoenas to the three rating agencies in connection with the alleged practice of “unsolicited ratings, “notching,” and “exclusive contracts.” CLICK HERE FOR FULL ARTICLE.

"There are allegatuions that some raters conduct an unsolicited rating and then demand the issuer pay for it or face a possible poor rating," the attorney general said. Notching is when raters allegedly threaten to downgrade an issuer's debt unless they get a contract to rate the issuer's entire debt pool, even if parts already have been assessed by another agency.
Exclusive contracts give issuers discounts for having all their debt rated by a single agency. "Such agreements may hinder competition by locking out other debt raters," the attorney general said.

These practices, if they did occur, are designed to do anything but ensure accurate classification of residential mortgage backed securities, such as collateralized debt obligations (CDOs). Whether the alleged practices violate antitrust laws or not, they could and would have resulted in inaccurate and misleading ratings upon which investors relied in purchasing CDOs, which have been sold in the billions. Such practices would also explain why many such products have been substantially downgraded only a few months after receiving a favorable rating.

In fact, the same Wall Street Journal edition carries a report with the headline “CDO Ratings Are Whacked By Moody’s: AAA to Junk in a Day Raises More Questions About Credit Arbiters.” The Journal announces $8.3 billion of DOWNGRADES by Moody’s primarily in connection with mortgage back securities. In one instance a $843 million CDO slice, known as a tranche, and having a AAA rating (which means first call on the income stream of a mortgage loan pool) was downgraded “10 notches to a junk rating of Ba1.” Another $229 million AAA tranche was cut “14 notches to a junk rating of B2.”

These kinds of changes can lead to a distress sale by purchasers, such as insurance companies, pension funds, and hospital or educational non-profits, who are required to hold rated investments by regulatory mandate or by the terms of their established investment policy.