by Mish

Part 1 Quick Recap

  • Investors are buying bundles of CDOs without having a clue as to what is in them
  • Rating CDOs is a cash cow for the rating companies
  • There is a clear conflict of interest between the rating companies and the deals they are involved in
  • Ratings programs are based on Monte Carlo Simulation but the initial input assumptions about defaults and recovery rates may be far off the mark
  • After the initial rating, CDOs are not marked to market thus no one really knows what anything is worth
  • No one is rating the rating companies or their models
  • No one is even concerned about this state of affairs

Are the Monte Carlo models (or more importantly the assumptions going into the Monte Carlo models) any better? How can anyone even know if the only “mark to market process” is based on what the model says?!

The scariest thing is that we are in a monetary environment that is unprecedented in history. M3 is soaring in nearly every major country on the globe. Asset prices have never been more correlated than now. The amount of derivatives in play is in the hundreds of trillions of dollars all bet on Monte Carlo Simulation. Wow!

Who is the ultimate guarantor?

Let’s now turn our attention on who is guaranteeing this stuff. The short answer is simple: MBIA and Ambac. The long answer (No One!) can be found in Who’s Holding the Bag?

Note: I will try and clip things relative to Monte Caro simulation but the entire document is extremely well presented and highly recommended reading.

Rating Agencies Are NOT Regulators

  • Rating Agencies are for-profit businesses
  • Earn fees for writing opinions
  • Rating Agencies have adverse incentives
  • Only paid if and when financing closes; ratings “shopping”
  • More issuance = More fees
  • Structured Finance is over 40% of revenues with fees ~4x that of traditional debt ratings
  • Rating Agencies have conflicts of interest
  • Rating Agencies have reputational risk with structured finance ratings
  • Slow to adjust credit opinionsWhat

Happens if the Rating Agencies Are Wrong?

  • Already Happening in Sub-Prime
  • Defaults have been higher than rating agency predictions
  • Rating Agencies have begun to adjust models and downgrade tranches
  • Tighter standards for securitizations / CDOs
  • Acknowledging likelihood of higher than expected correlation
  • Lack of new ABS CDOs dramatically reduces demand for new mortgages
  • Banks pulling warehouse lines
  • Originator bankruptcies / exiting business (~50 in last 15 months)
  • Home price depreciation predicted by National Association of Realtors
  • Upcoming payment shock will make things worse
  • Borrowers can’t refinance because of tighter standards
  • Rising inventories and smaller pool of qualified buyers reduces value and liquidity of properties

Who’s Holding the Bag?

First losses borne by BBB and equity investors in CDOs/ securitizations

  • Combined position represents only 5-10% of total collateral
  • At ~9% losses, all capital through BBB is worth zero
  • Moody’s currently estimating 6-8% cumulative losses for 2006 sub-prime issuance—higher than initial expectations

Senior tranches typically guaranteed by Bond Insurers


  • Bond Insurers sell credit protection on senior tranches of ABS & CDO securitizations
  • Bond Insurers and CDO Buyers perceive low risk and accept nominal yield

Financial Guarantors are unique counterparties

  • They don’t put up capital. They simply sign their name
  • One of few counterparties in derivatives market not required to post collateral on decline in value of contract
  • Only counterparties not required to post collateral even in the event of a downgrade in their credit rating
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How Does MBIA Account for Wider Spreads?

  • Supposed to mark to market any losses on derivatives
  • MBIA’s CDO guarantees are held to maturity and do not trade
  • With no market price, MBIA “marks to model”
  • MBIA’s internal model incorporates rating agency inputs
  • Rating Agencies have not downgraded senior tranches, therefore MBIA has not recognized any MTM losses
  • If exposures were marked to market, slight movements in credit spreads would impair or eliminate MBIA’s capital base

Accelerated Revenue Recognition

  • MBIA’s current methodology accelerates revenue recognition and inflates book value
  • MBIA recognizes deferred premium revenue on an accelerated basis
  • Company claims that the appropriate method for recognizing deferred premium revenue is in proportion to “the expiration of related risk”
  • MBIA effectively guarantees a stream of payments. Therefore, risk expires only when payments are made
  • New FASB Proposal, dated 4/18, requires MBIA to recognize revenue in proportion to risk expiration (scheduled payments), not the passage of time

Risk is Hidden in Guarantor Portfolios

  • Moral Hazard in the Structured Finance process combined with a flawed Rating Agency function has overstated credit quality for hundreds of billions of dollars of guaranteed bonds
  • Guarantors have no margin for error
  • Credit Market participants believe they have transferred risk to AAA-rated Financial Guarantors
  • Guarantors’ counterparties are unsecured and have no right to collateral even in the event of a downgrade
  • When losses hit, these guarantees will have no value, and counterparties are left holding the bag*

It sure seems like a hell of a lot is riding on the Monte Carlo Simulation of CDOs as well as the parameters and assumption that feed into the model. If and when a Credit Event occurs that rifles through multiple CDO tranches, the guarantors will be about as well capitalized to handle the guarantees as is Madame Merriweather’s Mudhut Malaysia. Do I smell a government bailout coming up?

This post originally appeared on Minyanville.

Mike Shedlock / Mish/

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