US financial institutions reported an increase in Level 3 assets in Q3 to $610 billion (see Financial Times article). This amounted to an increase of 15.5 percent from Q2 as low liquidity has made it difficult to sell MBS and CDO assets. Classifying assets to Level 3 also gives the banks more control over how valuations are modeled and set. As banks begin reporting Q4 results, many analysts expect the number of writedowns of these assets to increase, especially given the recent announcement that the Treasury plans to use TARP money for capital injections directly into financial companies, as opposed to the original purchase of illiquid assets.

As if the credit markets did not have enough problems with actual credit default swaps (CDS) and collateralized debt obligations (CDO), now it has to worry about their synthetic relatives (see WSJ article). While synthetic CDOs have been talked about for a while, additional pain from synthetic CDO losses may be on its way, possibly setting back any recovery in the credit markets.

Synthetic CDOs essentially allow banks, hedge funds, and insurance firms to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high investment-grade credit ratings (often AAA or AA). Like a normal CDO, different tranches, or levels of risk and return are sold. Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, might invest in the lower-rated or unrated equity tranches. As the credit crunch progressed, many CDOs had exposure to financial companies, such as Lehman Brothers. Such exposure has caused previous AAA-rated products to now trade for 50 cents on the dollar, falling from 60 cents just a few weeks ago. The resulting hedge fund liquidation is pushing up the cost of default insurance, which in turn is raising the cost of borrowing, and putting more pressure on the credit markets.

Specialized funds, such as Constant Proportion Debt Obligations (CPDO) are also causing problems. If you felt that CDOs were not complex or risky enough, no problem. CPDOs juice returns by adding leverage, as much as 15 to 1. Of course, such leverage is risky, so many CPDOs have safety triggers that force them to exit their investment if their losses reach a certain level. Unfortunately, many are starting to reach their trigger levels. Some companies that sell protection on credit derivatives, called Credit Derivative Product Companies (CDPC) or Derivative Product Companies (DPC), have made matters worse by leveraging as high as 80 to 1. The CDPCs are similar to the monoline financial guarantee companies (remember Ambac, MBIA, etc.), except they do not have the burden of regulation (ah, remember the days). In order to stabilize company returns and ironically help secure a AAA rating, such companies would not post collateral, since posting collateral on trades could force collateral calls on losing trades and force portfolio selling. Of course, now, many firms are learning what forced selling is all about, or even worse, insolvency.

Hindsight is usually 20-20 (except when you still don't understand the product or exposure), but you still have to wonder how things were allowed to get so out of control. As an analogy, does it really make sense for me to be able to take out insurance on my neighbor's house, as well as mine? Should every neighbor on my street be allowed to insure against my house burning down? Or even better, on a house that does not even exist? Apparently so. Greed and common sense are not always close friends.

The WSJ has a nice article summarizing the auction-rate security mess, along with a short primer on what auction rate securities are, as well as how they are bought and sold through auction. Definitely worth the read for those interested in what has recently become a larger Wall Street focus. Auction-rate securities are essentially a form of debt issued by municipalities, student-loan organizations, and others interested in borrowing for the long-term, but doing so at short-term interest rates. How is this achieved? By auction, of course. Every 7, 28, or 35 days, depending on the product, banks will hold auctions in what amounts to a resetting of the interest rates as the securities are passed on to the new security holders (or reset for existing holders that want to stay long).

As reported, UBS, Merrill Lynch, and Citigroup alone have committed to buying back more than $36 billion of the securities. The problem that each of these companies find themselves in, among others, is that at times the auction-rate securities may have been promoted as being similar to short-term CDs, but with higher returns. Unfortunately, as credit problems increased, the auction-rate security market also began to freeze up, making it difficult for these securities to be re-priced. Many investors were left with bank statements that simply listed a "null" placeholder where their security prices were once quoted, implying that liquidity was poor enough that a reliable price could not be provided. To complicate matters, apparently the liquidity issue has persisted for a while, even as more securities were being marketed and sold, causing many banks to prop-up the market by issuing their own bids. The WSJ reports that UBS alone may have submitted bids in just under 70% of its auctions between January 2006 to February 2008. Allegations against Merrill Lynch imply that they gave the false impression that demand was high, driven in part by dark pools of liquidity in the auction market (see previous posts here, here, here, and here on dark pools of liquidity).

As recourse, and a way for UBS to hopefully reduced the intensity of this recent black eye (how many eyes does UBS even have?), the company has agreed to buy back from investors nearly $19 billion of auction-rate securities, starting with individuals and charities this October, all the way to institutional clients in mid-2010. It is worth noting that while UBS plans to start buying back securities in October, the actual purchase could take longer. As reported in a Barron's article back in May, and discussed in a previous post, how much money investors get back from auction-rate securities depends on who originally issued the securities. The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will probably have to wait a little longer. If you or one of you investment funds purchased auction-rate securities sold by a CDO or student-loan trust, well, you may be waiting a while to get your money back, possibly many years.

The auction-rate security issues once again highlight the need for better due diligence and a better understanding of risk. As we often forget, higher reward is almost always accompanied by higher risk - I dare say 100% of the time, but someone will always find exceptions in an inefficient market. If you look for more return, you need to understand the risk. Auction-rate securities based on CDOs should have raised red flags for some. Deception is one thing, but offering a blind-eye is another. Furthermore, the way we talk about risk also probably needs to change. For instance, have you ever noticed that we seem to be having "100 year floods" every other year, or how the metaphorical "perfect storm", whether in finance, insurance, or other fields seems to occur with more regularity? Anecdotal? Sure. But eventually simply stating that the recent event was the prefect storm or a once-in-a-lifetime event will not cut it. There are only so many times that you can cry wolf before no one cares about the real danger lurking in the woods. Maybe auction-rate securities and their current issues provide another one of those warning calls we need to listen to, regardless of its eventual magnitude and implications in the current market.

Reuters reports that while the failure of Bear Stearns would have likely triggered a series of counterparty failures in the credit default swaps market had the Fed not come to the rescue, CDS securities have actually held up pretty well and remained relatively liquid even while other financial markets have had their challenges. To date, since the market for credit derivatives has come into being, there has not been a default from a major dealer or bank. Ironically, the Bear Stearns issues themselves may have helped bolster the CDS market since not only did the Fed prevent potential counterparty failures associated with Bear, but they also gave the impressions that other major derivative counterparties were too big to fail.

Other markets have not fared as well. Recent credit problems and housing related losses have reduced the flow of capital in the mortgage-backed security, CDO, auction-rate security, corporate bond, and preferred shares markets. On the other hand, liquidity in the CDS market, especially for 5-year duration securities, has been better than other markets, even though it too has experience less dealers, lower liquidity, and wider bid-ask spreads than normal. Yet, it is still functioning and allowing investors with illiquid corporate bond exposure to buy protection with credit derivatives.

Of interest for traders is that in some instances CDS securities have weakened ahead of stock prices, giving traders some clue as to what equities are a cause for concern. As an example, the CDS spreads for Bear Stearns widened by 10 times over two months last summer, significantly under-performing the stock and giving some insight into potential problems. Shortly near the end of the two month period, two Bear Stearns hedge funds collapsed from bad mortgage bets. The traders that were focused on credit risk hedged their exposure in the CDS market long before problems became evident to the equity market. Something worth noting as we hear of new activity in the credit derivative markets going forward.

Unfortunately, it will not be enough to suffer losses from just regular credit default swaps (CDS) and collateralized debt obligations (CDO). As reported in the WSJ, additional pain from synthetic CDO losses may be just around the corner. Synthetic CDOs have been around for a while, but have become popular in the last few years as a way for insurance companies, banks, and funds to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. While many of the problems with CDOs linked to mortgage debt have been uncovered and are currently being felt, problems with CDOs linked to regular corporate debt are now raising the interest of rating agencies.

Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high "investment-grade" credit ratings. Like a normal CDO, different tranches, or levels of risk and return are sold. The tranche structure allows some investors to receive higher returns (while taking higher risk), while making it possible for others to take much less risk, but also receive lower returns. Again, much like a normal CDO, it is possible to create a higher investment grade asset (tranche) out of lower quality securities. Additional details regarding collateralized debt obligations can be found here.

Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, typically invest in the lower-rated or unrated equity tranches. As with any CDO, in order to increase the returns of the equity tranche, the banks that created the CDOs can simply include lower-grade (higher return) debt. As the credit crunch progressed, more of these lower-grade companies have defaulted on their debt, causing the CDO losses to move up to the higher tranches. Given the synthetic nature of the CDO, rating companies are now being forced to develop new methodologies that will allow them to examine synthetic CDOs.

New downgrades will surely result from this closer examination, forcing additional selling of already distressed securities, putting further pressure on the markets. Combined with higher energy costs, this should prove to be a challenging time for some companies and investors, as well as the market in general. The old saying, "may you live in interesting times," will certainly get tested as we move into the dog days of summer.

I often get asked about subprime, Colateralized Debt Obligations - CDO, Collageralized Mortgage Obligations - CMO, Credit Default Swaps - CDS, and that odd thing called a tranche by people other than my students - who already had to endue my lectures on the subject. Therefore, I figured it was worth putting together something for the blog, outside of what I normally teach. Hopefully I can find the time to develop and post a series of tutorials this summer, but in the mean time the following short segment from CNBC's PowerLunch is a good start regarding subprime and the creation of mortgage-backed derivatives (such as CMOs).

There are other explanations (videos and Powerpoints) that are more entertaining and a little less tasteful at times (and also sometimes better at explaining the subject), but I will take the high road for now and let you find those on your own. A few longer presentations that are more informative, but also a little dryer, also exist.

Some investors who purchased the "super-senior" portions of CDOs are beginning to take action to try and protect their investment. Traditionally, super-senior tranches are the safe portion of the CDO, usually safe enough to garner an AA or AAA rating. This comes in part, not just because the super-senior tranches are senior, thereby being the last to incur losses when the debt backing the CDO goes bad, but they are further protected since the senior tranche has now been broken into two tranches, with the super-senior tranche being the highest. Therefore, even if losses approach the senior portion of the CDO, which they have in some instance with the mortgage-backed CDOs, the super-senior investors are suppose to still be safe. Unfortunately, this has not been the case for all CDOs, causing investors in these securities to take action. Some investor groups are now using any power they have to seize control of the deals to make sure they receive their money first. What options do they have? The super-senior investors can either redirect cash flows until they are paid off (acceleration), or pursue what is called the "nuclear option", which involves immediate liquidation. Each are a difficult call since the redirection of cash flows may decrease or stop all together, while the nuclear option causes the securities to be sold at fire-sale prices, sometimes at 60 cents on the dollar. Nonetheless, many super-senior investors feel they have no other options considering that they often bought the highly rated debt as part of the "safe" investment portion of their portfolios, and were not expecting any losses or risk with these securities. The problem is widespread. Morgan Stanley research shows 4,485 downgrades this year alone for various CDOs, with over 4,000 of the downgrades related to CDOs of asset backed securities.