Sunday, March 01, 2009

Rational Despondence Taking Hold

It might surprise people to know that, despite my extremely dry and sarcastic sense of humor and my reflexive criticism of new ideas, I'm really an optimist at heart. I honestly think everything's going to work out just fine and we're all going to be better off when it's all over (whatever it happens to be at the minute).

I have to say, though, that my optimism is starting to show a few cracks. I freely admit to being one of Paul Krugman's irrational despondence believers; aka those who think that a combination of margin calls and mark-to-market valuation (neither of which, mind you, are bad ideas) are artificially driving CDO asset prices down lower than what they're really worth. They may only be worth 50%-60% of what the banks originally paid, but the banks are being forced to value them at something like 15%-20%, which is causing problems, and I mean, c'mon, there's no way they're that worthless, right?

Well, as it turns out, they really are. Gillian Tett of the Financial Times did some digging on just what exactly all those CDOs are worth, and the results aren't pretty. Key pieces:
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.

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.
This isn't just bad, this is like freakin armageddon. $300 billion, about 2/3 of what used to be the banks' most prized assets, are performing so badly they're in a formal state of default. And when the banks do their best to recoup the losses by seizing and selling the underlying assets, they're getting about 20 cents to the dollar. And remember, all these things were supposed to be virtually risk-free!! Something close to $80B of assets the banks all thought they had are simply gone, *poof*, like that. But you can bet the $80B in liabilities that financed those assets haven't gone away.

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This is hitting pretty close to home, and not just on the optimism front. I studied this stuff in college and seriously considered working for Wall St before I fell in love with CapitalOne. Heck, I probably know (and partied with) a bunch of people who designed and worked on these things. Maybe they know something that I don't, but I keep asking the same question: what happened? I mean, there's a reason they're called asset-backed securities; they're backed by assets. If the security doesn't perform, you seize the assets, liquidate, and recoup most of your loss. And yet it's pretty clear that's not happening. Was my entire Masters of Engineering degree all based on a gigantic lie?

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