The Rise and Fall of a Subprime CDO
Reading the lead story in today’s Wall Street Journal brings to mind the children’s ruse of crossing one’s fingers behind one’s back while making a statement, thereby shielding oneself from the consequences. Based on the WSJ’s excellent analysis of how one exotic subprime-mortgage-backed instrument was created, rated and sold, it is hard to escape the conclusion that all parties involved had their fingers figuratively crossed in hope. This includes not just the creators, raters and sellers, but also the buyers - after all, the children’s game contains an element of self-delusion.
The subscription-only WSJ article provides a lengthy but well- worth reading reconstruction of the rise and fall of a Collateralized Debt Obligation named “Norma CDO I Ltd.” Norma was formed in late 2006. Most of its slices were rated AAA by the ratings agencies in March, but were downgraded to junk status in November.
One of the key insights of the article is that rather than dispersing risk as they are designed to do, subprime-backed CDOs can be packaged and sold in a way that in effect concentrates the risk. This implies that bank and other losses from CDOs are far from over.
The subprime-mortage crisis is far greater in terms of potential losses than anyone expected because it’s not just physical loans that are defaulting. - Greg Medcraft, chairman, American Securitization Forum.
As if on cue, Goldman Sachs analyst William Tanona upped his projection for fourth-quarter writedowns at big financial firms, including Merrill Lynch, which helped give birth to Norma. He now puts writedowns for Citigroup, Merrill and JP Morgan Chase at $18.7 billion, $11.5 billion and $3.4 billion, respectively, up from his previous estimates of $11 billion, $6 billion and $1.7 billion .
The article includes an animated graphic (available free from wsj.com) that illustrates the steps in Norma’s rise and fall.
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