How Might Subprime Issues Unravel?

Is there anything more expensive than reaching for yield?

Its been touch-and-go lately in the subprime sector lately, brought on by the combination of higher interest rates and a blow up in a Bear Stearn’s Hedge Fund. Here’s the latest from Bloomberg:

"Merrill Lynch & Co.’s threat to sell
$800 million of mortgage securities seized from Bear Stearns Cos.
hedge funds is sending shudders across Wall Street.

A sale would give banks, brokerages and investors the one
thing they want to avoid: a real price on the bonds in the fund
that could serve as a benchmark. The securities are known as
collateralized debt obligations, which exceed $1 trillion and
comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices
may not reflect the highest rate of mortgage delinquencies in 13
years. An auction that confirms concerns that CDOs are overvalued
may spark a chain reaction of writedowns that causes billions of
dollars in losses for everyone from hedge funds to pension funds
to foreign banks. Bear Stearns, the second-biggest mortgage bond
underwriter, also is the biggest broker to hedge funds."

Let’s have a look at those prices that are schmeiessing Bear Stearn’s fund:

CDO Subprime-backed, sold at 3.6% over Prime 
BBB, BBB minus

chart courtesy of Markit

Ouch! That’s a new low on the ABX BBB minus CDOs, down 40%. This validates the old expression there is "nothing more expensive than reaching for yield."

The weekend edition of the WSJ detailed exactly how Bear ran into trouble:

Bbb"The fund bet a popular index that tracks subprime
mortgages, the ABX, would fall. Late last year and early this year,
those moves bore good returns, says a person familiar with the matter.
Then the tide began to turn. After reaching a low of 62 late in
February, amid
rising numbers of defaults and delinquencies in the
subprime market, the ABX unexpectedly recovered in the months that
followed, reaching 72 in mid-May. It has since gone back down to 61.
This led to losses for Mr. Cioffi.

Mr. Cioffi’s team also bet collateralized debt
obligations, or pools of mortgage-backed bonds, would keep their value.
But some of them fell in value, leading to further losses."

As the above chart showed, the ABX CDOs now trade even lower, at 60.

So much for the theory that pools of risky assets wouldn’t fall. Indeed, it is slowly starting to dawn on people that the Subprime-Loan Risk has increased significantly. Yet another Bloomberg article today:

"The perceived risk of owning low-rated subprime-mortgage bonds created in the second half of 2006 rose to a record as loan delinquencies and mortgage rates climb, according to an index of credit derivatives.

Bbb_minusAn index of credit-default swaps linked to 20 bonds rated BBB- fell 2.9 percent to 62.12, according to Markit Group Ltd. The ABX-HE-BBB- 07-1 index’s previous low of 62.25 came on Feb. 27. An ABX index linked to 20 similar securities from the first half of 2006 remains about 10 percent off a low hit in February.

About $515 billion of securities backed by subprime mortgages were sold last year, according to Arlington, Virginia- based Friedman Billings Ramsey Group. U.S. foreclosure filings surged 90 percent in May from a year earlier, to 176,137, Irvine, California-based RealtyTrac Inc. said today.

Subprime mortgages are made to borrowers with poor or limited credit histories or high debt. Interest rates on the loans are usually fixed for two years, usually at least two percentage points higher than the safest mortgages, and then typically rise 3 percentage points or more unless benchmarks that the rates are tied to decline.

Late payments of at least 60 days, foreclosures and seized property among loans tied to the latest ABX index rose 1.63 percentage points to 8.75 percent in April, after climbing more slowly in the previous two months, Barclays Plc analysts say, based on “remittance reports” bond trustees released May 25. The index had rebounded 18 percent between Feb. 27 and May 14."

Will the liquidity rich markets be able to shake this off? if the Bear fund is the only blow up, I would imagine yes.

However, if there are other funds out there with lurking sub-prime issues like this one, then the deadly derivatives crowd — of which I have not been an active participant — may actually have something ugly to worry about. The Bear Stearns fund was highly leveraged — it was $21 billion long, $9 billion short ($13B net?). On equity of $660 million, that works out to be  about 20 to 1 . . .

UPDATE: June 21. 2007 12:29 pm

There’s an interesting article on the history of the ABX sub-prime indices:

"Founded and run by a former bank credit-trading executive, 45-year-old Lance Uggla, the Markit firm — with the backing of 13 of the world’s biggest banks — is helping turn the opaque world of credit trading into a high-volume and more transparent business. The ABX.HE indexes that it runs are acting as a barometer of the subprime market and also allow investors to trade credit protection against that market.

Markit’s Mr. Uggla came up with the idea to found Markit five
years ago while overseeing credit-trading operations at TD Bank Financial
Group’s TD Securities’ London operations. He noticed how little available
pricing information there was.

At TD Securities, "we were running a global credit-trading group
that had some $20 billion-plus in assets," Mr. Uggla says. "We built the Markit
database to gain insight into credit pricing across the major markets."

He approached the bank with the idea of spinning off his trading
group’s database and the technology behind it as its own company. The
Toronto-based bank signed off on the plan with the caveat that Mr. Uggla had to
find other banks to become investors as well as to send their credit-derivative
pricing to Markit.

A spokesman confirms that the bank supported Mr. Uggla but says
specifics of the deal are confidential.

By 2003, Mr. Uggla had a dozen banks signed up. He sold stakes in
Markit to each founding bank, including Bank of America Corp., Morgan Stanley, Toronto-Dominion Bank and
Goldman. Like other customers, they also must pay fees for Markit’s data. Mr.
Uggla made a critical acquisition in 2003: a database operated by J.P. Morgan
Chase & Co., Deutsche Bank and Goldman. That database keeps a record of
companies, their legal entities and their debt obligations.

Index With Odd Name Has Wall Street Glued; Morning ABX.HE Dose



Bear Stearns Fund Collapse Sends Shock Through CDOs
Mark Pittman
Bloomberg, June 21 2007

A ‘Subprime’ Fund Is on the Brink
June 16, 2007; Page B1

Bond Risk Rises on Concern Over Bear Stearns Hedge-Fund Losses
Hamish Risk
Bloomberg, June 21 2007

Index With Odd Name Has Wall Street Glued; Morning ABX.HE Dose
WSJ, June 21, 2007; Page C1

Print Friendly, PDF & Email

What's been said:

Discussions found on the web:
  1. winjr commented on Jun 21

    “As the above chart showed, the ABX CDOs now trade even lower, at 60.”

    Is this actually the price at which the CDO’s trade? My understanding of the Markit system was that their charts reflect the relative cost of insurance on the asset being graphed. No?

  2. Barry Ritholtz commented on Jun 21

    No idea — that was the only chart I could find that was easily reproducable

  3. michael schumacher commented on Jun 21

    and these are “professionals” right???

    too funny…at least the Bear Stearns part.

    So this will cause a massive write down against the assets? Where is Larry when they need him??

    I take so much solace in the fact that Hank has called for a bottom yet again…

    Yep sub prime is sure contained!!!-LOL


  4. Christopher Laudani commented on Jun 21

    Hey Barry,

    Look on the bright side – none of the Bear Stearns execs will lose their original $40 million investment in the fund.

    I’m sure they made it all back (and more) in the form of fees and expenses.

    So its all good!

  5. KP commented on Jun 21

    Calculated Risk has been all over this lately.

    All that leverage was bound to break free sooner or later. I just hope that the chain reaction proceeds slower than many expect it will.

    Housing bottom my ass!

  6. Estragon commented on Jun 21

    Winjr – “My understanding of the Markit system was that their charts reflect the relative cost of insurance on the asset being graphed. No?”

    My understanding of this particular index (ABX-HE-BBB 07-1) is that it more or less reflects the value of the underlying bundles of mortgage pool tranches. They’re complicated beasties though, and I could well be wrong.

  7. Estragon commented on Jun 21

    BR – “Will the liquidity rich markets be able to shake this off? if the Bear fund is the only blow up, I would imagine yes.”

    While reading the piece I’m thinking “$800 million… pfft, some of the big investment banks probably have bar tabs bigger than that”.

    Then I start thinking, what if one of the big IB’s starts shooting against the weaker credits? Liquidity is a double edged sword, and isn’t always stabilizing – especially when it starts sloshing around in illiquid markets.

  8. winjr commented on Jun 21

    “My understanding of this particular index (ABX-HE-BBB 07-1) is that it more or less reflects the value of the underlying bundles of mortgage pool tranches. They’re complicated beasties though, and I could well be wrong.”

    Estragon, if that were the case, wouldn’t you think there’d be a FASB reg around somewhere requiring the holder to mark to market? It appears that no mark to market is actually going on because actual values are “unknown” for accounting purposes.

  9. GerryL commented on Jun 21

    It is interesting that Nouriel Roubini who predicted the subprime contagion was regularly on Kudlow. Kudlow would laugh at him. Now that his predictions are coming true he is no longer on the show.

  10. some guy commented on Jun 21

    Barry, I heard similar numbers to what you quoted for their long/short exposures, but I haven’t seen it quoted anywhere. Do you have a source for where you got those numbers?

    the chart Barry put up is for the ABX BBB- which consists of 20 individual reference bonds, so there are similarities to a CDO in that it is a portfolio of other structured products, but CDO’s are then retranched into AAA, AA, A, BBB and equity pieces and the ABX is not (TABX is the tranched ABX derivative contract) so it’s not a good reference for where specific CDO bonds “Trade” or are priced as you have to consider the rating on a CDO bond.

    Also, most cdo’s are rather unique and the asset representation in the ABX may not accurately represent a given CDO so there can be a lot of disparity between a given CDO and the ABX chart Barry threw up on the site. Many CDO’s will have a better asset selection than the ABX as managers actively choose them, but that’s not to say they still won’t take heavy losses.

    Finally, CDO paper rarely trades so where bonds are being priced and what they are worth can and probably does vary significantly. This forced liquidation of Bears assets may provide some clarity on market levels and force dealers, hedge funds, insurance companies, etc… to reprice their books. I say maybe because they’ve been able to avoid doing so for a while now so who knows.

  11. michael schumacher commented on Jun 21

    what a market when the the real value on an asset class is’nt realized until the owner is either forced to write it down( to make amends for overall market movement) or sell it.

    Sounds alot like the sellers of homes this year: “It WAS worth X in 2005 so it’s worth X now”

    How come I can’t do that with my house??-LOL

    Just like the real estate market….inventing value that is/was never there.

  12. Estragon commented on Jun 21


    I believe FAS159 requires companies to value individual securities and derivatives with a consistent method (eg. amortized cost, mark to market), but leaves it to them to choose the method for each specific derivative.

    some guy:
    Nice explanation! Do you happen to know if many CDO’s etc. have been battle tested in courts? I’ve read through some of the docs, and the complexity strikes me as fodder for lawsuits.

  13. winjr commented on Jun 21

    “I believe FAS159 requires companies to value individual securities and derivatives with a consistent method (eg. amortized cost, mark to market), but leaves it to them to choose the method for each specific derivative.”

    A guy who knows his FASB’s. :) I don’t; just tax. Bear with me. If Merrill today sells BBB tranches at 30% off par, would all holders of the same tranch be required to mark to market at 30% off, assuming the sale data was public information?

  14. S commented on Jun 21

    When the 10-Qs for the period just reported are filed, Merrill will join Goldman and Morgan Stanley in the $1 trillion club (i.e., assets of $1 trillion on its balance sheet).

    Undoubtedly, some of the trillion in assets on Merrill’s balance sheet includes these esoteric securities that everyone has been very happy to mark to model to keep the Ponzi afloat.

    So I fully understand why the B/Ds and money center banks want to rescue the Bear Stearns hedge funds. It is in their best interest to prevent the establishment of a market price for the paper that’s usually marked to model.

    So I just don’t understand how Merrill benefits by forcing everyone to mark down their positions to market….when presumably they have positions that will be marked down in the process.

    The only logical reason I can think of is that Merrill perceives the problem as worse than most of the others and they want to be the first out the door. Am I looking at this totally wrong? Are there other reasons why Merrill is being a hardass?

  15. some guy commented on Jun 21

    ABX positions are being marked to market daily according to the official Markit close… at least they should be. CDO positions are tougher to mark to market because it’s very difficult to determine what the market is.

  16. Estragon commented on Jun 21


    I’m not an accountant, just an investor.

    As some guy suggests above, liquid securities would be valued at the current exit price in an orderly market. The way I see it, just seeing a big chunk trades at a lowball price doesn’t necessarily force everyone holding that security to mark it down to that price for three reasons:

    1. There may be bids for smaller blocks at prices higher than the forced sale. That would meet the exit price requirement, as size impairments aren’t considered for fair market value AFAIK.
    2. You could argue that the market was not orderly for the security at the time of the forced sale, and that there’s no longer term impairment of value.
    3. The specific security may not be valued on a mark to market basis by a particular company in the first place. Illiquid securities intended to be held to maturity would be valued to a model, and that would still be the case unless the model itself was determined to be wrong.

    JMHO though.

  17. Stuart commented on Jun 21

    would it not be reasonable to imply that the ABX is a proxy of the underlying market of the CDO positions? i.e. if the ABX has dropped 40%, could you not conclude that the underlying market for the CDOs is also decreased near 40%?

  18. Estragon commented on Jun 21


    It seems to me to be apples and oranges to some extent. Maybe what we CAN say is that there does appear to be the smell of rotting fruit in the air ;-)

  19. wyler commented on Jun 21

    . . . I just don’t understand how Merrill benefits by forcing everyone to mark down their positions to market….

    S — I was wondering the same thing. My conclusion was that it would provide a PPT opportunity to set up a white-knight buyer to purchase an appropriate amount at an appropriate price to preclude markdown and calm markets.

    However, given the apparent sloppiness and start-stop decisions of the proceedings together with the variances in media-reporting, I’m now beginning to question that, too.

    There’s also a grudge explanation (if one can hold a grudge so long) that’s been bandied about: Bear didn’t particpate in the LTCM bailout — see comment below this DealBreaker post:

  20. bondguy commented on Jun 21

    The ABX index referenced a series of sub prime traunches issued in the previous several months. As such it is a proxy for how the cash sub prime market is trading.

    It was amazing to me that Merrill would even think about selling these bonds. All the major bond dealers have massive exposure to CDOs of various collateral(sub prime mbs, leveraged loans etc). Everyone in the bond market knows that there is NO liquidity in these CDOs (I had one dealer flat out tell me never to ask for a bid!). The street MUST keep this game going and I really thought that Bear would step up and buy the bonds just to keep it all quiet.

    The next shoe to drop will probably be more downgrades by Moody’s of cash sub prime mbs(they just downgraded a bunch last Friday night). These downgrades may lead to more forced selling. The street will keep the game going for a while but I expect by year end it will be ugly. Don’t forget that the collateral performance by the loans originated in 2006 is bad, but the big suprise to the market is that 2004, and 2005 collateral is performing somewhat worse than expected.

    Also remember that much of the leveraged buyout money is coming via leveraged loan CDOs. Any disruptions in the CDO market just may slow down the buyout craze.

  21. johntron commented on Jun 21

    It’ll be interesting if Fed-induced liquidity to ease the CDO issues (after a mini-crisis whoosh down) will find its way into equity markets….to foment one last orgy of speculative frenzy a la 1997 (post-Asia), 1998 (post-LTCM) and 2000 (post-Y2K).

    Thus satisfying those who’d want a parabolic blow-off top before a true bear market.

  22. Mortgage Broker Coaching, LLC commented on Jun 21

    Are you acting like a used car salesman?

    Mortgage Broker Coaching Blog – I can just hear this guy screaming at me on the television, NO MONEY DOWN, NO CREDIT, NO JOB AND NO PAYMENTS UNTIL 2030!Is this how your clients perceive you in the marketplace? Of course

  23. wally commented on Jun 21

    “A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark.”

    It is worth thinking long and hard about the utter illogic of the position implied by this statement. If banks, brokerages and investors know that a benchmark price would kill them, then they ought to immediately get out of the positions they are in. This means that WHETHER OR NOT a Merrill sale of Bear collateral goes through, the damage is done. It may not show yet, but it is done.

  24. Neal commented on Jun 21

    Multiple choice question

    These are valuable assets because:

    a) No-one knows the value of them.

    b) There is no ready market for them.

    c) Selling them at value would destroy the market.

    d) The people that structured them had no grasp of the housing market.

    e) Some people made billions on convincing others that these were a good deal.

  25. stuart commented on Jun 21

    Hmmm… then given the relatively illiquid market, how does one determine the market value for them, especially the lower grade tranches? That to me, at least, would appear to be a relevant and timely question. Oh, what a wickid web we weave..

  26. semper fubar commented on Jun 21


    e) Some people made billions on convincing others that these were a good deal.

    Where do I pick up my prize?

  27. Neal commented on Jun 21

    The prize will be shipped direct to you, no need for you to pick it up. I’ll need your address, SSN for identification purposes and a major credit card number to cover the shipping costs.

  28. Estragon commented on Jun 21


    Value by model is largely done based on historical defaults etc. Therein lies the problem.

  29. RealEstateRisk commented on Jun 21

    The best part is the fact that the manager of the Bear Stearns hedge fund was selling the worst assets to another fund that he was going to try to take public in a july IPO! It may have had a chance to get approved by the SEC last week, but after this weeks blow up not a chance.

  30. Eclectic commented on Jun 21

    Musical Chairs – a common game of amusement, operated according to a circumstance in which music is played, and upon a sudden stopping of the music, a number of ambulating participants (P) vie for a fixed number of chairs that is specifically established as “P minus one.” Each cycle of the game produces a participant unable to claim a chair who is subsequently disqualified from continuing and is removed from the game, as is one chair such that the available chairs for the next cycle continues to be P-1. The game is concluded with the completion of the cycle in which when P = 2 and only 1 chair is available. The winner takes some sort of prize for having possession of the last chair in the cycle.

    Hedged and Leveraged CDO Derivatives Contracts Market – A similar game of musical chairs, but one played in secret in which nobody knows how many participants there are (not even the participants know), nor do they know how many chairs there are.

    However, I would imagine that Dr. Benber N. Anke (from everything he’s written and said) may suspect that the number of chairs is substantially less than P-1.

  31. Winston Munn commented on Jun 21

    What a racket – Moodys, et al, help create the CDO tranches, are paid higher for this type of work, and then rate the very tranches they helped create.

  32. Philippe commented on Jun 22

    A repeat of hide the truth as long as possible?
    « Time can heal » but to a certain degree and as long as the capital and owned funds of the participants are not impaired.
    The aftermath of the sub prime, real estates and to be read after « LBO« :
    Banks and financial companies risks exposures are not correctly reflected in their financial statements (main actors worldwide)
    Profits statements are since long inflated, as real profits are not truly assessed (adequate provision for losses are not provided and it is to be feared that they cannot afford to provide for it)
    Rating agencies are not reliable indicators for risk assessment purpose.
    The leverage on capital and owned funds of investment banks is unsustainable and LTCM debacle will prove to have been a small incident in the financial history.
    What will be the outcome of derivatives linked unwinding ?.
    Greed is healthy as long as the core play is not « Head I win, tail you lose »

  33. EricP commented on Jun 22

    Did I not read correctly but didn’t the story say BS was short credit in February and the rebound hurt them? Based on this information, if the Feb low was 62, and then it rallied to 72, BS got long at 72. So they are not too far in the hole at 60, as opposed to the rest of the market who own paper at 95+.

  34. Greg0658 commented on Jun 22

    I been wanting to ask you all but been waiting and re-reading BR’s post to figure it out myself.

    The top of the hour trade (forgot what pm hour) on Feb 27th – do you think the events in the above charts helped create that stutter or was it part of the cause of the stutter?

  35. Stuart commented on Jun 22

    Another S&L type of debacle taking shape.
    As an aside, Trichet lecturing the US that they should not have discontinued publishing M3 today. To paraphrase. “If you don’t publish indicators on money supply, how can you control the root cause of inflation.” Love it, absolutely love it.

  36. Scott commented on Jun 22

    “I really thought that Bear would step up and buy the bonds just to keep it all quiet.”

    Didn’t they try to do this through the back door, but they got caught by some other hedge funds that were betting things would fall apart?

    Hedge Funds Slam Bear Stearns Over Subprime Losses

  37. Eclectic commented on Jun 22

    Motor Truckers.

    They are all motor truckers.

  38. Eclectic commented on Jun 23


    I have an interesting philosophical question for you.

    Regarding my previously described death row inmate, the one with the death sentence permanently commuted by the governor until such time that the 10-y-T closes at or higher than 5.250… You remember my inmate, don’t you?

    Sure you do… there’s very little I write that you don’t remember.

    Well, given that such inmate were to have the capacity to either, 1) – loan money to help stabilize a sub-prime CDO leveraged hedge fund, or 2) – issue margin calls for loans already outstanding to same, which of these options do you rekkin he’d elect to do?

    You are free to assume that the death row inmate is otherwise a rich motor trucker and money is no object.

    Which one would you do?

    Do you think for making a decision he’d take into consideration anything said by Paulson?… Anything said by the hedge fund?… Anything said by banks that already lend to the hedge fund?… Anything potentially said by Dr. Anke?… Any summary of things said (by anyone) and reported (whether accurately or not) by media?

Posted Under