Defaults of structured credit vehicles based mainly on subprime mortgages continue to rise and now total $170 billion, up from $54 billion at the beginning of this year. Consequently, the $450 billion market for asset-backed collateralized debt obligations (CDO) has been crippled by these rising defaults.
Banks and bond insurers with these deals are suffering and investors are seeking legal action. Ambac, the second largest bond insurer, reported $3.1 billion of mortgage-related charges this week.
Mortgage-backed CDOs attracted lots of investors in recent years because its structure created different slices of risk (aka tranches) that referenced an underlying pool of assets. Senior tranches carry higher credit ratings due to potential losses from the pool of assets borne by the smaller subordinated tranches. However, in the past year, many highly rated CDO tranches have been downgraded sharply and this triggered an Event of Default (EOD) for many structures. When a CDO experiences an EOD, many investors of the deal are pushed to the side and super-senior investors assume control of the CDO.
After seizing control, these super-senior holders will try to get their money back ahead of other investors, including those that held the AAA-rated slice of risk, by accelerating payments to themselves from the assets or liquidating the portfolio. Some other holders are now contesting these actions in court.
Data shows that Merrill Lynch had underwritten 26 CDOs in default and UBS and Citigroup each have 24 deals they have underwritten in EOD. Underwriters often keep significant amounts of the most senior notes of the CDOs on their books. Currently, Citigroup leads the pack with $30 billion, followed by Merrill Lynch’s $29 billion and UBS with $26 billion. Among the managers of CDOs in default, Strategos Capital Management leads with $14.2 billion.
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