The implications of this event, if it occurs, are far reaching. One important result which could occur is further negative headline exposure for the Collateralized Debt Obligations (CDO) industry. This is due to the fact that many CDO managers loaded their CDO portfolios with subprime credit when times were good. However, as the tides turned in recent months these investors have been getting killed, especially the lower quality debt/equity tranches of these portfolios. In fact, the S&P is even considering directly downgrading the CDOs with exposure to the subprime industry - an event that would likely force some insurance companies, pension funds, and other conservative investors to cut CDO exposure. In fact, I talked to one CDO trader today who said, "I need a new job asap...things are tough right now."
In addition, the prices of subprime securities are likely to move further below par because big investors such as pension funds can only hold credit above a given credit rating (as stated in their covenants), and this downgrade will likely push some of the subprime debt below the pre-stated credit-rating cut off. As a result, some of these investors will be forced to sell.
But keep in mind this potential downgrade only represents about 2% of the entire subprime loans industry, which has roughly $565 billion of credit in issuance. Therefore, while the entire subprime credit market sold off today (and the subprime-exposed CDOs got hit), it's actual effect on my 2nd point (forcing "conservative by design" investors to sell) is probably rather minimal. But its more realistic effect (and reason it wreaked havoc on the subprime market today) is the fact that it does manage to remind investors that the subprime industry remains tremendously dangerous, especially as home prices continue to struggle. But I'd argue the "professionals" shouldn't need to be reminded of that, again.
But keep in mind this potential downgrade only represents about 2% of the entire subprime loans industry, which has roughly $565 billion of credit in issuance. Therefore, while the entire subprime credit market sold off today (and the subprime-exposed CDOs got hit), it's actual effect on my 2nd point (forcing "conservative by design" investors to sell) is probably rather minimal. But its more realistic effect (and reason it wreaked havoc on the subprime market today) is the fact that it does manage to remind investors that the subprime industry remains tremendously dangerous, especially as home prices continue to struggle. But I'd argue the "professionals" shouldn't need to be reminded of that, again.
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Reader Comments (Page 1 of 1)
7-11-2007 @ 8:47AM
Mike said...
You HIT it. The subprime market AND the ripple effect is terribly dangerous. The real estate market begged for a good correction. It is starting to get it...