Collateral Damage: Sizing and Assessing the Subprime CDO Crisis

Abstract

This paper conducts an in-depth analysis of structured finance asset-backed securities collateralized debt obligations (SF ABS CDOs), the subset of CDOs that traded on the ABS CDO desks at the major investment banks and were a major contributor to the global financial panic of August 2007. Despite their importance, we have yet to determine the exact size and composition of the SF ABS CDO market or get a good sense of the write-downs these CDOs will generate. In this paper the authors identify these SF ABS CDOs with data from Intex©, the source data and valuation software for the universe of publicly traded ABS/MBS securities and SF ABS CDOs. They estimate that 727 publicly traded SF ABS CDOs were issued between 1999 and 2007, totaling $641 billion. Once identified, they describe how and why multisector structured finance CDOs became subprime CDOs, and show why they were so susceptible to catastrophic losses. The authors then track the flows of subprime bonds into CDOs to document the enormous cross-referencing of subprime securities into CDOs. They calculate that $201 billion of the underlying collateral of these CDOs was referenced by synthetic credit default swaps (CDSs) and show how some 5,500 BBB-rated subprime bonds were placed or referenced into these CDOs some 37,000 times, transforming $64 billion of BBB subprime bonds into $140 billion of CDO assets. For the valuation exercise, the authors estimate that total write-downs on SF ABS CDOs will be $420 billion, 65 percent of original issuance balance, with over 70 percent of these losses having already been incurred. They then extend the work of Barnett-Hart (2009) to analyze the determinants of expected losses on the deals and AAA bonds and examine the performance of the dealers, collateral managers, and rating agencies. Finally, the authors discuss the implications of their findings for the “subprime CDO crisis” and discuss the many areas for future work.