That distant subprime cousin: How you're related

Speaking of the complexity of funding mortgage loans (see previous post), Moody's Investors Service has a report out on the risk the subprime mortgage meltdown could pose to financial guaranty companies that insure mortgage-backed securities (MBS), and CDOs (collateralized debt obligations).

Companies rated by Moody's insured $7.5 billion in MBS backed by subprime loans in 2006. It's comparatively easy to evaluate the impact of subprime mortgage defaults on those securities -- zilch. Moody's expects cumulative losses for the worst performing pools of subprime loans originated in 2006 will range from 10 percent to 16 percent.

But that won't be a problem for most of the MBS guaranteed by the insurers in 2006, because they had Aaa ratings. Losses would have to hit 26 percent to 30 percent before most of those highly-rated securities would be affected and the companies would have to start paying out claims, Moody's says.

But assesing the risks subprime loans pose to CDOs invested in MBS and asset backed securites (ABS) is trickier, because their exposure is indirect.

"In many instances, the ABS CDOs insured by the guarantors have invested in subprime RMBS and/or in other CDOs that have, in turn, invested in securities that include some subprime RMBS," Moody's analysts explain. "The complexity of these exposures, with the subpirme mortgage loan risk being once or twice removed from the direct investment of the ABS CDO, renders reasonable estimation of CDO performance .. quite challenging."

Most of the guarantors rated by Moody's have been active in insuring CDOs that are invested in ABS and MBS -- to the tune of $61 billion in 2006 and 2007. If subprime losses hit 14 percent, Moody's warns that four out of five companies active in insuring ABS CDOs "would need to undertake capital strengthening measures to maintain their Aaa ratings."

For a diagram from the Moody's report and further explanation of how defaults on subprime loans can affect securities that aren't directly invested in them, click continue reading.

Subprime borrowers may have an 80 percent first mortgage and a 20 percent closed-end second mortgage (far left in diagram). The loans are packaged into pools of collateral that form the basis of mortgage backed securities (MBS). The securities are sliced up into "tranches" with different levels of risk, with those tranches with the greatest risk generating the biggest returns but which have lower priority to the cash flows generated by the loan payments. The Aaa-rated tranche has the first priority to the cash flow, followed by Aa, A- and lower rated tranches.

These tranches may be held along with other ABS (asset backed securities) in CDOs,  (collateralized debt obligations). High grade CDOs are typically invested in Aa or higher rated tranches, while mezzanine CDOs typically have Baa or higher rated tranches. Both may be invested in lower-rated tranches.

The high grade CDO at the far right of the diagram ends up exposed to lower rated MBS tranches even if it's only invested in the highly rated tranches of a mezzanine CDO. The mezzanine CDOs exposure to Baa and Ba rated RMBS tranches (subprime) produces expsoure for the high grade CDO.

The big picture

If you want to take a step back and look at the entire picture, here's another diagram from the International Monetary Fund report mentioned in an earlier post today. It's like one of those mazes from the Sunday comics. See if you can help Sammy Sawbuck find his way from the subprime borrower's wallet to the hedge fund investor's bank account. Watch out for haircuts, margin calls and fire sales of assets!

(Click for larger image)

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