CDOs Are Hit With Fallout
From Laxity With Subprimes

Turmoil in the subprime-mortgage market fanned out yesterday, hitting a group of investments that are exposed to this struggling class of home loans.

Moody's Investors Service said yesterday it may cut its credit ratings on slices of 91 collateralized-debt obligations, or about $5 billion of securities. It is a small percentage of the overall CDO market, but still an important development, because it is a signal that subprime fallout is rippling through financial markets to an important class of investments.

In another sign of these ripple effects, Fitch Ratings released a report yesterday raising cautionary flags about the commercial real-estate market. It projected rising defaults in this sector after years of increasingly lax lending standards, which could hit bonds backed by commercial real-estate loans.

The CDO market has exploded in size in the past few years. Last year alone, $320 billion of CDOs were issued by Wall Street, according to data from Deutsche Bank. That included $170 billion backed by asset-backed securities, including subprime mortgages.

CDOs are important more broadly to the economy. They helped to drive the growth in subprime lending by buying the riskiest part of subprime-backed bonds. The investments are widely held by pension funds, insurance companies, banks, some mutual funds and hedge funds. They have been alluring because in the past few years they have offered high returns and, in many cases, been marketed with promises of minor risks. Now that risk/return formula is changing.

Moody's action came a day after it and Standard & Poor's said they would downgrade hundreds of subprime- mortgage-backed bonds widely held by CDOs. S&P has also released a long list of CDOs it believes are holding some of the bonds on which it will soon cut ratings.

CDOs typically hold hundreds of bonds or loans, much in the way a mutual fund holds stocks. Many mortgage-backed securities tied to subprime home loans reside in these CDO investment pools. Unlike those of mutual funds, CDO managers, which include the big Wall Street investment banks and smaller boutique investment managers, dice and slice their holdings so investors can choose the amount of risk they take on with their CDO holdings.

The riskier slices of some CDOs are now coming under assault. Deutsche Bank data show that investors were demanding 7.75 percentage points above a popular interest rate benchmark in mid-June to hold triple-B-rated CDOs, up from about 3.70 percentage points at the beginning of 2007, evidence they want more return for their risk.

Some investors worry that this aversion could spread to the less risky, and more widely held, slices of the CDO market, too. "I don't think the typical owner of triple-A[-rated bonds] realizes how badly they're going to get hurt when these CDOs get repriced -- it's pretty severe," says Thomas Swaney, co-manager of the Oppenheimer Champion Income Fund.

Troubles in this market have been building for months as delinquencies have risen on subprime mortgages. Last month, two hedge funds run by Bear Stearns Cos. nearly collapsed, in part because of struggling CDO investments.

At this point, it isn't clear how severe the fallout will be. According to Thomson Financial, global issuance of CDOs has continued to grow, hitting $265 billion so far this year, up from $202 billion over the same period in 2006. However, the rate growth has slowed significantly; issuance over the same span had jumped from $52 billion in 2004 to $102 billion in 2005. This includes CDOs that hold investments other than subprime loans.

Though subprime troubles have so far been contained to a narrow slice of the financial markets and the economy, a report last week by Credit Suisse estimated that potential losses to CDOs heavily steeped in the subprime market could range from $26 billion to $52 billion.

The lower-rated slices of CDOs absorb initial losses when mortgages in mortgage-backed securities default, providing a cushion for investors holding the higher-rated, investment-grade slices of the investments.

If demand among investors collapses for these lower-rate slices which provide the cushion, Wall Street could have problems putting these vehicles together in the future.

"We had thought the downgrades to structured finance CDOs would come at the end of the year, but the pace of deterioration suggests that rating agencies may pull the downgrade lever sooner rather than later," said Anthony Thompson, head of U.S. asset-backed securities and CDO research at Deutsche Bank.

Investors are still spooked from last month's forced sale of CDO securities by the Bear hedge funds. Sale of these CDOs, which were mainly backed by mortgage bonds, sparked fears of falling prices and panic selling.

These fears were soothed somewhat by a bailout of one of the funds by Bear Stearns, and, a steady pillar of support: investors such as insurers and pension funds that have longer investment horizons and are less perturbed by swings in prices.

But downgrades are likely to heighten worries again, as insurers and pension funds may have restrictions on the credit ratings of the assets they hold. Ratings cuts may force them to sell their holdings at a loss.

--Diya Gullapalli contributed to this article.

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