More Trouble Ahead: S&P Lowers CDO Assumptions
Here we go - again. Standard & Poor’s recent announcement to lower its assumptions on how much money investors will recover following defaults of subprime-exposed collateralized debt obligations (CDOs) indicates additional downgrades are likely on the horizon.
More downgrades mean banks, insurance companies and securities firms will be forced to raise more capital, cut dividends or reduce assets. And that means investors are likely to encounter additional financial losses.
Problems with CDOs have caused monetary havoc with investors - and now they’re asking questions. Many want to know why the risks associated with the product were never fully disclosed to them; others want answers as to why rating firms like Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s Ratings Services missed the mark in assessing the risks of mortgage-backed securities in the first place.
As a result, CDO lawsuits are gaining ground.
S&P’s latest warning of additional ratings cuts comes on top of the more than $351 billion that the ratings firm already has issued in less than a year. As reported in an April 28 article by Jody Shenn on Bloomberg.com, the CDOs covered in S&P’s recent adjustment are at least 40 percent invested in various U.S. home-loan bonds created since Sept. 30, 2005, or pieces of other CDOs with similar holdings. The most-senior bonds from the CDOs originally rated AAA should recover 60 percent of principal owed, while securities rated A or lower will get nothing.
Investors should recover 35 percent of principal after defaults on securities from the CDOs junior to their super-senior classes but also originally rated AAA, S&P said. Investors with originally rated AA classes should recover 5 percent at best.
Mortgage-linked CDOs - mainly classes previously rated AAA by S&P or Aaa by Moody’s - are at the center of the more than $320 billion of asset write-downs and credit losses reported by some of Wall Street’s biggest investment banks and securities firms. CDOs repackage assets such as mortgage bonds and buyout loans into new securities that assume varying degrees of risk.
Ambac Financial Corp., the second-largest bond insurer, reported $940 million of new reserves last quarter because of expected losses on CDO “squareds,†which are made up solely of other CDOs, and “high-grade†CDOs, which hold asset-backed bonds with high ratings, including other CDOs.
Rating Agencies Under Fire
Subprime-exposed CDOs have a beating since the beginning of 2007. Prior to the subprime fallout, Fitch, Moody’s and Standard & Poor’s assigned highly favorable ratings to many of these mortgage-backed securities. Then, following the subprime crisis and the resulting credit crunch, the rating agencies reversed their ratings, downgrading billions of dollars of mortgage-related investments.
All of which has created an outcry from investors and analysts alike to hold the rating agencies liable for assigning investment-grade ratings on doomed subprime securities. For their part, investors are not remaining idle. Many are taking legal action.
So far, CDO lawsuits have been filed by shareholders, who allege the investment vehicles’ risks were never properly disclosed by their broker. In the future, however, the next shoe to drop from the subprime fall-out could involve legal claims against the credit ratings firms, banks and hedge funds by institutional investors, including other hedge funds and pension funds.
Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.Â
