Interest Rate Roundup

Tuesday, March 13, 2007

The subprime saga continues -- and what about the CDO fallout?

Today's episode of "as the subprime world turns" deals with more bad news out of New Century Financial and Accredited Home Lenders. The skinny...

* New Century Financial is now under investigation by the Securities and Exchange Commission. Speculation of a bankruptcy filing is everywhere because the company's lenders are demanding the subprime mortgage company repurchase the outstanding mortgages they helped finance.

* Accredited shares are getting crushed ... again ... in early pre-market trading. The company said it's seeking waivers on its debt agreements, is looking at raising new capital, is planning to cut more jobs, and will likely miss the March 16 deadline for filing its annual report. The company has had to pony up $190 million in margin calls in 2007, two thirds of that in just the past few weeks, per Bloomberg.

Another interesting angle to this story: The subprime problems are causing bond investors to look more closely at collateralized debt obligations, or CDOs. CDOs are a fancy form of fixed income investment. They hold bundles of loans, bonds, and derivatives. You can buy various pieces of a CDO, from the lowest-rated, highest risk, highest return piece on up to the highest-rated, lowest-risk, lowest-return piece.

Investors have been snapping up CDOs like candy to boost their returns. A whopping $918 billion in CDOs were sold last year. That aggressive demand has fueled the aggressive creation of new CDOs, which in turn, has sparked aggressive bidding for risk assets -- including high-risk mortgages -- to go into those CDOs.

It has been a virtuous circle that drives funding costs down for consumers and corporations and suppresses risk premiums. But if fears of subprime-driven CDO losses spread, it could cause CDO demand to wane. That would raise borrowing costs market-wide, leading to potential liquidity problems, especially in the high-flying leveraged buyout/private equity takeover markets. After all, most of these mega-deals rely on a steady stream of incredibly cheap debt.

Serious stuff -- so you may want to read this Bloomberg story if you're looking for more details.


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