Study: Mortgage Risk Exposes CDOs to Significant Potential Losses

Risk in the U.S. mortgage market may have been severely understated for years, according to market analysts in a paper presented late Thursday at Hudson Institute, a public policy research organization.

Drexel University’s Joseph Mason and housing analyst Joshua Rosner from Graham Fisher & Co. unveiled new research which raises concerns that mortgage-linked collateralized debt obligations (CDOs) are exposed to significant and unanticipated losses if the U.S. housing market continues to stagnate.

CDOs are structured derivatives that aggregate existing securities, and the authors argue that MBS pools have become the predominant class of assets backing a majority of collateralized debt obligation issuance.

“The FDIC reports that 81 percent of the $249 billion of CDO collateral pools issued in 2005, or $200 billion, was made up of residential mortgage products,” the study said. “Moody’s CDO Asset Exposure Report for October 2006 reveals that 39.5 percent of the collateral within the 678 deals covered by Moody’s consists of RMBS, just over 70 percent of that in subprime and home equity loans and the other 30 percent in prime first-lien loans.”

The authors charge that inadequate transparency, massive structural changes in asset composition, and “a credit rating industry ill-equipped to evaluate market risk and operational weaknesses” could result in a broad financial decline, initiated by a weakening housing industry and aggravated by a retracting credit market.

“The danger in these products is that in changing hands so many times, no one knows their true make-up, and thus who is holding the risk,” said Rosner. “Revelations by HSBC and others over the past few weeks have finally confirmed that these risks are much more significant than the broader markets had anticipated.”

Mason and Rosner argue that their analysis of subprime spreads suggests that “investors might not fully appreciate these risks,” as investors have not been demanding higher returns for investing in riskier assets tied to the U.S. mortgage market.

“This study of risk in the subprime mortgage market is very timely,” said John C. Weicher, director of Hudson Institute’s Center for Housing and Financial Markets. “The subject has been much in the news just in the last few days, but there is a need for further research.”

Download: Access the full research paper by clicking here.