An Inside View: Managing a CDO, and Why the Rating Agencies Matter

I received the below email a few weeks ago in late June from a HW reader in the capital markets who asked to remain anonymous. Given what’s taken place today with both S&P and Moody’s (and I’m sure, very soon, Fitch Ratings), I thought it would be appropos to share. The story speaks for itself:

A friend of mine works as a portfolio manager for a $2.2B CDO [invested heavily in subprime bonds]. I spoke to him on Friday for an hour. Asked how he is doing, he says “nothing.” I ask what do you mean nothing, I’m hearing all of these stories about CDO’s and losses (Bear Stearns for example), he shrugs and says nothing will happen until the rating agencies do something.

Asked about losses, he says they are there, but he doesn’t have to mark-to-market his portfolio until someone discovers it or the rating agencies force his hand. So his plan is to lie low and collect the management fees (and bonuses) and pretend as if there are no losses.

Asked about management fees, he laughs and says it’s a low 50 bps. Wow! On $2.2B, that’s a cool $10M yearly which he and his four colleagues have to split up at the end of the year. He says he has the best job in the world and says there is really no work to do every day. Just wait and hope that the rating agencies don’t downgrade his CDO pool and voila, at the end of the year, he and his partners can split the $10M spoils (minus the expenses for one Park Avenue office, and a secretary).

I am amazed that nobody (regulators, investors, the public) has beseeched the rating agencies to review all the subprime CDO’s by now given the headlines and the incredible losses hidden there. There is literally no one regulating these CDO’s and hence it allows a neophyte finance guy like this idiot to pocket $2M in salary this year while his investors are facing certain losses (of about 20% at least since he told me he holds the riskiest tranches).

I would suppose, if the above is true, that the portfolio manager in question is no longer doing “nothing” — and if he’s truly the neophyte he’s been painted to be, I’d also venture a guess that the poor guy is probably in way over his head at this point.

Irrespective of the story itself, it gets at a point I made in some earlier posts about the real impact of the moves today by S&P and Moody’s– they’re now essentially forcing mark-to-market activity on downgraded or soon-to-be downgraded mezzanine and equity tranches throughout the ABS markets.

The problem here, as S&P aptly noted in its mess of materials released Tuesday, is that underlying collateral performance isn’t going to get better anytime soon. Think about it: that 2006 subprime vintage that’s already starting to look like the worst ever originated? A huge chunk of borrowers in that vintage — those who haven’t already fallen victim to EPDs — will be staring down a reset they can’t afford in 2008 and 2009. And it doesn’t right now look like anyone is really going to be there to lend to them when they’re going to need it.

(I can already hear some of you saying ‘but what about FHA?’ — let me disavow you of that notion right now: if you seriously think FHA reform is coming down the pike from Congress anytime soon, you probably also think the Yankees are going to win the pennant this year).

HW readers working in default or REO management are going to be pretty busy for the next two years or so, and both S&P and Moody’s just tacitly admitted as much in their announcements today. It won’t be long until many CDO and related fund managers will be forced to admit the same.

Update: A post over on the Financial Times blog nails the issue here on the head better than I can:

The great unknown here is how the underlying owners of subprime-related assets might react to specific downgrades. In short, will holders become forced sellers so as to stay in line with their stated investment criteria?

If the answer is “yes,� find yourself a tin hat.