Subprime CDO pricing getting perilous, managers say

By Al Yoon

MIAMI (Reuters) - Pricing of collateralized debt obligation bonds laden with subprime mortgage securities is getting more perilous amid deep uncertainties over when ratings on the assets will be downgraded, money managers and Wall Street analysts said.

Prices on CDOs -- or debt securities created by compiling slices of existing asset-backed bonds -- don't yet reflect the strong likelihood of downgrades by rating companies such as Moody's Investors Service, they said. But vast disagreements over what a CDO is worth based on expected delinquencies or losses is keeping them from trading at all in many cases.

"To slap a price on a bond, the hardest thing is (to value) the ratings trigger," Evan Kestenberg, a CDO trader at United Capital Markets, said in a panel discussion at the Information Management Network Spring ABS 2007 conference in Miami on Monday. "What you can't guess about is when are these going to be downgraded."

Market prices on bonds typically reflect delinquencies and losses two to three years earlier than rating downgrades, Lang Gibson, Merrill Lynch & Co.'s director of CDO research said on an earlier panel.

The CDOs in question are loaded with subprime mortgage asset-backed securities whose values have been socked this year by soaring delinquencies on the underlying loans, especially those created in 2006. More than two dozen subprime mortgage lenders have already closed down or gone bankrupt as the default rate on their loans topped internal expectations.

"A lot of downgrading has to happen" on CDOs that include subprime asset-backed securities, Gibson said.

The expected downgrades may arrive sooner than two or three years since the rating companies have more inputs to consider than in past crises, Christopher Flanagan, head of structured finance research at JPMorgan Chase & Co., said on the first panel. Those variables include the credit default swap market which has become a popular way for investors to hedge their holdings and express opinions on the value of a bond, he said.

Investors should take heart that there is a host of information available on the loans backing the CDOs, giving them plenty of time to make good decisions on the probability of a downgrade, he said.

There is "a long way to go to reach a point where problems are deep enough to cause rating actions," he said. Rating actions may not be seen until 2008 or 2009, he said.

While CDOs are thinly traded, there is no sign that investors are dumping the securities on a wholesale basis on expectations of downgrades, Merrill's Gibson said.

Kestenberg of United Capital said he was "seeing a lot of offers" but the CDOs are often worth significantly less than the seller's indication, crippling the trade, he said. The environment is "difficult" because "it seems that bonds are worth either 90 or 40," with little in between, he said.

Traders and money managers said the weaker bid for CDOs in the past month has wrongly infected the sister market for collateralized loan obligations, which are backed by senior secured bank debt. Yield spreads on CLOs rated "BB" have widened some 150 basis points in recent weeks, even though "nothing has happened in the underlying market," said Ross Heller, a trader at JPMorgan, on the second panel.

CLOs represent a buying opportunity, but most investors are staying away out of fear their purchases won't be the ones to stem the price decline, said Kestenberg, who recently bought some "BB" rated CLOs.

"It's a tough call when you're bidding on this stuff," he said. "We're not overloading the boat."