U.S. FDIC chief looking at banks' CDO exposure

By John Poirier

WASHINGTON, July 11 (Reuters) - The Federal Deposit Insurance Corp. is looking "very carefully" at banks' exposure to collateralized debt obligations (CDOs) tied to subprime mortgages and whether rising default rates may creep into higher-rated CDO tranches.

"We're going to see more downgrades," FDIC Chairman Sheila Bair said on Wednesday, referring to a slew of CDO downgrades announced on Tuesday by two major credit rating agencies.

CDOs are investment-grade securities that are created by bundling together portions of loans, mortgage-backed bonds, municipal debt, credit card receivables or other securities.

CDOs that include subprime mortgages rose in issue volume to about $189 billion last year from just over $100 billion in 2005, according to Barclays Capital.

"I think the question is, to what extent is this going to creep into the higher-rated tranches. Most of these securitizations are over-collateralized but giving rising default rates and the fact that a lot of these loans haven't reset yet, it could creep into the higher-rated tranches," Bair said after addressing a Washington meeting of the New York Bankers Association.

"We're certainly looking at CDO exposures (of banks) very carefully and monitoring whether they could creep into higher-rated tranches," Bair said.

Bair said the FDIC lacks detailed data on U.S. banks' current holdings of CDOs, but it was a small percentage of their overall portfolios.

She also said the recent losses at two Bear Stearns Cos. Inc. BSC.N hedge funds that held subprime-linked securities was not the end of the problem.

"It's going to get worse before it gets better. How much worse, I don't know," Bair said. "Going forward, investors really need to be paying attention to what they're buying. And rating agencies need to be carefully evaluating these mortgages backing these pools."

In the third and fourth quarters of 2007, many subprime mortgages are scheduled to reset to higher rates, which could trigger more defaults, she noted. "Clearly, the direction of interest rates and the direction of home prices is going to affect a lot of this."

The U.S. Securities and Exchange commission said last month it had opened a dozen investigations into CDOs linked to subprime mortgages.