The Great CDO Liquidation

First, Federal Reserve Chairman Bernanke let out the cry “raise capital or be acquired.” Then he fueled up his helicopter and hit the skies. The banks got the message, and except for Bear Stearns (BSC), the multibillion dollar preferreds started flowing. Massive shareholder dilution will follow when they start converting to common at below market rates. My compliments to the hedge funds; they got a much better deal than the sovereign wealth funds. At this point, the Washington Mutual (WM) and National City (NCC) preferreds are in the green, while the Citigroup (C) preferreds are in the red. The consolation is that all of the preferreds pay a high initial dividend rate.

The next fund raising step is to sell some of their unrealized losses. On April 22, the Financial Times “Prices slashed on Chrysler loan sales” reports Goldman Sachs (GS) and Citigroup are selling Chrysler debt for as little as 63%. Then on April 24, the FT “Credit vehicle defaults reach $170bn” reports the CDO defaults climbed to $170B from $54 at the start of 2008. (The FT quoted Total Securitization.) Merrill Lynch (MER) underwrote 26 CDOs currently in default and has raised $9.5B through debt sales last week. The banks are finally de-levering. Apparently, maintaining risky debt on the banks’ balance sheets is not supported by their cost of capital.

I wrote in "Super-Seniors take Control of CDOs" that based on an “event of default”the most senior CDO tranches can call for acceleration or liquidation. The FT cites that of the 151 CDOs “experiencing an event of default”, at least 16 have been liquidated and another 15 given liquidation notices. Another 58 CDOs are in acceleration mode – all payments going to the most senior tranches. The top three banks holding super-senior CDOs are Citigroup $30B, Merrill Lynch $29B, and UBS (UBS) $26B.

Asset Backed Alert (April 25) “Secondary Trades Surge as Sellers Rush In” reports that the activity in the secondary asset backed market has increased over the last two weeks. Prices have temporarily stabilized and sellers are accepting whatever they can get. Some buyers are receiving funding from dealers that have access to the Fed. Bear Stearns knows the Fed can change its mind with no notice. Bids are ranging from below 50% to 95% based on the seniority of the tranches.

Liquidation brings another interesting play. Trust clauses allow super-senior note holders the first option to purchase the CDO’s collateral. The super-seniors would simply be trading their tranches for all of the CDO’s underlying mortgage bonds and other assets. Then they sit tight and wait for the bonds to recover. Super-seniors get everything and the rest of the tranches get nothing.

The banks are revealing new ways to win and new ways to lose each week. As long as the banks are not as Cramer says “taken under”, time is on the side of the patient investor.

Disclosers: Author is long BSC, C and UBS.

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