CDOs and CMOs Bring Street Terror

The WSJ on June 20th reported,

Two big hedge funds at Bear Stearns Cos. were close to being shut down last night as a rescue plan developed over several days fell apart in a drama that could have wide-ranging consequences for Wall Street and investors.Merrill Lynch & Co., one of the hedge funds’ lenders, said it would move to seize collateral — much of it mortgage-backed debt — from the two funds and sell it…

Selling those CDOs could be a big problem for Wall Sreet because it establishes a price for essentially securities that are not marked to market.

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

CDOs were created in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk-bond king Michael Milken. Sales reached $503 billion in 2006, a fivefold increase in three years. More than half of those issued last year contained mortgages made to people with poor credit, little loan history, or high debt, according to Moody’s Investors Service. (emphasis added)

From Le Metropole Cafe (by subscription only, free trial available)

Hammered by exposure to a risky type of mortgage-backed security, Brookstreet Securities Corp. of Irvine, Calif., yesterday told its 500 or so affiliated reps and advisers that “disaster” had struck, and that the firm could close if it doesn’t come up with at least $5 million.

The Cafe says the firm’s $11 million in capital was wiped out when $85 million of CMO’s in the company’s account were re-priced 20% lower.

CMO = Collateralized Mortgage-backed Obligations, which are pool of pass-through mortgage bonds tranched to reflect the degree of sensitivity to prepayment (particularly, agency CMO).

ABS = Asset Backed Securities, for example home equity loans (HEL), credit cards, etc. These are securities backed by receivables [payments] that are either secured (HEL) or unsecured (credit card), tranched on the basis of prepayment and default risks.

CDO = Collateralized Debt Obligation, for example, ABS CDO which consist of a portfolio of different ABS bonds, and the payments to the holders of these trust certificates are derived from the cash flows of the ABS bonds.


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