Tom Petruno explores the mysterious world of CDOs in two articles from today’s LA Times. In, “Test For Bonds Tied to Loans,” he does a good job describing what these arcane financial vehicles actually are:

A CDO creator could take a pool of mostly sub-prime mortgage-backed bonds and cut it into tranches (French for “slices”). At the top of that stack of slices would be the highest-quality tranches, which offered modest yields but (theoretically) no risk of principal loss. The investors in the lower tranches would earn higher yields while also agreeing to absorb any losses suffered by the loan pool, if necessary. At the very bottom would be the so-called equity tranche holders, who would get paid only if everything worked out well.

Petruno also exposes the amazing growth of the market for CDOs writing, “Investors wildly embraced the CDO concept: Global sales reached a record $476 billion last year, nearly six times what was sold in 2001.”

In, “Getting a Handle on CDOs is a Complex Challenge,” Petruno really asks the question that needs asking:

…amid rising mortgage defaults and deepening fear about widespread fraud in loan underwriting during the housing boom, the rating firms are under pressure to review their upbeat CDO grades.Relatively few of the CDOs sold in recent years have been downgraded… Yet many analysts say the market prices of the diciest mortgage bonds, those backed by so-called sub-prime loans, indicate that still-rosy CDO ratings aren’t reflecting reality.Some mortgage bonds rated BBB, the lowest investment-grade rating, “are going to see real losses of principal soon,” predicted Janet Tavakoli, head of Tavakoli Structured Finance Inc., a consulting firm. What happens if investors are shocked to see their CDO slices downgraded in quality, and fear worse to come?

For now, it seems, CDO holders and ratings agencies are content to pretend that nothing’s wrong. Denial is a powerful thing.
LIV

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