Accounting experts and collateralized debt obligation analysts say low interest rates and an arcane accounting rule will prevent the number of CDO write-downs from ballooning. They say that even with the avalanche of downgrades affecting the CDO collateral, low interest rates support high valuations on the CDO bond prices. Low interest rates also provide accounting relief as they increase the price of other fixed-income instruments. Since CDO performance is booked on a net basis, losses in CDOs may be offset by profits on other bonds in a portfolio and never appear on the books. This is reinforced by the Emerging Issues Task Force rule 99-20, governing CDO write-downs, which analysts say, leaves a lot of room for interpretation. Finally, the lack of transparency in the CDO secondary market allows investors to avoid booking their CDO performances as losses, as they inflate the market value of their CDO notes.
Write-downs are not easy to quantify since investors do not release them, says Douglas Lucas, a CDO analyst at UBS Warburg. So far, the only significant headline came from the $826 million charge taken by American Express two years ago. "Some don't aggressively write-down stuff as much as they should but then again, it's a subjective valuation," says another CDO sell-side analyst.
Jim Mountain, a partner at Deloitte & Touche, and a CDO accounting specialist, says that although CDOs are being downgraded, investors can get away with booking losses and still be in compliance with the EITF 99-20 rules. He notes that low interest rates allow CDO investors to still earn a premium to today's interest rates. Mountain also points to EITF 99-20 as perhaps aiding in decreasing the visibility of CDO problems because it leaves a lot of room for interpretation, particularly in assessing the market value of CDO notes. UBS Warburg's Lucas goes as far as saying that higher interest rates could lead to a surge of write-downs, at least for fixed-rate CDO notes. If interest rates increase, he explains, investors would have to face depreciation of their portfolio on two fronts: downgrades in the collateral and loss in value of the notes due to the interest rate effect.
The loophole, explains Mountain, is consistent with EITF as the rule does not require investors to take a loss as long as lower future income on a bond due to collateral's credit impairment is consistent with current market interest rates. Douglas agrees with Mountain's analysis in the case of fixed-rate CDOs: "On margin, the decline in interest rates has lessened write-downs on fixed-rate CDOs," which, he says prevail for triple-B tranches. Fixed-rate CDO notes were widespread before 1998 when CDO bonds were mostly backed by high-yield bonds, a collateral particularly sensitive to downgrades today. An analyst estimates those to 50% of the supply at the time.
One fact perhaps keeping a lid on CDO write-downs is the secondary market itself where there is almost no trading activity, continues Mountain. "It's easy to be overly optimistic on the value of your bonds because there is no market that says: you're too high. " With much of the secondary CDO trading varying from dealer to dealer and investors in some case relying on their own cash flow modeling, it is tempting to reach optimistic conclusions on what the exact fair market value of a CDO tranche is, experts say. --Emma Trincal