May 31 (Bloomberg) -- The numbers looked compelling. Buy this investment-grade collateralized debt obligation and you'll get a return of up to 10 percent, Credit Suisse Group said. That was almost 25 percent more than the average yield on a similarly rated corporate bond.
Investors snapped up the $340.7 million CDO, a collection of securities backed by bonds, mortgages and other loans, within days of the Dec. 12, 2000, offering. The CDO buyers had assurances of its quality from the three leading credit rating companies --Standard & Poor's, Moody's Investors Service and Fitch Group Inc. Each had blessed most of the CDO with the highest rating, AAA or Aaa.
Investment-grade ratings on 95 percent of the securities in the CDO gave no hint of what was in the debt package -- or that it might collapse. It was loaded with risky debt, from junk bonds to subprime home loans. During the next six years, the CDO plummeted as defaults mounted in its underlying securities. By the end of 2006, losses totaled about $125 million.
The failed Credit Suisse CDO may be an omen of far worse to come in the booming market for these investments.
CDO holdings have already declined in value between $18 billion and $25 billion because of falling repayment rates by subprime U.S. mortgage holders, Lehman Brothers Holdings Inc. estimated on April 13. In many cases, investors don't even know that values have dropped.
In this secretive market, there is no easy way for them to find out what their CDOs are worth.
Many of the world's CDOs are owned by banks and insurance companies, and the people who regulate those firms rely on the raters to police the CDOs.
American Express Co. learned about risky CDOs the hard way. The New York-based company invested in high-yield CDO transactions starting in 1998. By 2001, American Express reported losses of more than $1 billion from those investments.
Chief Executive Officer Kenneth Chenault told shareholders in a July 2001 conference call that the company didn't understand CDO risk. He said when his traders first bought CDOs, defaults were at historically low levels.
``Many of the structured investments were investment grade, so they thought they had a reasonable level of protection against loss,'' he told investors. ``It is now apparent that our analysis of the portfolio did not fully comprehend the risk underlying these structures during a period of persistently high default rates.''
As a result, he said, American Express would stop buying CDOs. Chenault declined to comment for this story.
The Enhanced Monitoring Report, which is written for clients who pay an extra $10,000 to $130,000 for such studies, provided further background about the CDO called SPA.
This ill-fated CDO included a collection of subprime mortgage- backed securities and junk bonds. S&P, Moody's and Fitch stamped 85 percent of the CDO with an AAA or Aaa rating because that portion was guaranteed by bond insurer MBIA Inc.
On April 24, Moody's withdrew its rating on the major part of SPA, saying in a two-sentence note that investors in this tranche had been paid in full.
What Moody's didn't say was that Armonk, New York-based MBIA paid the investors after the CDO had collapsed because many of its underlying securities had defaulted. MBIA spokesman Michael Ballinger says the insurer paid investors in the AAA or Aaa tranche $177 million.
The tranche had suffered about $73 million in losses, which MBIA covered. Moody's spokesman Anthony Mirenda and Credit Suisse spokesman Pen Pendleton declined to comment on SPA.
With no regulation and little transparency, the CDO market thrives, and credit raters are helping lead the way, the University of San Diego's Partnoy says.
Investors haven't been deterred by American Express's $1 billion loss. Nor have the March and April studies by Moody's and Lehman showing the concentration of subprime debt in CDOs slowed down CDO sales.
