Monday, June 15, 2009

Alphabet Soup: ABS CDS

Quick review:

Credit default swaps (CDS) function as insurance policies for certain securities. If a bond defaults, a buyer's loss can be mitigated from the profit generated by the CDS.

CMBX: protection on commercial mortgage backed securities

ABX: protection on residential mortgage baked securities

At this point in the cycle, it is safe to say that the lower rated trances, (single A, triple BBB, triple B-) won't recover. Therefore, the prices will stay pinned at their current levels. The killer here is the higher rated tranches. To attain these higher ratings, these securities have the most stable cash flows in the deal structure. The lower rated tranches get stuck with the initial losses, an attempt to shield the higher rated tranches from diminished cashflow.

It is not working. Whether it's Fitch, S&P or Moody's issuing downgrade notices and warnings or you just take a look at the above graphs, more losses are on the way.

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