Is that a meteor heading towards earth?

The end of the world scenarios for the sub-prime debt collapse are now focusing on CDO’s, whatever the hell they are.

I really had no interest in learning about the innards of the financial markets but I guess I should have an opinion about whether CDO’s are meteors and whether they are headed toward earth.

If I understood it, I think this article would explain it all, “Unpacking the Risks in the CDO Market”.

Saskia Scholtes and Gillian Tett have a long piece in the FT on risks in and to the collateralized debt obligation (CDO) market ““ the market which seems to be the center of attention and fears these days, in the wake of the Bear Stearns brouhaha. There are some good points made in the piece, but I think it’s worth teasing out exactly what the different risks in the CDO market are, because even the excellent Tett is failing to make some very important distinctions.

* First, there’s the risk that holders of subprime mortgages will default on their loans. This is a known and relatively easy to quantify risk. Subprime mortgages issued in 2005 and 2006 already have high default rates, and those rates are likely to rise even higher when the mortgages reach their second birthday and higher adjustable rates start kicking in. The problem is that the connection between subprime default rates, on the one hand, and CDO valuations and default rates, on the other, is so complex that it’s very difficult to say in a simple sense that a rise in mortgage defaults will lead to a rise in CDO defaults. It’s worth remembering that the key risk in the market for any mortgage-backed security is not default risk but prepayment risk, and that a high mortgage default rate, in and of itself, is not necessarily particularly worrisome from the point of view of a CDO holder.

* Fourth, there’s what used to be called rollover risk. If investors start liquidating their CDOs, that means there’s going to be a pretty large supply of cheap CDOs on the secondary market. In turn that means that there’s going to be much less demand for expensive CDOs on the primary market. And the steady stream of billions of dollars which has been flowing until now from CDO investors all the way, ultimately, to private equity shops, homeowners, and other consumers of credit will dry up. This is the credit crunch that many people are so worried about. And it can happen even if CDOs don’t get liquidated en masse, if investors simply lose their appetite for new ones.

These four risks form a nice little circle. Subprime defaults can, in theory, pass through into defaults on CDO tranches. That, in turn, can, in theory, trigger CDO liquidations. That, in turn, could mean the amount of liquidity in the credit markets drying up. And that, in turn, will mean that subprime borrowers find it much harder to refinance ““ thereby increasing the chance that they will default.

But while all the risks are real, the linkages between them all are far from clear, and the different risks don’t necessarily cascade onto and exacerbate each other in this way. They might ““ or they might not. If investors turn out to have reasonably strong stomachs, they might not want to liquidate at prices well below their entry points. And CDOs themselves, even the ones based on subprime mortgages, might not default nearly as much as homeowners. And without the passthrough mechanism of risks two and three, the vicious cycle loses a lot of its teeth.

So there is cause for concern, to be sure. But there isn’t cause for panic.