CDOs: Factchecking Krugman

Paul Krugman has a reasonably good overview of the mess in the CDO market today (free version here). But he goes much too far when he tries to impress upon us how big the problem is:

With the collapse of the $800 billion market in bonds backed by subprime mortgages — the price of a basket of these bonds has lost almost 40 percent of its value since January — it’s now clear that many investors who bought these securities didn’t realize what they were getting into.

This is simply not true. The thing which has lost 40% of its value since January is the ABX.HE index of BBB-rated subprime credit default swaps. Which is nowhere near being a basket of subprime-backed bonds. For one thing, it measures not bond values but CDS prices. Maybe that's a niggle. But much more importantly, it measures the value only of the riskiest tranches of the CDOs that Krugman is so worried about.

As with most tranched securities, CDOs are structured so that the riskiest portions take the first loss, the next-riskiest portions take the second loss, and so forth. The bits of CDOs which have dropped in value by 40% since January are precisely these riskiest portions, which account for maybe 5% of the total amount of subprime-backed debt outstanding. The vast majority of CDO investments are triple-A securities which haven't dropped in value by anything near 40%. Maybe a few points, tops.

As for Krugman's bigger argument, he, like James Hamilton, sees a clean and direct causal relationship between falling house prices, on the one hand, and falling CDO valuations, on the other. I'm willing to believe that relationship is there, but so far I have to take it on faith, because no one has done a good job of explaining how this relatinship has worked in practice. I can see how falling property prices lead to higher default rates on subprime loans. But no one has done a good job of explaining how high subprime default rates feed through into big losses for MBSs in general and CDOs in particular. People seem to make that step without really thinking about it – and I suspect that what happens in reality is actually rather more nuanced.