As if an odd wind was blowing through the market, several firms released research reports last month surrounding stability in the collateralized debt obligation arena.

As it happened, Standard & Poor's issued a Dec. 19, 2002 report aimed primarily at implications for bond insurers from the poor performance of the CDO sector. Prior to that, Gotham Partners, a New York-based hedge fund, issued an opinion piece targeting insurer MBIA. That report, dated Dec. 9, 2002, expressed several concerns and, more specifically, cited what it said were billions in losses due to MBIA's "overexposure" to CDOs. Gotham's figures were based on mark-to-market accounting valuations.

Not unexpectedly, the hedge funds' report initially triggered some widening in spreads, according to sources, and MBIA released its own review of its CDO holdings shortly thereafter.

An MBIA spokesman said the Gotham report was not an independent research report but a "negative advocacy piece by a hedge fund that has shorted MBIA stock."

Word on the Street is that the hedge fund bought $1 billion of credit default swap protection on MBIA, causing spreads to widen dramatically, from 35 basis points to 100 basis points as of last Thursday.

However, Gotham apparently has not been able to cash in. Sources said that while prices have been pushed up, no one has come in behind Gotham. "No one is buying...a liquid market is not there," said one source.

Gotham Partners was unable to comment by press time.

This seeming war of research and risk evaluation has rehashed some old demons in the CDO world: how does one implement mark-to-market accounting with CDOs.

Among the many negative points harped upon by Gotham Partners report on MBIA, the most eye-popping numbers surrounded risk and loss associated with the insurer's CDO portfolio.

"Based on mid-market prices for the CDO exposures disclosed by MBIA as of August 31, 2002, we estimate that MBIA has a $5.3 billion to $7.7 billion mark-to-market loss in its portfolio..." the firm wrote. The hedge fund culled its information from Wall Street dealers, it said, but did not disclose the identity of the dealers in the report.

According to Richard Smith, a credit analyst with S&P, the billion-dollar plus loss figures cited by Gotham did not jibe in the least with what the ratings agency understands to be the MBIA's risk to CDOs.

"It's hard to imagine that MBIA with some $60 billion in its CDO/CDS portfolio is sitting on a loss equal to ten percent of that," said Smith. "We've done our analysis, looking at MBIA... the worst case loss on MBIA is $600 million to $650 million. That's a significant difference."

In its December report, S&P reaffirmed MBIA's triple-A rating.

The opposing viewpoints on MBIA's loss potential apparently stems from how the figures are crunched. Gotham's report uses mark-to-market accounting figures to quantify MBIA's entire CDO portfolio.

As it stands, CDOs can have either a market value or a cash flow credit structure, depending on the way the CDO protects debt tranches from credit losses. According to research from JPMorgan, nine out of ten CDOs, both by number and volume, use the cash flow credit structure.

In a market value structure, the CDO's assets are marked-to-market periodically. The mark-to-market value is then reduced to take into account future market value fluctuations, according to the bank. If the reduced value of assets falls below par, CDO assets must be sold and debt tranches repaid. By comparison, cash flow CDOs do not have a market value test. A common cash flow structuring technique involves diverting cash flow from subordinated tranches to senior tranches if the quality of CDO assets diminishes by some objective measure. And while managers and obligation holders can sell CDO assets after a default, there is generally never a requirement to sell CDO assets.

It appears it is this particular area claims triggered by defaults that sets the foundation for the opposing valuations of MBIA's portfolio.

"Mark-to-market accounting for derivatives introduces earnings noise. It's certainly not a solid measure of overall loss potential," said S&P's Smith. "If it never gets to a point of a claim (and a default triggers a claim), it doesn't matter."

Independently of the MBIA controversy, Lang Gibson, director of structured credit research for Banc of America, stated that CDOs do have mark-to-market concerns, via his Dec. 13, 2002 research note.

While Gibson was not addressing concerns raised about MBIA, he was instead looking at FASB rulings and proposals that impact the CDO market. According to rule EITF 99-20, every SEC reporting company must apply the "dreaded asymmetric LOCOM (lower of cost of market) accounting through P&L for credit sensitive CDOs,' which have been mostly been interpreted to be single-A rated notes down to equity," Gibson said. "So only double-A and triple-A CDOs held in the available for sale account (or comparable) are required to have their losses flown strictly through the capital account."

S&P's research report notes that MBIA insures the highest rated tranches. The report was not drafted in direct response to Gotham's piece, Smith said. The piece addressed several areas investors had expressed concerns over, due more to worries over weakened credit performance of CDOs this year than anything else, he added.

"Periodic mark-to-market brings in a degree of income statement volatility. As credit spreads move, it isn't the best indicator of loss for MBIA," said one CDO analyst.

According to MBIA, as of Sept. 30, 2002 its gross CDO exposure was $76.0 billion and its net CDO exposure was $62.7 billion.

"Based on current rating agency ratings, over 85% of MBIA's CDO portfolio is rated double-A or better and 81% is rated at least triple-A...the net insured CDO book was comprised of 67% synthetic CDOs and 33% funded CDOs," MBIA noted in its December report.

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