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Subprime Mortgage Credit Derivatives by FRANK J. FABOZZI, THOMAS A. ZIMMERMAN, DOUGLAS J. LUCAS, SHUMIN LI, LAURIE S. GOODMAN

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CHAPTER 12

ABS CDO Losses and Valuation

In this chapter, we predict mortgage bond losses within the portfolios of ABS CDOs. We look at 420 CDOs and their 20,797 underlying mortgage bonds from 4,259 underlying mortgage loan securitizations. Given the high collateral losses we predict for ABS CDOs, relative value among CDO tranches is dependent on structural idiosyncrasies. Structural terms control when collateral cash flow is cut off to subordinate CDO tranches and how much cash flow is diverted to senior CDO tranches. We find:

  • Collateral losses will affect the very top of mezzanine ABS CDO capital structures. We predict that 86% of senior AAA tranches from 2006– 2007 vintage subprime mezzanine ABS CDOs will default. Among BBB tranches, we predict 99% will default. These figures are horrific from a ratings and risk management point of view and indicative of the greatest ratings and credit risk management failure ever.
  • Losses on mortgage loans underlying bonds owned by ABS CDOs vary greatly by vintage. Subprime loans originated 2006–2007 will have twice the losses of subprime loans originated in 2005. The effect follows through to the mortgage bond level. 2006 subprime mortgage bonds in the CDOs we study will have almost three times the losses of 2005 subprime mortgage bonds.
  • The single best predictor of ABS CDO losses is the amount of 2006–2007 collateral they contain. After accounting for this variable, no other objective attribute of CDO collateral quality improves the prediction ...

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