Finally Waking Up to the Credit Derivatives Mess
According to the very interesting and comprehensive article, the AAA tranches of CDOs (collaterised-debt obligations: a vehicle used to package credit derivatives) have been substantially downgraded in value (see the chart of the ABX index -- and index of credit derivatives -- below) with fears of more downgrades to come. This would wreak havoc on already shaky financial markets.
There is also the question of accounting for these credit derivatives. The recommended method is to stick it in a category called "Level 3" which assesses "fair value" using "assumptions that market participants would use." But is that a good way to assign "fair value"? This situation is made worse by the fact that Level 3 securities have grown so much that they "now exceed shareholder equity" of many banks. No wonder many investment and commercial banks (as well as insurers, hedge funds, etc.) have been accused of not marking down their credit derivatives sufficiently.
Things can get much worse: AAA rated securities are relied on by a diverse range of investors -- from old age pensioners and municipal goverments to high flying hedge funds and banks. If AAA rated securities take a bigger hit because of their links to credit derivatives -- and/or other type of credit linked instruments (linked to consumer loans, for example) start sliding -- things can get really ugly ... much uglier than it is now.