So, State Street (the manager) has begun liquidating securities held by the Carina CDO.
Consequently the rating agency has to downgrade the senior classes (rated AAA earlier) by as much as 18 notches (to CCC- in some cases).
Yup - You read it right - 18 notches in one go. What’s more the rating agency says that if the process of liquidation is halted, the ratings of some of the classes of securities would have to be lowered even further.
So much for all the fancy packaging and repackaging and the redistribution of risk.
When liquidity dries up, everything goes for a toss. That fat tail that we keep ignoring.
I remember my days of fund management when fancy investment bankers would tout the virtues of having a core illiquid portfolio to improve gains (yield pick up is the jargon they would use) and all my talk on the virtues of liquidity (especially in a completely illiquid market like that in India) would be laughed at and jeered.
I was never very popular with these bankers. After all they used to make a multiple of what I used to - for selling us (the fund managers) all that junk while preaching sound risk management techniques at the same time.
Well, the lessons from the mature markets are there for all of us to learn.
PS : It needs to be clarified that State Street only manages the portfolio. It is not an investor in the CDO. Hence it does not face a loss due to the liquidation or downgrade of the securities. Ultimate investors (unknown to us) in the CDO would be the ones worst hit. This would include dealers like the investment banks, hedge funds etc.