subprime etc

In the beginning, there were subprime mortgages. They were gathered together to make a subprime bond, and tranches were created within the subprime bond. Then those bonds were gathered to make Collateralized Debt Obligations, or CDOs, and more tranches were created. The highest of the tranches got paid first when money came in, and if there was enough, all the tranches got paid.

But they didn't stop there, and new CDOs bought tranches of other CDOs, and they were called CDOs-squared. Synthetic CDOs were created, and they were supposed to act like they owned tranches of other Mortgage-Backed Securities, but apparently didn't. Very smart people got paid a lot of money to do all this, and they seemed to forget that at the bottom was the sketchy credit of subprime mortgages.

Very little is known about exactly who owns what, so it has been unclear what values were. But Merrill (MER) finally stopped its claims of capital adequacy and a sale took place. That they financed most of the deal doesn't let them off the hook completely.

But The Economist reports that "with Merrill's net exposure to CDOs now down to $1.6 billion (the rest hedged with 'highly rated,' non-monoline counterparties), the worst of the pain is surely over -- especially since most of the securities that remain date from 2005 and earlier, before underwriting became really sloppy." About 80% of Citi's (C) remaining CDO exposure is from pre-sloppy underwriting days, and that has been marked to $.61on the dollar.

Merrill also halved its exposure to $7 billion in leveraged loans. I mentioned last week that several firms have marked their loans to finance leveraged buyouts to $.80 -- JPMorgan (JPM) and Credit Suisse (CS) among them -- and that trades of leveraged paper north of $.85 have taken place.

Then on Friday, a deal between Ambac (ABK) and Citi to settle a collateralized-debt insurance obligation between the two parties for $850 million to end a treaty guaranteeing $1.4 billion in paper allowed Ambac and MBIA to rally. Ambac had written the paper down by an extra $150 million than the settlement called for. So, at least in one instance the accounting markdown was too excessive.

It could be the worst is over. Subprime mortgages and the turbo-charged CDOs are being dealt with more openly than heretofore. Leveraged loan portfolios are being marked down and some trades are taking place. Next up will be American International Group's (AIG) earnings this Thursday.

AIG is the poster child for balance-sheet confusion. They have take $20 billion in markdowns on their Credit Default Swap portfolio, but have asserted the economic risk is a small portion of that. A report this week that is without drama and massive new writedowns would go a long way toward moving the market to the view that the end of the horrendous credit underwriting cycle might be in sight.