We all “invest” a lot of cash in (e.g.) pension plans, who have to put it work in order to fund future liabilities. In order to do so they need the highest return they can get without taking to much risk (jargon: “chasing yield”).

Because too much risk would be extremely irresponsible for a pension fund, most pensions funds are allowed to ONLY invest in NON-subprime securities.

The problem with CDOs (basically a security consisting of slices of different bags of mortgages) is that they are designed NOT to be traded, but to be HELD TO MATURITY, earning a nice yield (i.e. return) in the meantime. This is because they are extremely illiquid (i.e. difficult to sell). As every product is different and very opaque it is almost impossible to be sure you can realise the stated value on your books.

As long as you don’t have to sell, there’s no problem as you can continue “guesstimating” the true value (i.e. the value you should keep on your books) by “marking-to-model” instead of “marking-to-market”.

1. Once you are FORCED to liquidate a CDO position, because of investors bailing out of a highly-leveraged fund or margin calls from third parties, the trouble starts. You don’t want to sell at a much lower (true) market price because that would imply your “model” has been completely wrong all the time. This would mean revising ALL CDO’s values down, again leading to more margin calls and investors bailing out.

2. And more specifically for pension funds: Once S&P, Moody’s, etc. decide to downgrade certain CDO’s to below-investment grade status you want to liquidate these holdings BEFORE everybody else does. This, again, will lead to more cases of (1.) as well as serious ACTUAL losses for those pension funds.

Basically, you don’t want to be the last one out of the very small door. That is what is happening lately, and especially the last few days as the rating companies start “re-evaluating” (i.e. admitting their models were wrong before) “certain CDOs”.

From here on, it can only get worse.

Moody’s actually downgraded, S&P did not (although S&P was first to drop the bombshell). Which means we’re not talking phantom losses here — we’re talking real dollars now.

You’re correct, too, that the downgrades hit primarily the mezzanine and the equity tranches (BB and below)….but keep in mind that the loss of BB and BBB and BBB- means that AAA and AA aren’t exactly looking like the bullet-proof investments they once appeared to be, which is likely what is driving the downward price pressure in those particular securities.

And let’s face it — we haven’t really yet seen the mark-to-market effect yet.

Can I nominate ‘contagion’ as the housing word of the year?

I’m assuming that S&P and Moodys downgraded today based on the poor performance of these particular securities, [which was what they indicated] so the AAA and AA degradation shouldn’t have been factors.

I did however, think it was an indication of just how far these downgrades are likely to spread. “Containment” isn’t happening.

The M&A bubble that’s been driving the DOW, etc. is fueled by the CMBS and junk bond people. It’s the bubble blogosphere’s consensus, for what it’s worth, is that those markets only have a couple of weeks to live and a lot of announced deals just won’t find investors over the next few months.