Credit Market Fall-Out #4 - The FDIC is Looking at the CDOs Held by Banks

The FDIC is looking at the quality of the CDOs held by banks. The question I have is who is looking at the quality of the CDOs held by pension funds, mutual funds, and insurance companies? What will happen in the market place when some CDOs are downgraded by one of the rating agencies and a bank, pension fund, mutual fund, or insurance company can no longer hold the security in its portfolio? From Reuters.

The Federal Deposit Insurance Corp. is looking "very carefully" at banks' exposure to collateralized debt obligations (CDOs) tied to subprime mortgages and whether rising default rates may creep into higher-rated CDO tranches.

"We're going to see more downgrades," FDIC Chairman Sheila Bair said on Wednesday, referring to a slew of CDO downgrades announced on Tuesday by two major credit rating agencies.

CDOs that include subprime mortgages rose in issue volume to about $189 billion last year from just over $100 billion in 2005, according to Barclays Capital.

"I think the question is, to what extent is this going to creep into the higher-rated tranches. Most of these securitizations are over-collateralized but giving rising default rates and the fact that a lot of these loans haven't reset yet, it could creep into the higher-rated tranches," Bair said after addressing a Washington meeting of the New York Bankers Association.

"We're certainly looking at CDO exposures (of banks) very carefully and monitoring whether they could creep into higher-rated tranches," Bair said.

Bair said the FDIC lacks detailed data on U.S. banks' current holdings of CDOs, but it was a small percentage of their overall portfolios.

"It's going to get worse before it gets better. How much worse, I don't know," Bair said. "Going forward, investors really need to be paying attention to what they're buying. And rating agencies need to be carefully evaluating these mortgages backing these pools."