This is the general idea behind Morgan Stanley's (MS) plan to take downgraded collateralized debt obligations (CDOs) and turn them into new securities, some with AAA ratings.
According to Bloomberg, Moody's (MCO) will rate about $87 million of the deal as "Aaa," with about $43 million rated as "Baa2," or just slightly above non-investment grade. The bonds that will make up the new CDO come from another, older CDO created in early 2007 that lost its top rating last month. The process has been used with mortgage securities recently, but Morgan Stanley's move is the first of its kind using a CDO. The instruments are one of the "alphabet soup" of structured finance products being blamed for $1.5 trillion in losses at global financial institutions.
Regaining a "AAA/Aaa" rating for structured products will help restore some liquidity to the market, because many institutional investors are forbidden from owning debt with a lower rating. The original appeal of products like CDOs was that redistributing risk by exposing certain investors to losses first allowed parts of deals to receive the top rating, even though the entire deal itself would be ineligible.
Of course, things didn't exactly turn out the way they were planned -- when entire deals are created out of poorly underwritten subprime mortgages and suffer from 60 percent+ delinquencies, even investors holding the top-rated portion become vulnerable to losses. The underlying premise of compensating some to bear the first losses, in exchange for providing a lower-risk, lower-return asset to others is completely valid. But the idea of the Triple-A is that the security provides unquestionable safety, and that means some bundles of loans simply have too much risk to create a Triple-A rated piece of significant size.
The fact that Moody's will give its top rating out again is a departure from actions earlier this year and is the first nod of confidence to the much-maligned structured finance market in a long time. Many new investment products fare poorly their first time through a recession, and hopefully this is a step in the right direction in understanding how to appropriately evaluate and price risk.
There's no telling how many billions in CDOs could be re-securitized like this, but if market demand exists and helps to create price transparency, it will go a long ways toward figuring out what losses remain hidden behind mark-to-model valuations.
James Cullen also edits and writes at CollegeAnalysts.com.