Debt Fire Sale Is Imminent

Holders of funky, hard-to-value mortgage paper are starting to wave the white flag and unload bundles of debt once worth billions of dollars into the secondary market at a fraction of their original values.

Banks such as Citigroup(C Quote - Cramer on C - Stock Picks), Merrill Lynch (MER Quote - Cramer on MER - Stock Picks) and UBS(UBS Quote - Cramer on UBS - Stock Picks) have taken hundreds of billions of dollars in writedowns after being the most active originators of so-called collateralized debt obligations (CDOs) and asset-backed securities (ABS) that have plunged in value and caused a general seizing-up in the market.

But widening worries about the credit market, a series of downgrades by ratings agencies and a growing sense that it might be time to give up the ghost of a return in value in these securities are helping to drive some auctions by financial institutions, say debt traders.

Traders say a few smaller, one-off sales have hit the market since the markets froze in July. But more liquidations are expected soon, as other sellers finally unwind their troubled CDO and ABS portfolios.

CDOs are comprised of debt, including home mortgages and student loans, originated by investment bank affiliates, repackaged into securities and structured into bonds tiered by their credit ratings.

Over the next few days, traders of CDO securities expect to see debt once worth approximately $1.8 billion hit the markets. Bids on the individual debt components likely will be sold for values equivalent to 5 cents to 20 cents on the dollar or less. "Sellers are saying, 'I don't care if we make money on this, I just want to finally reduce my exposures,'" one hedge fund trader told TheStreet.com.

One large portfolio to be sold has a notional value of approximately $900 million in single-A-rated debt. The identity of the seller could not be determined, but offers for all or part of the lists are due Thursday.

Two more lists of securities, including one known as Diogenes III managed by an arm of State Street(STT Quote - Cramer on STT - Stock Picks), are expected to take offers next week, one trader notes. The State Street Global Advisors-managed deal is a $750-million triple-B-rated list, which was originally underwritten by Deutsche Bank(DB Quote - Cramer on DB - Stock Picks) and consists of long positions in cash or synthetic, primarily subprime residential mortgage-backed securities and synthetic short positions. Those securities reference primarily housing-sector related single-name corporate entities. Deutsche underwrote a series of similar Diogenes debt over the past year and a half.

Ratings agencies, including Moody's Investors Service and Standard & Poor's, have been aggressively downgrading asset-backed paper and CDOs due to a belief that the deterioration in the housing market may be more severe than the agencies had predicted. Those downgrades coupled with the downgrades of some monoline bond insurers are causing increased uncertainty about how long pain in the credit markets may lasts.

On Monday, Moody's lowered the rating on 10 CDOs of asset-backed deals which had been worth more than $7.6 billon.

Making matters worse are revelations by intuitions such as insurance firm American International Group(AIG Quote - Cramer on AIG - Stock Picks), which stated that its auditors found that it undervalued losses in credit default swaps it had used to hedge losses in its fixed-income portfolio.

Buyers of CDO paper are willing to take a chance at investing in the troubled paper because deals even at zero are valuable, assuming they don't default, because they pay a coupon. One trader speculated that at a price in the ballpark of about 15 cents on the dollar, a buyer could fetch an attractive 20% yield on some of the paper being trading and another 20% if the debt reaches maturity.