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April 19, 2005

Financial Scare of the Week: CDOs

In the past few days, the Financial Times has run several stories, including a full page article today, on CDOs (collateralised debt obligations) and the potential risks they present to the financial system.

CDOs are a way to repackage a portfolio of existing financial assets (usually bonds or loans) into new tranches, which are built so as to have different riskiness. (see more explanations below)

Last year alone, the cash value of all CDOs issued and sold to investors in Europe and America reached $120bn - nearly equivalent to all European corporate bond issuance in 2004.

The CDO market has been tested on a small scale by market jolts before - and come out relatively well - but it has never suffered a serious upheaval while so many investors hold so many highly leveraged instruments.

"We are in uncharted territory," admits one policymaker. "If a crisis hits, we think the market will absorb shocks smoothly - but the truth is that no one knows for sure."

 

Clouds sighted off CDO asset pool (Financial Times, today, subscription required)
A manager running a CDO borrows money from investors, via a special purpose vehicle, and buys debt-linked assets. Whether the liabilities can be repaid depends on the performance of these assets and the skill of the manager.

 

050410_cdo

Unlike a mutual fund, however, the risks assumed by investors are not always equal. There is usually a tranche of equity, which can produce high returns but also carries high risk since it is exposed to any losses resulting from underlying asset defaults. A separate `senior debt' tranche carries less risk, since it gets repaid first, but offers less potential return. Between those are tranches of `mezzanine' debt.

The assets inside a CDO can be corporate loans (when it is usually called a collaterised loan obligation, or CLO). However, they can also be bonds, asset-backed securities or credit default swaps (derivative instruments that bet on the risk of corporate default). The fastest growing segment of the market is for `synthetic' CDOs (sometimes called CSOs). These are composed of credit default swaps, without cash bonds, and may not have full investor funding.

Synthetic CDOs allow investors much greater leverage and flexibility. They also solve a practical problem: demand for CDOs is growing so fast that managers are running out of cash assets to put into the funds. Another innovation, the `CDO squared', is a CDO composed of multiple synthetic CDOs. Some banks even offer a `CDO cubed' - a CDO of CDOs of CDOs.

To explain a bit, credit default swaps are instruments whereby a bank gets someone else to bear the risk on a loan it makes: it pays that counterparty a predetemined margin annually in exchange for that counterparty to cover any losses under the initial loan. Such instruments can be taylored to specific risks - the counterparty can be required to pay only if certain specific events have triggered the loss. The counterparty needs not lend money to receive its remuneration, it only has to be able to make a payment in the case of loan default. Insurance companies or fund managers in search of extra income are typical counterparties for these.

 

The cash value of all CDOs issued and sold to investors in Europe and America reached $120bn - (the value was $445bn if the notional value of all derivatives in these instruments is included). That lower figure is nearly equivalent to all European corporate bond issuance in 2004.

In some respects, this startling growth is a potentially positive step for global markets. After all, an instrument such as a CDO takes forms of corporate debt and repackages it to spread the risk among multiple investors - rather like a mutual fund allows many investors to share equity investment. That creates more liquidity and flexibility in financial markets, which should, in theory, help the financial system to withstand shocks.
(...)
Yet the very same traits of CDOs that can be so benign also carry potential risks. (...) The fact that CDOs disperse credit among multiple investors means that, if a nasty accident did ever occur with CDOs, it could richochet through the financial system in unexpected ways. [Also], the CDO boom has taken place amid extraordinarily benign credit conditions. And, as Mr Gibson [head of trading risk analysis at the US Federal Reserve] notes, a recent study by international investors suggests "that there is a minority of investors - perhaps 10 per cent - who do not fully understand what they are getting into". (see also Fed official warns on structured credit market)

The CDO boom has several causes:

  • tightening banking regulations (known as Basel II) are forcing banks to hold thus risk; CDO are a good way to tranfer risk off their balance sheets into the hands of other investors;
  • easy money and strong competition have eroded margins in most traditional activities. CDOs offer better returns to investors (who take the riskier tranches) and nice arbitrage (trading) opportunities to banks;
  • it's trendy and sophisticated, and thus attracts hedge funds and other new players.

     

But with demand increasing, prices have also gone up, thus reducing returns (yields go down when prices go up, just like for bonds). This has led to increasingly complex products (using synthetic instruments as described above) which have an increasingly tenuous link to the underlying assets and harder to understand risks.

And that's the problem: these instruments have been created in a fairly benign financial period (no crisis, a lot of money and investors), and it is not clear (i) how they will behave if things turn sour, and (ii) what kind of consequences this will have on the financial markets and financial institutions in a time of crisis.

 

The CDO market has been tested on a small scale by market jolts before - and come out relatively well - [but] it has never suffered a serious upheaval while so many investors hold so many highly leveraged instruments.

"We are in uncharted territory," admits one policymaker. "If a crisis hits, we think the market will absorb shocks smoothly - but the truth is that no one knows for sure."

No one knows for sure. That's nice to know...

Banks are full of people who worry about whether the previous crisis will happen again. They never seem to catch the guys who take new kinds of risks, make tons of money while the going is good (for the banks and for themselves), think they have found a new Graal - until some new circumstances bring these risks to the fore and wipe out all the gains previously made. The banks clean it up more or less painfully, tighten their controls over these risks, and the cycle starts somewhere else...

Further references:

A selection of articles on CDOs

Bankers are dangerous people (a diary from a few months back)

Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb

Posted by Jérôme à Paris on April 19, 2005 at 23:00 UTC | Permalink

Comments

Seriously, why are you all still talking about that Old White Male when you could learn about Young Males (not enough women in our profession, sadly) and their shiny financial toys...

Posted by: Jérôme | Apr 19 2005 23:04 utc | 1

Seriously, why are you all still talking about that Old White Male when you could learn about Young Males (not enough women in our profession, sadly) and their shiny financial toys...

Also, Kos posted for your recommends.

Posted by: Jérôme | Apr 19 2005 23:04 utc | 2

Jerome,

This shit is getting even worse. There have been many financial instruments through the years, but the elite are finding ever more risky ways to hedge. Brady bonds from the 80s were the most blatant to start where repackaged bad central and south american debt was sold as Brady Bonds. Now there are a proliferation of hedge instruments. The ultra rich and elite financiers are just like insurance companies, many are cross managed. Looking over everything to reduce risk, such as the bankruptsy bill that just went through congress.

If they can't hedge on the market, pass a law. This is getting to be some real sick shit.

Posted by: jdp | Apr 20 2005 2:11 utc | 3

If they can't hedge on the market, pass a law. This is getting to be some real sick shit.

Ay-yi-yi. I'm glad I'm off Wall Street.

I don't think my nerves could take it.

Posted by: fourlegsgood | Apr 20 2005 5:58 utc | 4

So would you trust someone selling you CDOs with Enron debt included? Enron had an AAA credit rating until two weeks before it went down. Sure debt made for excellent CDOs.

The "sister" of CDOs are Mortgage Backed Securities (MBSs). A bank lends to 100 homeowners than turns back and sells these "assets", i.e. the risk for being payed back, to (private) investors.

Who made the appraisals for those homes? How much could one really get on the market for those homes if those homeowners go "belly up"?

I think it is very, very dangerous when banks do not carry such risk anymore, but can sell the risk as "assets" to investors. The bank then has no longer any interest to check for the creditworthiness of the debttaker. Indead is has interest in high appraisals, doing may loans and doing lot of business of this kind while moving the risk to investors.

I am with the FT here. It is a huge accident waiting to happen and whoever buys such "assets" should better that money in a bar. At leasttehy will have some fun and the hangover will not be as severe as when this debt bubble blows up.

Posted by: b | Apr 20 2005 6:28 utc | 5

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