The Risk Isolation with CDOs
Whenever we isolate lenders with those who own the debt, such as the case with CDOs, where the debt is sold to others who then assume both the income streams and the risk, there is the potential that the risks inherent in the securities will not be managed or even understood satisfactorily.
CDOs are touted as a low risk investment to individual investors. After all, banks and other lenders lend this money, and they are pretty risk averse, preferring low risk, so their loans must be pretty low risk, right?
With some types of CDOs, such as mortgage backed securities, the debt was even collateralized, and therefore if the borrowers defaulted, their properties could be sold and at least most of the risk of losses could be managed, at least in theory.
This model assumes that the lending that comprises the CDOs will be fashioned according to sound risk management principles. As we know, during the mortgage crisis that brought on the Great Recession of 2007-2008, in many cases this was not done properly at all.
Stories emerged such as the picker from California whose income was only $17,000 a year, with no real prospects for increasing it, being given a mortgage for $750,000. Many of these mortgages were structured by making the initial payments very low and then having them normalize later.
When they did normalize, the buyer was expected to refinance his mortgage, where the assumed increased equity that was earned by the exploding increases in property value at the time would be used to service the mortgage.
As soon as prices stopped going up, the whole thing came down like a house of cards and default rates skyrocketed. As it turned out, this alarming way of managing risk by lenders was all fueled by investors hungry for more and more mortgage backed securities, and when the mortgage market became saturated, lenders just went out and loaned to many people who should not have qualified.
These mortgage backed securities and other CDOs still maintained their investment grade ratings though, so that’s what the investors looked at, even though rating agencies do have a conflict of interest and make a lot of money rating investments. Many think that their rating these securities properly would have resulted in their biting the hand that fed them, as they collect a lot of money for rating CDOs, and there was probably a lot of truth in that.
The Structure and Rationale of CDOs
The problems that we faced with CDOs don’t have anything to do with the proper structure or rationale of CDOs, which in themselves should increase and not decrease the risk capacity to manage credit defaults.
It must be kept in mind that the default rate is separate from the structure of CDOs, or at least it should be, although the market is not supposed to look to encourage lenders to take bad loans. In order for this not to happen, you have to have an acceptable level of transparency, meaning that investors need to be aware enough of what risks are actually present in a given security.
In order to allow for a more efficient assignment of risk with CDOs, they are broken up into distinct parcels called tranches. Each tranche would then be rated according to its desirability, with better tranches receiving higher ratings, AAA for instance as opposed to tranches which would be rated AA, A, and BBB.
Therefore, more conservative investors could stick to the higher rated tranches, while those who are willing to accept higher risk could purchase lower rated ones. The whole thing in itself is well designed and does what markets do, to assign risk from those who are less able to manage it to those who are more able.
For this to work though, we do need enough transparency, and this is where things can go awry. Those who took big positions in CDOs and in mortgage backed securities in particular ended up underestimating the degree of systemic risk inherent in the investments, particularly in light of the bursting of the so-called housing bubble.
To make things worse, a lot of the investment was placed not with asset backed CDOs, but with what are called synthetic CDOs, derivatives that are only based upon the underlying stream of payments that true CDOs own.
Synthetic CDOs mostly relied upon credit default swaps, where premiums would be collected to protect against the defaults that exploded when the crisis hit. Credit default swaps are even more exposed to systemic risk, and this has become a lot like a naked option writer seeing their position explode against them when defaults hit a crisis level, you know that the losses involved will be severe because there’s huge positions to cover.
If we can compare CDOs with naked option writing, which is known to be the riskiest position an investor can take, then this is nothing like the investment grade bonds that CDOs were compared to and treated like.
Why We Still Need CDOs
CDOs are a fairly new phenomenon and it’s not like the credit market could not do without them and still function well. They do make the management of credit more efficient though, and there’s no question about this, because this is what they are designed to do.
However, when risk managers fail to exercise enough caution, and worse, are incented not to, collecting huge bonuses and making their employers even more money without proper regard to the overall risk, this can place their institutions in positions that they may not be able to handle.
It is one thing to not properly prepare for catastrophic events, which may be big enough to bring down the entire economy of the world, but are quite unlikely. You cannot adequately prepare for everything, but when you do not prepare for events that are quite likely, like the housing crisis, then you are not coming close to acting responsibly enough.
The biggest thing that was missing in this CDO and credit default swap debacle was people simply being made aware enough of the actual risks involved with these securities, although regulation has since stepped in to ensure that we do a better job of this going forward.
While the market for CDOs is only a fraction of what it was prior to the recession, the market for CDOs was simply too big for its own good at the time, fueled by a lot of bad mortgages and not enough attention to their quality.
CDOs are mostly traded by institutions such as investment banks and funds, although individuals sometimes invest in them directly. Depending on the quality of the CDO, they can still be a fairly conservative investment and more so than investing in the stock market.
CDOs are more like bonds, other than the debt that they are holding is an assortment of consumer and business debt that has been securitized.
There are people who look at banks and wish that they could make money the same way that banks do, and investing in CDOs provide exactly that.
The trick though is to make sure that you are investing in prime loans and mortgages, and not poorer quality debt. However, since the crisis, things have really settled down in this market, and one need not take on excessive risk unless one wants to.
CDOs are income investments though, as bonds are, and they can provide investors with a nice source of income, perhaps to help them manage their retirement years. They are not supposed to be high risk, and especially not very high risk, but we’re now seeing them being treated and used more like they are supposed to be.
CDOs/Collateral Debt Obligations FAQs
How do collateralized debt obligations work?
Collateralized debt obligations, or CDOs, are securities that are formed by buying debt notes and packing them into segments called tranches. Each segment is organized according to risk, with the senior traches having the least risk and return, on down the line. Investors purchase these CDOs in order to earn income like they do with bonds.
What does collateralized debt obligation mean?
The value of a collateralized debt obligation is derived from the income flow that they generate, and the underlying assets, the loans that are combined in the security, serve as the collateral for it. This means something of value outside what is being exchanged directly, in this case the security is secured by the debt obligations.
What is the difference between mortgage backed securities (MBS) and CDOs?
Mortgage backed securities are a form of CDO that just holds mortgages. CDOs can hold any form of debt, and are usually a combination of secured and unsecured loans, mortgages, and corporate bonds. The mix of types of loans looks to reduce the risk of just buying higher risk debt. Mortgage backed securities are in a lower risk category.
What is the collateral in a CDO?
Collateral with a CDO is different than collateral that may be put up to secure a loan, your car or house for instance. In the case of CDOs, they are secured by the loans and other debt that it contains, where as long as the payments on the debt are made as agreed, this will ensure that principal amounts are repaid and the holders of the CDOs enjoy the benefits.
What is the role of CDO?
CDOs serve as important constituents of the debt market, as they allow both better price discovery and greater liquidity to debt markets. CDOs place debt obligations in the hands of those who desire to hold it the most, and also serve to expand the debt market from lenders to investors like mutual funds and pension funds.
What is the difference between a CDO and a synthetic CDO?
The value of CDOs are derived from the value of the underlying debt, and holding CDOs do involve owning a portion of this debt. Synthetic CDOs do not involve owning any collateralized debt obligations, as they use other techniques such as trading in credit default swaps and options to achieve their returns.
What is CDO position?
When we have a stake in an investment, it is called taking a position. Positions can either be on the long or the short side, with the long side meaning that you are betting on the value going up and the short side having you make money when the value of the security decreases. Investors can either take long or short positions in CDOs.
Is a collateralized debt obligation a derivative?
Financial derivatives involve securities that derive their value from something else, such as futures contracts deriving their value from the price of the underlying asset, or options being valued by the price of what the option is on. Collateralized debt obligations derive their value from the value of the debt it securitizes, so it is a derivative.
What are debt tranches?
Tranches is French for slices, and debt tranches are slices of an overall debt portfolio that are categorized according to risk. Senior tranches are comprised of higher-quality debt, meaning less default risk, while junior tranches are composed of higher-risk debt. Investors can choose which tranche serves their needs the best.
Are synthetic CDOs still legal?
In spite of criticism such as synthetic CDO’s being the financial equivalent of a nuclear weapon, synthetic CDOs remain legal. The problem with them during the subprime crisis was more a lack of transparency than anything, and they are particularly complicated financial instruments that must be understood. Many didn’t and took on much more risk than they thought.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
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