CDOs: Whistling in the Dark

We have mentioned before that the CDO market, a dark, murky, but rapidly growing part of the financial markets, is looking dodgier by the day.

A brief primer: CDOs resemble other structured credits, like mortgage backed securities, in that they are structured into tranches of varying credit quality and maturities. The top tier is often credit enhanced, either by being overcollateralized or by the use of third party guarantees, to achieve its target rating. Hence, the rating agencies are intimately involved in the structuring of these deals, and since they are paid fees by the originating investment banks, they suffer from a conflict of interest.

A concern recently voiced in the marketplace, beyond the conflict of interest, is that the rating agencies lack the skills to rate these instruments, since they are often composed of pools of underlying instruments that themselves are difficult to model. For example, mortgage backed securities (which were already tranched) can go into CDOs. To put it bluntly, anyone at a rating agency who is skilled enough to model a CDO will make more money working for an investment bank or money manager, so they cannot hang on to the staff with the crucial know-how.

Now this wouldn’t matter so much if these instruments were marked to market. The shortcomings of the rating agencies would be captured in the marketplace (it’s common for corporate bonds to trade down before the rating agency works up the nerve to downgrade them).

However, pension funds and some other institutional investors are not marking these CDOS to market. John Plender, in a Financial Times article, explained:

The hedge funds need to make about 20 per cent gross a year, before a welter of fees, to provide that 1 per cent a month for their backers. Such a spectacular return can be gained either by market outperformance, which is beyond most fund managers, or by taking on leverage through borrowing, or trading in derivatives. For most, that means adopting leveraged strategies in illiquid assets, to avoid leaving capital values hostage to market volatility.

Structured credit products are tailor-made for this task. Collateralised debt and loan obligations (CDOs and CLOs) invest in poor-quality assets such as subprime mortgages or loans to super-leveraged buy-outs, and sell matching liabilities to investors. Yet the sale involves an alchemical transformation. The package is sliced and diced into high- and low-risk tranches, with usually up to 80 per cent being rated Triple-A or AA and the residue being very lowly rated or unrated.

For pension funds and managers of official reserves, the resulting high-grade paper is a boon in a world where the number of Triple-A corporate borrowers has dwindled to a handful.

For hedge funds the low-grade paper, which provides a cushion against default risk in the high-grade tranches, is likewise a boon, especially since, as Mr Maxey points out, it lends itself to arbitrage whereby hedge funds take long positions in the high-risk tranches and short positions in the low-risk tranches, which are relatively expensive. This ought to increase market efficiency since more investors can buy into a given pool of low-quality credit-enhanced assets.

The peculiarity of this trade is that profit is never arbitraged away in the benign phase of the credit cycle because positions are not constantly marked to market. Their illiquidity requires them to be marked to a model approved by credit rating agencies. As we saw after Enron and the subprime mortgage fiasco, rating agencies, who are paid by those who they rate, do not adjust ratings to reflect deteriorating economics. They close stable doors after profligate horses have bolted.

It follows, as Mr Maxey notes, that relaxing lending standards is perfectly rational. To increase lending volume, banks could either reduce their interest rates or reduce underwriting standards. Given the hunt for yield, this is a no-brainer. So collapsing standards will now stretch out the credit cycle while ensuring the delayed downturn will be more savage when the defaults finally happen. This subverts the argument that structured products uniformly enhance market efficiency. Credit is being mispriced, courtesy of credit rating agencies that are insensitive to market risk. Stand by for systemic consequences in due course.

Now if this isn’t troubling enough, many of these CDOs are blind investments. This sort of CDO is called an actively managed CDO, and the CDO manager goes out and raises money, and then proceeds to invest the money. Thus not only do you not know what you are getting into, you are never certain what you own, since the manager is trading it, possibly on a daily basis.

There is every reason to expect this to end badly. Michael Panzner points us to this post at Winter (Economic & Market) Watch:
I continue to be outraged by the whole Milky Way and credit agencies scam. At risk of sounding like a broken record, a poster at Prudent Bear spotted this.

A friend of mine works as a Portfolio Manager for a $2.2b CDO pool of subprime loans. I spoke to him today for an hour. Asked how he is doing, he says “nothing”. I ask what do you mean nothing, I hear all these stories about CDO’s and losses (Bear Stearns for example), he shrugs and says nothing will happen until the Rating agencies do something. Asked about losses, he says they are there but he doesn’t have to mark to market his portfolio until someone discovers it, or the Rating agencies force his hand. So his plan is to lie low and collect the management fees and pretend as if there are no losses. Asked about management fees, he laughs and says it’s a low 50 bips. On $2.2b, that’s a cool $10m yearly which he and his four colleagues have to split up at the end of the year. He says he has the best job in the world and says there is really no work to do every day. Just wait and hope that the rating agencies don’t downgrade his CDO pool and voila, at the end of the year, he and his partners can split the $10m spoils (minus the expenses for one Park Avenue office, and a secretary). I am amazed that no body (regulators, investors, the public) hasn’t beseeched the Rating agencies to review all the Subprime CDO’s by now given the headlines and the incredible losses hidden there. This is a SCAM and somebody needs to stop it.”

Wile E. Coyote deal making and risk taking:

The fees for arranging loans are as alluring for the commercial banks as they were for subprime lenders. “It’s like crack cocaine for them,” says the unnamed private equity partner. In LBO deals, “the banks don’t care any more about the [quality of] credit. As long as they can sell it all, they’re fine.

Why do bond investors put up with this? “They don’t really have much choice…..if you’re managing a high-yield bond fund, there’s really not an option of going to 25 per cent cash. So you have to invest in the best deals that you can find. And because there’s so much money out there, the issuers can say, ‘You want to argue about covenants? The deal’s oversubscribed 3 to 1. See you on the next one”…..

If that strategy explodes in their faces because they end up holding some worthless junk debt, so be it. For as long as it lasts, it’s an easy route to profits. Hedge funds get into trouble and are forced to close shop all the time, but no one ever asks them to return their fees. “Why would you not just take the highest possible risk with other people’s money? If there’s literally no downside, it’s the rational thing for you to do…

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