Thursday, May 29, 2008

CDOs: The Future of Leveraged Fixed Income

(Accrued Interest) Collateralized Debt Obligations (CDOs) have been the bane of Wall Street recently. Falling CDO prices have been a major player in the write downs at big brokerages and the near insolvency of monoline bond insurers. And yet the CDO structure will not only survive this period, but is likely to become the dominant means of leveraged investing in credits.


First, let's consider what a CDO is, and what it isn't. At its simplest, a CDO starts with a portfolio of credit-risky securities. The purchase of this portfolio is funded by the sale of a series of debt tranches. Payment to debt tranche holders follows a seniority scale, such that the senior-most debt holder gets paid first, then the next-most senior, and so on. Most CDOs have at least 4 or 5 levels of seniority among debt holders. If there is any cash flow left, it is paid to an equity holder. It is common for the equity holder to represent as little as 1-3% of the total structure.

It sounds complicated, but the core concept is quite simple. It is similar to how banks fund themselves: you have depositors, senior debt, subordinated debt, preferred stock, and equity. As long as everything is going well, all debt holders get paid what they are promised, and whatever is left over is what the equity holder owns. If the bank goes under, depositors get paid first, then senior debt, etc. A CDO is basically the same idea, except that whereas the bank would have to go bankrupt before the credit tiering came into play, a CDO will take losses on individual credits over time.

The senior-most tranche of a CDO was usually rated AAA. This piece would usually amount to 60-80% of the total CDO structure, or put another way, 20-40% of the cash flows were subordinate to this senior-most piece. This meant the structure could take on substantial losses before the AAA tranche would suffer any cash flow short-fall.

Several things went wrong for the CDO market over the last 18 months. Many CDOs were constructed from consumer loan-related securities. It was assumed that losses in consumer loans would have a relatively low correlation, that a home equity loan for a teacher in Sacramento would have no correlation with a loan to an auto mechanic in Orlando. That assumption proved disastrously false in 2007 and caused CDOs built from consumer loans to fall apart en masse.

But it wasn't really the failure of CDOs themselves that created so many problems. Take the collapse of the SIVs. In most cases, SIVs collapsed not because they took on too much in cash flow losses, but because no one would buy their commercial paper anymore. In other words, the SIV arbitrage relied on the continued confidence in the SIV portfolio. Once that confidence was gone, regardless of what was actually in the portfolio, the SIV was toast. The very same thing happened to countless hedge funds and other leveraged vehicles in recent months. Any vehicle that relies on short-term funding is banking entirely on the continued support of short-term investors. Once that's gone, the whole structure is destroyed. A CDO doesn't have this problem. Generally speaking, the funding of a CDO is locked in at issuance.

Let's compare and contrast for a moment. A CDO equity investor, the one who only gets whatever is left over after all debt holders have been paid, is making a highly leveraged bet on credit losses within the CDO's portfolio. But that's the only bet being made. An investor in a hedge fund relying on repo financing is making a bet on both the portfolio and continued access to financing. Why should investors make two bets when they could make only one?

In addition, if properly funded, CDOs are safer for the system compared with other types of leverage. A CDO is a closed loop. If CDO portfolio losses are greater than initially assumed, investors in that CDO will suffer, but there is no contagion effect. We don't find pockets of lenders to the CDO hidden here and there. Of course, if CDO debt tranche purchases were funded by borrowing, then that's a different story. But such borrowing is not inherent to the creation of CDOs.

CDOs also rely on a very well known and time-tested arbitrage, assuming the right kind of collateral is being used. Credit investments have highly skewed return distributions: either you'll get paid the promised rate, or the bond will default and you'll take a huge loss (this is termed negative skew). It is well established that investors detest large losses more than they lust after large gains. Therefore credit spreads almost always price in more interest than is warranted by default expectations alone. A CDO can therefore buy a portfolio of credit instruments, and if the correlation of defaults is relatively low, make arbitrage profits on the investors disdain for negative skew.

I'm not suggesting the CDO market will soon return to its salad days of 2006. There were a lot of overly complicated structures and even more poorly conceived collateral portfolios. But the CDO market is starting to make a comeback, with 26 CDO deals pricing in April and May. As long as there is demand for leveraged credit, there will be, and should be, a CDO market.

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