Good Primer on CDOs

The Financial Times’ Paul Davies has written a good short piece on the basics of CDOs, which is useful if you are ever in the unfortunate position of having to explain them to someone new to the concept. He also suggests that subprime-related CDOs going pear shaped is not an indictment of the technology. Nevertheless, he also points out that a related similar financial structure, collateralized loan obligations, most commonly used for LBO debt, may be on the cusp of getting a bad name due to similar overly optimistic assumptions about the likely performance of the underlying assets.

One quibble: Davies is talking about “passive” CDOs. CDOs can also be “active” or “managed.” In that case, the debt is issued on a blind pool basis (at most, only some of the assets will have been purchased at the time of underwriting) and a manager trades the assets over the life of the CDO. It is a continuing source of frustration that I have never seen any information on the relative magnitude of active versus passive CDOs.

From the FT:

With the crisis at the riskier end of the US mortgage market gathering pace and investor jitters spreading to much broader segments of the debt markets, attention is increasingly being focused on the complex structured bonds that helped to fund this lending boom.

The intensity of this focus will only sharpen following news that two of Bear Stearns Asset Management’s hedge funds which were heavily exposed to something called collateralised debt obligations (CDOs) have essentially lost everything.

So what is a collateralised debt obligation?

The first thing to understand is that CDOs are a process, a kind of financial technology, rather than an asset class. The roots of this technology are in securitisation, which is the trick of borrowing money against cash you expect to receive in the future.

The reason sub-prime mortgages – lending to people who have patchy credit records, who cannot prove their incomes, or who want to borrow many times their incomes – took off in the first place was the discovery that such lending could be financed through wrapping the loans up into large pools and “securitising” the expected repayments.

Banks weren’t keen to lend to such risky borrowers and instead new companies such as Kensington in the UK were created to exploit this new business model.

Why would anybody else be keen to lend to these risky borrowers?

Herein lies the wonderful alchemy of securitisation and CDOs. The pool of debts created for these vehicles is like one side of a company’s balance sheet – its assets. They are an asset because they will provide income from repayments in the future.

The “company” that is created here must fund the purchase of these assets somehow and it does this by issuing debt and equity like any other company.

Through the magic of mathematical probability, the credit rating agencies will look at this “company” and say that the chances of, for example, 70 per cent of its assets all going bad and not providing income are very, very low. Thus it will give debt representing that share of the pool its safest AAA rating.

Many kinds of investors from banks to pension funds and life insurers love this triple-A debt, especially when it pays a higher interest coupon than other kinds of debt with a similar rating.

What about the rest of this pool of debts?

The next, say, 10 per cent of the pool faces a higher likelihood of turning bad so it gets a lower rating and so on down to the first 5 per cent of the pool, which is quite likely to see problems and thus gets no rating. This last bit is the “company’s” equity – it receives the highest returns, but bears the highest risk of suffering losses.

Mortgage-backed bonds are the debts that fund pools of mortgages directly, while debt issued by CDOs is used to fund pools of other kinds of bonds or loans that are issued by public and private companies, property investors and, crucially, mortgage securitisations.

So who buys this stuff?

Are you sitting down? Your pension fund is likely to have holdings of most parts of these kinds of deals from the safest triple-A paper down to the equity. Recent research from Citigroup suggests in fact that traditional asset managers – pensions and bond funds – have more than 40 per cent of their exposure to CDOs in the equity and less than 20 per cent in the safest triple-A bonds.

Are they mad? Am I going to lose everything?

Relax. There are a number of reasons why your money is not going to be entirely sucked down some strange financial vortex. First, equity tranches are very small in nominal terms and any pension fund’s money that is actually at risk will be far, far smaller than the amounts they have in other areas such as equities and ordinary bonds.

Second, so far in most markets the theories around ratings and mathematical probabilities have held up fairly well – and the kind of debts that these vehicles finance is not all off the scale of prudence, in the same way that US sub-prime lending became in recent years.

However, some hard questions are being asked about the aggressiveness of lending to leveraged buy-outs of companies such as Boots and much of this lending is financed by a special type of CDO known as collateralised loan obligations, which your pension may well have exposure to.

Third, the reason the Bear Stearns’ funds lost everything was because they borrowed money to invest in CDOs, which your pension fund will certainly not be doing – or not directly at least.

So I’m all right then . . .?

Not exactly. Such investments remain highly risky, although they can also be equally highly rewarding. Some kinds of structures have held up well in previous economic downturns, although others have been blown apart. But one thing’s for certain: they have never been used so widely to fund so many different kinds of debt as now.