Credit Crisis:
Alphabet Soup and the Quest
for Phantom Market Values

A website called The Great Unwind, concerned to stir the public to anger and action re the credit crisis, recently linked to a story here on TNC while discussing Credit Default Swaps.

But there was some terminology confusion in the GU piece — so I posted the comment below at their site.

It’s worth reading if you’re confused by the alphabet-soup of structured finance in the press — and for the brief pointed chat about why the notion of market value does not and never has applied very well to CDOs.

Hello there,

I was happy to see that you linked to my piece from August 2007 (seems like yesterday): What is a CDO (I mean really)?

I note however that the mention comes is in a sentence and a paragraph about Credit Default Swaps (not CDOs).

One should realize a CDO and a CDS are very different animals.

1.  A CDO is a vehicle constituted by some seven to ten contracts, all knit together and working as a finely tuned (ahem) machine.

Often two or three of these contracts are swap agreements, appended to provide protections to the investors in the CDO bonds (tranches).

A Credit Default Swap (CDS), on the other hand, is a single swap agreement.

(Except in very odd cases, swap agreements are executed on a standard ISDA contract form, which gets tweaked in detail to serve its desired purpose.)

2.  The point of a CDO is to press income and principal payments from a large underlying pool of other financial instruments through the risk-stratified tranches to produce stratified returns. The riskier tranches pay higher interest, but are the first to suffer losses when mishaps occur in the underlying pool.

Thus, the CDO looks like and functions as a diversifed investment vehicle — although (as the TNC piece explains) the genesis is likely to have been a particular guy’s problem.

The point of a CDS, on the other hand, like all swaps, is to hedge against the future.

The prime party (the Protection Buyer) pays a small periodic fee to the counterparty (the Protection Seller). In turn, the latter pledges to compensate the Protection Buyer if specified Credit Events befall specified financial instruments (bonds and the like).

So the Protection Seller functions like an insurer, receiving regular premiums in return for assuming some of the credit risk of the issuer of the specified bonds, etc.

3. A last note:

In the mainstream press, “CDO” (Collateralized Debt Obligations) is often used to refer to Collateralized Mortgage Obligations. But there are important differences between these.

(a) The underlying pool of a CMO consists entirely of mortgage bonds — that is, Asset-Backed Securities (ABS) the underlying assets of which are mortgage loans (and perhaps long-term commercial leases). The acronym “MBS” is used (Mortgage-Backed Securities) for this subset of ABS.

In contrast, the underlying pool of a CDO (at least all I’ve ever laid eyes on) is diversified. E.g., most deals I drafted restricted MBS to 2 to 4% of the pool.

(b) The differences noted are important when one turns to the now-crucial notion of “market value.”

(i) CMOs — because their pools are homogenous and because their raison d’etre is truly public (to distribute the risks and rewards of mortgage lending to the wide world) — trade fairly efficiently (ahem: they used to trade …) in the secondary market.

That is:  The mortgage loans underlying an MBS, and the MBS under a CMO, are packaged and rated in a roughly standardized way throughout the industry. They tend to be “cookie cutter” deals. One AA-rated Midprime MBS was not thought much different from the next.

And so, until summer 2007, they traded en masse, thus achieving “price discovery” — and so the notion of market value had foundation.

(ii) In contrast, a diversified CDO is a more complicated, less generic beast.

And (to return to the TNC piece you linked) the fact that a CDO was probably built to solve a particular guy’s problem means that it is full of special detail and problem-solving mechanics — leaving it nothing like a “cookie cutter” deal.  (It usually took two to four months, in the best of times, to get the contracts for a CDO together.)

Thus, CDOs are much less interchangeable with each other than CMOs, and thus much harder to trade after issuance.  In the best of times.

In short: There was never an active and massive secondary market in CDO tranches.

If somebody had to unload one, it was done with pensive phone calls through the underwriting investment bank’s switchboard, and not infrequently required “re-wrapping” the piece with a little more enhancement (eg, an additional 10 bps coupon interest) to make the sale.

(iii)   Further, all the CDO deals I was close to (as primary drafter: on emails and phone calls with bank, rating agency, portfolio manager and perhaps investors) were entered into with little notion of secondary trading:

– The aim (again) was to solve a guy’s problem — not to extend the credit business of a particular industry to the four corners of the globe.

– And the third-party investors in the CDO tranches weren’t looking for liquid assets, but rather something like a CD. Something that would pay attractive interest for a fixed period of time and then expire.

(CDOs were almost always wound up within 2 to 4 years — much much sooner than their (20 to 30-year “stated maturities.”)

(iv)  AND SO. Today, as investors and regulators worldwide demand to know the market value of their CDO tranches, the answer unfortunately is that they weren’t built to support the notion of market value, and never traded efficiently in the best of times.

They weren’t really bonds, one might say. They had the form of bonds, but the underlying economic reality was rather different.

4. This is why, in August 2007, the New Combat editor aired the notion of price controls on the wounded segments of the “structured finance” world.

It was clear then — in light of what was happening to MBS and CMOs, and the loss of confidence in the methodologies that rated them — that:

(x) trillions of dollars’ worth of CDO tranches would soon be under pressure to be sold or even unwound (that is, the underlying pool dissassembled and sold piece by piece), and, yet,

(y) those tranches were not built to trade in open markets. They were too complex and idiosyncractic.

It would have looked like panic, true, to institute price controls a year ago, when the wounded segments of the credit markets were largely confined to Mortgageland.

Things are very different now. The entire system of credit is under pressure. No segments aside from sovereign debt are trading worth a damn.

5. All that being prologue.

To (finally) address the gist of your post, let me refer you to a recent post at The New Combat -– which in turn refers to a recent Times piece about AIG that focuses on your concerns.

The TNC post then goes on to talk in parallel fashion about the catastrophic effects of the Lehman bankruptcy, discussing swaps in the process.