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Friday August 3, 2007

What is a CDO (I mean really)?

by William Johnney


Ed Note: The meltdown on Wall Street continued today, with the Dow Industrials down another 284 points and oil near an all-time high. T.G.I.F.

Bear on a mountain of asset-backed securities

Bear Stearns on a mountain of mortgage-backed securities.

This morning Standard & Poor's, the rating agency, downgraded its outlook for investment bank Bear Stearns from Stable to Negative. In reply, on an afternoon conference call, the Bear chief financial officer told analysts that the company had no plans to buy back its own stock (to arrest the plummet pictured above), the price of which promptly fell another five percent -- and the markets followed. As Todd Harrison at Minyanville likes to say, "As go the Piggies, so goes the Poke."

The Piggies being the banks, and the Poke the rest of organized humankind.

What's generally referred to as The Subprime Mess is hardly Bear's fault. Nevertheless the firm has become the poster child of the current credit-crunch fiasco, for it was the complete wipeout in late June of two Bear so-called hedge funds (hardly hedged, it turns out) specializing in mortgage-backed bonds based on loans to people with "subprime" FICO scores (usually defined as below 625) that started the landslide that today widened and accelerated.

Today for the first time spokesmen out of the Bullish camp came out screaming that the bond markets (other than in government securities) are now frozen, and that a disaster the likes of which has not been seen in most of our lifetimes is in progress. And the Bear CFO said that the bonds markets are the worst he has seen in his 22 years in the business. Most eyes are now on the Federal Reserve Bank. As if it might ride to the rescue.

But the problems are not simply liquidity problems, and even if the Fed lowers (this coming Tuesday) the two intra-bank rates it controls, not all the problems will soon go away.

For example: The mortgage-bond failures demonstrate that the rating agency methodologies used to evaluate and rate high-tech "structured finance" bonds are seriously flawed. This wethinks is why the private bond markets across all sectors (well beyond mortgage bonds) have seized up. The rating methodology failure means no one in the world really knows what their high-tech bonds are worth.

A radical thought, then: Perhaps the authorities might institute 90 days of price controls on the teeming mystery bonds to quell the panic. For example: Residential mortgage-backed securities rated AAA must trade between par and 79 cents on the dollar. Or don't trade. Something like closing the banks for 60 days after FDR took office in 1933.

During these 90 days, as the bond markets thawed and the mortgage industry got back on its feet, the (ahem) trading community would cautiously feel its way toward rediscovering, or perhaps discovering truly for the very first time, what the trillions of dollars worth of "derivative" securities held by banks, funds and insurance companies worldwide are worth.

Structured finance bonds known as CDOs -- collateralized debt obligations -- have been at the center of this credit crunch, because they are often based on pools of "asset-backed securities" including the failing mortgage-backed bonds at the heart of the Subprime Mess.

But what is a CDO? And why is the world filled to the gills with them?


I mean really?

A public answer:

Collaterized Debt Obligations are investment vehicles consisting of subclasses (called tranches) of bonds, stratified by credit rating (usually AAA down to BBB-, i.e., the full "investment grade" range).

Underlying the CDO is a large pool of other bonds -- be they basic corporates, asset-backed securities (ABS) such as mortgage or credit-card bonds, or even tranches of other CDOs. The interest and principal payments from this underlying pool get pressed thru the CDO tranches to produce stratified returns for their investors.

Similarly, "CLOs" and "CMOs" are complex bonds based on, respectively, pools of Loans (often used to fund leveraged buy-outs) and Mortgage bonds. (CDOs may include loans and often include mortgage bonds, but typically in small amounts amid a diversified pool.)

The pool is assembled by an investment bank, which hires a Portfolio Manager and a Trustee. The Bank then forms the CDO's Issuer (a "special purpose vehicle" usually offshore), sells the tranches to institutional investors, nets from the proceeds its fat fee, and retires to a beachhouse in Southhampton for a month, leaving the PM and Trustee to run the deal.

A fair enough answer as far as it goes. But it fails to capture the economic reality of most of the deals I worked on across the past six years.

A few pointers, then:

-- A CDO often happens because a guy with a problem calls an investment bank. Or maybe the bank calls him. To inform him of the problem.

-- The guy with the problem almost always winds up as the Portfolio Manager of the CDO that seems to be his solution.

-- And he often goes home after closing with the riskiest tranche in his pocket.

Three examples:

A Simple Problem:

Languishing in the deep trough of an interest-rate cycle, a pension fund's bond portfolio is yielding peanuts -- making it hard for the fund to meet long-standing commitments to pensioners.

Solution: Moonlighting. Why not make a little gravy on the side by serving as Portfolio Manager of a CDO (or a dozen) with a pool of bonds similar to your own? No need to hire new spreadsheeters -- the same guys watching your in-house portfolio can manage the CDOs.

A More Complicated Problem:

An insurance company is pushing regulatory limits on investments characterized as debt, whether due to underperform- ance of same, or regulatory change, or poor management by the in-house spreadsheeters.

Solution: New Bonds for Old! Rather than wade into the markets to dump or improve your portfolio trade by trade -- why not let Bank take, say, $500 million in old bonds off your hands and repackage them in a new CDO? Bank is confident that by applying its expertise and working its clients it can place your lumber at competitive rates.

And remember, you'll be collecting the Portfolio Management Fee every payment date -- along with whatever interest trickles down to the BBB- tranche you'll be buying to close the deal. Nobody else wants that piece -- Moody's is saying it looks like $30 million -- and holding it will focus your managerial mind, assuring portfolio performance for all investors top to bottom. Won't the regulators be pleased to find your books lighter by $470 million in yesterday's bonds?

Such "repackaging" is now utterly common, and, in my experience, the raison d'etre of most CDOs.

So it's not simply that bankers think CDO fees are awesome. But rather that the world is full of bond portfolios that regularly need tune-ups, as things change or stuff happens. With the advent of Excel, the CDO became the efficient solution to a problem as old as finance.

(What's that? Can't quite swallow the whole $30 million BBB- piece? Bank will be happy to take half, at its usual discount, and sell it tomorrow to a guy in Asia re-wrapped and enhanced with an extra 10 bps of coupon interest. Bank is here to get deals done.)

A More Interesting Problem:

The spreadsheeters at a "hedge fund" specializing in mortgage-backed securities fail to sniff a change in the wind, an approaching squall -- and suddenly realize they're hardly hedged at all. Something must be done.

But such bonds are arcane and lightly traded (to be kind) -- not easy to sell in the secondary market even in the best of times.

Solution: Bank will be happy for an appropriate fee to launch a Synthetic CDO with a "notional" (imaginary) Reference Portfolio that happens to be identical to your imperiled portfolio of MBS.

Bank will also be happy to serve as Counterparty to the Credit Default Swap Agreement at the heart of the CDO contract, acting as Protection Seller -- and thereby cushioning the CDO investors against the ill effects of any Credit Events that may befall the Reference Portfolio.

(For example: A subprime mortgage bond in the Reference Portfolio -- and thus also in the troubled hedge fund -- is downgraded by Fitch. Or misses an interest payment. The Trustee notates the occurrence of a Credit Event. And the market price of the bond drops like a rock. But if you bought Protection in a swap agreement, hey, you got some cushion.)

So, to solve the unhedged hedge fund's problem, it merely remains for said fund to buy the entire CDO.


That's right. There's no third-party investor behind the curtain. The guy with the problem is not only serving as Portfolio Manager -- but he's buying every tranche for (say) $500 million.

The sale proceeds get invested in secure collateral -- because remember, this is a Synthetic CDO, which means the Reference Portfolio is just a list of MBS issues stapled to the back of your Private Placement Memo. There is no underlying pool of bonds to purchase.

So the $500 million -- net of bank fees, rating agency fees and other closing costs -- goes to the Issuer's reserve account, in the Trustee's care. But nobody holds cash. So instead it gets parked in a safe investment that happens to throw off enough income to make the CDO work. Which investment, in this case, is credit card asset-backed securities.


That's right, we put the five centamills in credit card bonds -- Moody's and S&P said fine.

But are they safe?!

Safe?! They're golden!

That's what you said last year about the mortgage bonds! Who says credit card bonds can't fail?!

They never have! They got a stellar track record!

If all goes well, each quarter the interest income from the $500 mm in credit card ABS pays (i) the coupon interest on the CDO tranches to the investor (the hedge fund), (ii) the management fees to the Portfolio Manager (the hedge fund), (iii) the swap premium to the counterparty (the bank), (iv) the Trustee fee and (v) miscellaneous expenses.

And upon the occurrence of Credit Events, the Counterparty as Protection Seller (the bank) will compensate the CDO Issuer as Protection Buyer, as per the terms of the swap agreement. Which compensation then flows to the investor (the hedge fund). Until the Protection written into the deal has been exhausted. After which further losses will be absorbed by the $500 mm credit card ABS -- thus reducing the amount of principal repaid to the investor (the hedge fund) when the deal winds up.

So, is this really a CDO? Sure -- says right here on the cover.

But in essence it's nothing like a vehicle for public investment. More like a tailor-made, if byzantine, insurance policy. And it may be that the lawyers who drafted the deal, and the rating agencies that blessed it, maybe even the tax man, have little or no idea of the economic reality.

So what's a CDO really?

A CDO is a problem solver. And each quarter in the business world problems blossom anew.

That's why there's so many CDOs.

David Byrne Talking Heads Stop Making Sense Big Suit

Ed Postscript: Oh it's a tangled world we've weaved since the advent of Excel -- a worldwide web of hundreds of trillions of dollars' worth of complex, derivative obligations.

Is it a more dangerous world than the one that preceded it?

Do the rating agencies have the muscle and talent to police it?

Can any self-regulatory system work when We're all Yuppies Here and nobody gets paid unless the deal gets done?

However that may be, at the moment nobody in the world has a clue as to what their CDOs are really worth. And they are waiting for a man in a Big Suit to tell them.

The End

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