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S. Balakrishnan

Can a rated bond offer a much better yield than its peers? On the face of it, no. But modern financial engineering has a way of making these things possible. And that has brought to the fore the risks to investors and the system when structured debt products implode.

The culprits are collateralised debt obligations (CDOs). They are portfolios of bonds or loans bundled together and sold to a special purpose vehicle (SPV), which creates and sells investible securities backed by the portfolio – in effect synthetic instruments.

So how does the yield get extra juice? It is here that the concept of portfolio diversification comes into play. While the chance of an individual subprime loan going sour may be high, when combined with hundreds and thousands of other (uncorrelated) subprime assets, the incidence of default, in theory, comes down dramatically. A simple calculation shows that a 90 per cent default probability for a single bond reduces to just 7 per cent for a portfolio of 25 such bonds.

This provides the conceptual basis for the design and structuring of CDOs.

Typically a CDO consists of several tranches of varying credit quality from the highest prime to the lowest subprime debt, with investors buying into those tranches meeting their risk-return mix. In addition, those holding the lower-rated tranches absorb defaults in the higher-rated tranches up to a specified limit. This strategy of diversification and partial default protection enables CDOs to offer better yields compared to other prime paper in the market having the same rating.

It is not surprising that CDOs caught on in a big way with investors. They seemed to improve yield without extra risk – the dream of any portfolio manager.

CDOs support a multibillion dollar industry in the US, comprising mortgage borrowers, lenders, investment bankers, quants (who design and price CDOS), lawyers, raters and last (and in this case the least, given the current turn of events), investors.

CDOs have, of course, facilitated the segregation of market players into originators, intermediaries and investors. Tranched structures mean risk transfer corresponds precisely to risk appetite.

The recent subprime mortgage crisis and consequent credit spread widening has blown large holes in CDOs. Investors are discovering reality is very different from statistical models – asset correlation means diversification does not reduce risk as much as thought.

More than anything, CDOs are devilishly difficult, if not impossible, to price. Investors are belatedly realising they are sitting on mountains of unpriceable, illiquid, unsaleable paper, having been trapped into investing by the ratings of rating agencies and the yield sweetener. Warren Buffett once called derivatives ‘mass weapons of financial destruction’. CDOs seem to aptly merit his description.

More Stories on : Debt Market | Financial Scan

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