On the second coming of CDOs
I was flicking through the IFR yesterday when I hit upon the following: “New York-based Arbor Realty Trust came to market Wednesday with 2013’s first commercial real estate CDO, a risky derivatives product closely associated with the 2007 financial crisis.” I thought to myself: “Here we go again…”
This was not the “Here we go again…” you might have expected. I am not at all averse to CLOs and CDOs. Frankly, I think they are brilliant. I worked with Collateralised Loan Obligations for long enough to be able to appreciate how clever they are in the way they shift risks around a debt portfolio and how they enable investors to choose how much of that risk they are prepared to fund and for what return they are prepared to do so.
Please let me dip into the old tool-box to explain.
Imagine a debt portfolio as a field full of land mines, those are the possible defaults, say a hundred of them, which are more or less evenly distributed over the terrain. Most of the land is safe but somewhere you might tread on one and… boom! A CLO is a field of equal size with an equal number of land mines. However, the difference is that the vast majority of mines are concentrated in one corner of the field. That renders that particular corner highly perilous but the rest of the field becomes significantly safer. It’s as simple as that. That is how you get a triple-A rating on 80% of a portfolio of BB credits. It’s a game of statistics which plays with the probability of default of individual credits which underlies each alphanumerical rating assigned by the agencies but which then goes on to assign ratings to each tranche of the CLO.
A similar analogy is where you take a portfolio and turn it 90 degrees, thus causing the bulk of the default risk to drop to the bottom, like one of those Eiffel Towers in a snow storm. I could go on.
Risk is like energy – it can be converted but it can’t be destroyed.
Alas, the structure itself has nothing complicated or difficult to understand about it. The problem lies in the methodology of the ratings agencies and, far more in my view, the way in which the structuring banks try to arbitrage that methodology and to squeeze their CLO (or CDO) over the line in order to achieve the desired rating. Often enough, triple-A rated tranches just needed sneezing at in order for them to fall over and to drop back to double-A and so on down the rating scale for the full capital structure of the transaction.
So long as everybody understands the risks, all is well. However, what seemed to have escaped many investors was that if defaults were to occur, then the rating on the entire structure would be dragged down. Simply put, if you own the second to default risk and the first to default risk defaults, then the second to default has just become the first to default, going forward. Is that such a complicated concept to understand? I think not –- or at least it shouldn’t be for all those MBAs and CFAs and PhDs who now populate the investment world.
So far, so good. We know the risks. What we struggle with is assessing what the correct remuneration is for taking those risks. Investment bankers – and commercial bankers for that matter – spend their lives trying to price risk and if they can’t do it for something as simple as the primary product – bonds, equities and real estate – what chance of getting the first and second derivatives right?
Shuffling the risks around in the process of creating a structured portfolio generated huge opaqueness and it was in this, the fog of war, that the structurers struck gold. Huge profits could be extracted from excess spread without anybody noticing. Happy days! CLOs and CDOs became the geese that laid the golden eggs.
Alas, there is no such thing as a bad credit, just a wrong price. CDOs were going to blow up in the credit crisis – that’s what they do – and even if the returns had been weighted more in favour of the investors and less in favour of the banks they still would still have done so. However, the bank’s greed for fees was nearly equally matched by the investors’ greed for returns and both sides conned themselves and each other into believing what they respectively wanted to believe about the robust nature of the product and the superior returns they would and could generate out of the same aggregate amount of credit risk.
With underlying bond yields as low as they now are and total return prospects as miserable as they are, it is natural that people will try to beat the system once again. The cheap leverage which drove the last wave of CLOs and CDOs is gone so the old arbitrage deals will no longer be possible but there is demand for yield in a “risk on” year and the hungry structuring desks will be more than happy to oblige. But watch them –- the hand is faster than the eye! Risk is like energy – it can be converted but it can’t be destroyed.
Alas, it’s that time of the week again. All that remains for me is to wish you and yours a happy and peaceful week-end. I can’t but marvel at the current scandal here in the UK and Ireland where horse meat has been found in beef burgers. Please let me suggest that you watch carefully what you eat and by that I don’t mean that you go and spend Saturday or Sunday afternoon at the races…