CDO: Instrument of destruction?

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Institutional investors have returned, in part, to those complex investments known as collateralized debt obligations, or CDOs, according to recent news reports — most recently in Tuesday’s Wall Street Journal article, “One of Wall Street’s riskiest bets returns.”

Are they bad?

The securities themselves aren’t bad, even the synthetic variety. They do fill a need. The plain-vanilla CDO fills a need that institutional investors have for high yields coupled with a mandate for low-risk, highly rated securities.

Through a sleight of hand known as credit transformation, the CDO pools a bunch of lower-rated bonds to get securities with higher ratings. It helps lower-rated companies get money, says Scott Skyrm, author of “The Money Noose: John Corzine and the collapse of MF Global.”

The bundle of bonds that make up the CDO is divided into tranches based on their relative risk.

“You are pooling the credit and slicing the chance of credit default in the CDO. That bottom tranche is very speculative, full of bonds you think will be wiped out in a year. The top, the A tranche, is the most protected. There is probably no chance that there will be defaults,” says Skyrm.

“With the A tranche, you can somehow take a bunch of BB-, or BBB-rated securities and somehow get an A- or AA-rated security out of that,” he says.

Synthetic CDOs are not made of bonds. They are bundles of credit default swaps, or CDS, or other derivatives. A CDS is basically protection against default. One side of the trade wants coverage against default, and the other side says, “OK, I will provide that insurance or take on the risk of default.”

There are some benefits to synthetic CDOs, according to Dave Jefferds, co-founder and chief operating officer of DealVector, a firm that connects investors in the alternative investment space.

“You can customize it to the risk preference you want,” he says. In a cash deal, the credit risk and maturity of bonds is basically limited to what’s on the market. For instance, says Jefferds, “There might be an IBM bond that matures in 2016 and in 2017, but I want to go to the middle of that period. Or I want to do a one-year or a 10-year maturity; with a swap, you can tailor it to your risk preference.”

But it’s not all upside; there is also counterparty risk. Investors interested in buying synthetic CDOs have to deal with counterparties — the people who are putting the deal together and also state the value of the investment. If the value of the security fluctuates, one of the parties may demand more collateral. For instance, if the creditworthiness of some of the businesses goes down, then one of the parties to the transaction has to give the other party some money based on the value of the contract. Where it went wrong in the financial crisis was that valuations were often fraudulent, and there was a lot of leverage. Basically, there were too many incentives for people to lie and borrow lots of money in order to make lots of money.

“What happened in the crisis when everything went kablooey: No one knew what they were worth. The banks said these aren’t worth anything now, so send me all your money. Hedge funds and financial institutions collapsed because of the nature of the collateral calls that came out of the derivative trades,” says Jefferds.

It was really a systemic failure that led to the downfall of the CDO market, from mortgage underwriters who knowingly wrote bad loans to the underwriters of CDOs who put together bad products to the ratings agencies that had no way of accurately evaluating instruments that were based on fraud in a lot of cases — but went ahead and rated them anyway.

So what’s going on now?

Since the financial crisis, regulators have stressed and strained to find ways to make structured financial products more transparent, to monitor the shadow banking industry and to remove the incentives that allowed people to act fraudulently in the last decade.

The products that are being sold now are different because the CDO market is different now — and much smaller.

“None of the CDOs today involve home mortgages; some have been using corporate bonds and some credit default swaps,” says Anand Bhattacharya, professor of finance practice at the W.P. Carey School of Business at Arizona State University.

Issuance of the securities fell drastically after 2008, according to the Securities Industry and Financial Markets Association. Now the CDO market is starting to come back, slowly.

“It’s not a sea change or a big trend we should worry about. Credit is improving, and it is a legitimate bet to make given that the economy is getting better,” says Bhattacharya.

For now, the CDO market is under control. If history is any indicator, the economic triggers and vulnerabilities will likely come from some other source in the future. “You can always fight yesterday’s wars but can’t know the form of the skewed incentives for tomorrow. And that is the real policy challenge,” says Jefferds.

Follow me on Twitter: @SheynaSteiner.

Senior investing reporter Sheyna Steiner is a co-author of “Future Millionaires’ Guidebook,” an e-book written by Bankrate editors and reporters. It’s available at all the major e-book retailers.