CDO or collateral damage?

Cdoprobs060725

I was participating in JD Hamilton’s excellent presentation on the yield curve — I sure do recommend a visit, when I ran into the CDOs or Collateralized debt obligations.

All I can say this stuff is literally… dynamite; and the whole financial industry is sitting on top of them…

 

CDOs
are basically pools of bonds; 100 or more bonds in a pool, allowing
banks to sell to investors participation in a pool with a more
diversified risk  –where the failure of one company (bond) doesn’t
make the CDO worthless…

CDOs have evolved, they are now sold in tranches associated with different risks, hence different returns.

And their use has grown enormously, it’s estimated that the volume
of CDOs at the end of 2005 was $2 Trillion, 40% of the size of the $4.9
trillion bond market.

The other fascinating side to the CDO story is that its reduced the loan
spread or premium; and this in turn, has increased overall liquidity
and helped distressed companies to survive by allowing them to access
loans at half the historic rates.

On the other hand, it isn’t all rosy; as always, the models on which
the entire CDO industry is resting depend on human assumptions, which
may be at fault, nothing new here…

So, we may be enjoying the calm before the storm…

Anyhow, I found this other great post from Steve Hsu titled Gaussian Copula and credit derivatives which will clarify  any doubts related to the CDO subject.

And I’ll leave you with this little story from Steve’s post to entice further reading:

As with any model, forecasts investors make by using the model are only
as good as the inputs. Someone asking the model to indicate how CDO
prices will act in the future, for example, must first offer a guess
about what will happen to the underlying credit curves — that is, to
the market’s perception of the riskiness of individual bonds over
several years. Trouble awaits those who blindly trust the model’s
output instead of recognizing that they are making a bet based partly
on what they told the model they think will happen. Mr. Li worries that
"very few people understand the essence of the model."

Consider
the trade that tripped up some hedge funds during May’s turmoil in GM
securities. It involved selling insurance on the riskiest slice of a
synthetic CDO and then looking to the model for a way to hedge the
danger that the default risk would increase. Using the model, investors
calculated that they could offset that danger by buying a double dose
of insurance on a more conservative slice.

It looked like a
great deal. For selling protection on the riskiest slice — agreeing to
pay as much as $10 million to cover the pool’s first default losses —
an investor would collect a $3.5 million upfront payment and an
additional $500,000 yearly. Hedging the risk would cost the investor a
mere $415,000 annually, the price to buy protection on a $20 million
conservative piece.

But the model’s hedge assumed only one
possible future: one in which the prices of all the credit-default
swaps in the synthetic CDO moved in sync. They didn’t. On May 5, while
the outlook for most bond issuers stayed about the same, two got
slammed: GM and Ford Motor Co., both of which Standard & Poor’s
downgraded to below investment grade. That event caused a jump in the
price of protection on GM and Ford bonds. Within two weeks, the premium
payment on the riskiest slice of the CDO, the one most exposed to
defaults, leapt to about $6.5 million upfront.

Result: An
investor who had sold protection on the riskiest slice for $3.5 million
had a paper loss of nearly $3 million. That’s because if the investor
wanted to get out of the investment, he would have to buy a like amount
of insurance from somebody else for $6.5 million, or $3 million more
than he was getting.

The simultaneous investment in the
conservative slice proved an inadequate hedge. Because only GM and Ford
saw their default risk soar, not the rest of the bond world, the
pricing of the more conservative slices of the pool didn’t rise nearly
as much as the riskiest slice. So there wasn’t much of an offsetting
profit to be made there by reselling that insurance.

This wasn’t
really the fault of the model, which was designed mainly to help price
the tranches, not to make predictions. True, the model had assumed the
various credit curves would move in sync. But it also allowed for
investors to adjust this assumption — an option that some, wittingly
or not, ignored.

Because numerous hedge funds had made the
same credit-derivatives bet, the turmoil they faced spilled over into
stock and bond markets. Many investors worried that some hedge funds
might have to dump assets to cover their losses, so they sold, too.
(Some hedge funds also suffered from a separate bad bet, which relied
on GM’s bond and stock prices moving in tandem; it went wrong when GM
shares rallied suddenly as investor Kirk Kerkorian said he would bid
for GM shares.)