Getting your head around the CDOs

David French | 2/03/2009 11:40:30 AM

This article was originally published as 'Getting your head around the CDOs' on p 15 in The Morning Bulletin on 26th Nov 2004.

Collateralised debt obligations (CDO’s) typically offer a relatively high yield, with some type of capital guarantee or superior credit rating. Many investors are attracted by this combination, and recently brokers have been having a field day selling CDO’s.

Institutions, large banks for example, often run investment portfolios of their own. These portfolios help underpin the capital of the institution. Regulators are keen to see that bank’s capital is sound, and frequently perform checks to confirm that. On account of the Basle Accord (an agreement dealing with the international regulation of banks), there are significant changes afoot. Some overseas banks need to boost the credit quality of the investment portfolios underpinning their capital.

What can they do? Assume that the bank’s overall debt portfolio had an average credit rating of BBB+ (a middle range rating), but the regulator wants an average of A+. The bank could sell all of its lower quality assets and purchase higher quality assets, or insure its portfolio – both expensive alternatives. Enter the CDO.

The portfolio of debt assets is contracted out to an external manager experienced in issuing CDO’s. The manager determines that the BBB+ portfolio can be broken into several tranches with different credit ratings. Therefore the overall BBB+ credit rating is replaced by a number of portfolios with ratings of say AA+, A and BB. If the A and BB tranches are sold off, the bank can satisfy the regulators by simply retaining the paper rated AA+. The lower ranking A and BB tranches are offered to retail investors.

Many recent CDO offerings are secured against a large portfolio of debt assets. If one of those assets fails to pay interest or goes bust, there is no effect on the portfolio. But after that there is real risk of income and ultimately capital loss. One recent offering represented a portfolio of over 150 corporate bonds. If more than 2 went broke or missed an interest payment your income fell - more than 10 and you lose all of your investment.

If you held a real portfolio of 150 assets, the chance of ever losing all your money would be tiny. However, the CDO structure means that you would go out the back door with only 10 - just 6.7 per cent of the total portfolio. What’s more, the maturity of CDO’s is frequently 7 years or more. Right now we are in the best of financial times. If things change, say increasing interest rates and a deep recession, it is more than conceivable that the 10 incidents limit will be breached.

The bottom line is, the 9 or 10 per cent returns offered by CDO’s are a direct reflection of the risk the investor is taking on. If you understand that, fine. If you don’t, then steer clear.

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Getting your head around the CDOs