My 2 Cents:
The CDOs Madness


          The past few years have seen an unprecedented flow of liquidity into global capital markets. Fueled by strong global economic performance, accumulation of petrodollars and Asian central bank reserves as well as the explosion of alternative investment vehicles such as private equity and hedge funds, companies across the entire credit rating spectrum have had access to deep capital pools for funding expansion plans and growth. However, the recent volatility and reversal in credit markets has raised questions about the near and long-term outlook for the health of the global economy.

          The spectacular growth in liquidity in recent years created an investor appetite for highly leveraged financing arrangements with low credit protection. However, the losses suffered by market participants from sub-prime mortgage exposures and changes in credit rating agency views on risk in highly leveraged transactions have caused investors to re-evaluate their risk appetite and have led to a broad re-pricing of risk. 

          This, in my view, is good news. For far too long, too much money has been lent too cheaply and too easily to too many people. This wake up call was long overdue and the big question now must be whether the world economy is strong enough to cope with the latest credit crunch. The biggest risk to the global economy probably lies with debt-laden American consumers. A credit squeeze will no doubt aggravate the housing bust and falling property prices could drag consumers’ spending down further.

          Moreover, a broader market meltdown cannot be ruled out altogether. After all, many of the debt instruments with funny acronyms such as CDOs and CLOs (collateralized debt/loan obligations) that dominate today’s debt markets have never been tested in a serious panic. Credit derivatives have probably improved the stability of the global economy by dispersing risk, but it is no longer clear where that risk is being held. And many of the new risk dispersing instruments are so illiquid that trouble may not emerge for sometime.

          The only saving grace is the relatively healthy economic fundamentals in other countries outside the US. Current GDP growth across the globe is strong by historical standards. Corporate profitability globally is also healthy. What’s more, if the US economy were to head downhill fast, the US Federal Reserve, despite its public worries about inflation, has plenty of scope for cutting interest rates.

What exactly are CDOs, CLOs, LBOs, Prime Brokers and Hedge Funds?

          Now that investors and lenders have woken up, it’s worthwhile to retrace how things became this bad in the first place. Abundantly cheap money with rock-bottom interest rates makes people do stupid things. During the recent global debt bonanza, recklessness reigned supreme, where rash lending practices became commonplace. Banks were happy to allow dodgy borrowers to get away with ‘covenant lite’ loans, under which lenders waived the formerly iron-clad requirement that borrowers maintain a specified ratio of cash flow to interest payments, ensuring an adequate cushion against an industry’s downturn or a recession; not to mention about Ninja loans (to people with No Income, No Job or Assets) and “Pay-in-Kind” (PIK) notes where borrowers can pay interest in the form further IOUs instead of cold hard cash.

          All this borrowing was especially lucrative for investment banks that earned fat fees for underwriting huge volumes of mortgages and loans and junk bonds that funded LBOs (leverage buy-outs). And the biggest customers for these loans were entities known as CDOs (Collateralized Debt Obligations) and CLOs (Collateralized Loan Obligations). Although the names make them sound like financial instruments, but in fact, they are actually investment funds, typically operated by hedge funds or banks. CDOs buy bonds, including high-yield issues and mortgage-backed securities, while CLOs purchase corporate loans, including those used to finance buyouts. The CDOs and CLOs then turn around and sell a variety of bonds backed by the payments on the loans and the collateral securing them, such as houses, plants, equipments and inventories.

          So who are the buyers for these CDOs bonds? Traditionally, many stodgy investors such as pension funds and insurance companies steered clear of such bonds because they lacked investment-grade rating. But now banks can dice and slice these CDOs to suit potential investors. The riskiest tranche, known as equity, earns the highest return but takes the first hit from any defaults in the underlying portfolio. By adding other tranches on top, each taking progressively less risk, it is possible to create a security that rating agencies place the coveted triple (AAA) class from a pile of what essentially are junk bonds. By working hand-in-glove with the rating agencies, which were paid large fees for their involvement, investment banks managed to get masses of these mortgage-backed securities rated investment grade. All of a sudden risky consumer loans were reconstituted into something seemingly no more risky than a government Treasury bond. 

          As a result, these CDOs were extremely popular with banks and insurance companies (both US and international). They tended to buy the paper with the highest ratings i.e. the bonds that had first claim on the cash flow and collateral backing the loans. Next down the food chain were the hedge funds. They tended to buy the lower rated, higher yielding paper and then enhanced the yields by buying on margin, which enabled these hedge funds to produce returns of 20% or more. As one move further down the ladder, guess who loaned those hedge funds the money to buy the CDOs on margin? It’s the prime brokers that belong to the same investment banks that underwrote these CDOs in the first place. Now do you get the picture?

          This is all very well in theory, but only now are these new instruments being tested. Defaults in the 2006 vintage of sub prime loans have been much higher than expected, which led to the collapse of two Bear Stearns hedge funds. The end seemed to come suddenly and the contagion soon spread to other parts of the world especially in Europe where several hedge funds had to be suspended and smaller banks went bankrupt. The scale of the losses and the time it took for them to emerge surprised both investors and regulators.

Is the worst over?

          At this stage it’s hard to say but there are two sectors that are most vulnerable namely banks and the real estate sector. At the moment, most big banks’ balance sheets look pretty secure. Most Thai banks have very little exposure to CDOs with the exception of Bank Thai Plc. Other than that the world’s top 1,000 banks, Tier 1 capital rose by 19% in 2006. But things could easily get nastier as the dust settles and the real damage becomes more apparent as foreclosures run their course.

          As for the real estate sector, rising mortgage rates are bound to deepen the slump. Customers with poor or mediocre credit histories can’t get loans at all, a big shift from a year ago. It’s the same story for commercial real estate such as office buildings, hotels and apartments. They too depend heavily on the price of debt.

          At the end of the day, I think we have seen this cycle before. In some sense, all financial bubbles are alike. They begin with abundant cash, low interest rates and sound economic fundamentals. Then people get carried away and become reckless as more speculators pile in. And like all good things in life, it never lasts. However, the one good thing that will come out of this crisis is that as prices tumbled another cycle can begin when the prices of real estates, stocks and bonds become more reasonable again. All one can do now is to invest for the long term and invest often by using Dollar Cost Averaging technique.