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Wednesday, November, 28, 2007

Collateralized Debt Obligation (CDO): Pool of assets generally made up of debt instruments, which is subsequently securitized, usually in the form of bonds, then repackaged and sold to investors.

COLLATERALIZED DEBT OBLIGATION (CDO) IN THE REAL WORLD: When Pocket MBA started getting special requests to explain CDOs, it heaved a sigh of relief—as in, "Thank heavens nobody else understands these things either." (PMBA is nothing if not honest.) And Pocket MBA prayed that the subprime mortgage bust would pass quietly into the night, and take this summer's credit crunch along with it (a crunch in part spurred by the fact that many CDOs were holding pools of nonperforming subprime mortgage-backed securities). But as the credit crunch seems to be on the verge of spawning what the financial press called "son of credit crunch" (notice it's never "daughter of" anything, sugar and spice and all that, except "Daughter of Frankenstein," which is the name of a song, and Frankenstein's Daughter, which is the name of a film), PMBA began rummaging through its vast store of articles on financial products and asset backed securities, realizing it was high noon on figuring out CDOs. And then Merrill Lynch wrote down nearly $8 billion in assets, much of it mortgage- and hence CDO-related, which has been followed by a (portfolio) murderers' row of other financial institutions doing likewise. So here we are.

Of course, we all know what collateral is, and we all know what debt and obligations are. It's just that if you put those three words together, with your common sense of their definitions, you cannot have the first clue about CDOs.

CDOs are a relatively new investment vehicle, with roots in 1987 (how ominous) at long gone investment banking house Drexel Burnham Lambert. They have rapidly grown and last year (2006) some $918 billion in CDOs were sold, according to CDOs May Bring Subprime-Like Bust for LBOs, Junk Debt. Early on, CDOs didn't usually hold mortgages, but as demand heated up, CDO managers had to find more risk-laden investments to maintain the outsized return CDOs gave to investors. Thus, CDOs ended up in the "repackaging subprime" business, which all worked fine until homeowners began defaulting in droves. You can check out the Bloomberg report for a good sense of how the current mess evolved.

Anyway, our prime concern isn't how CDOs have tripped up institutions and the markets, it's what's in a CDO—how they're structured. As always, Pocket MBA prefers to over oversimplify. If you want to dig deeper, you can start with this week's special download CDOs in Plain English (Nomura Securities International, Inc.). It bottom lines CDOs thusly:

A CDO is similar to a mutual fund that buys bonds. However, unlike a mutual fund, most of the securities sold from a CDO are themselves bonds, rather than shares. In simplest terms, a CDO is an arrangement that raises money primarily by issuing its own bonds and then invests the proceeds in a portfolio of bonds, loans, or similar assets. Payments on the portfolio are the main source of funds for repaying the CDO's own securities.

If that doesn't make complete sense (but if you diagram it out, it does), Pocket MBA likes to think of CDOs as a used-car lot of debt. Better yet, it's like a scrap yard of debt. It's debt that used to have one form that now has another, and is being sold to people that can get value out of it by an entity (the CDO manager) that's not the original car dealer, but may be related to the car dealer.

So basically it's just a debt repackager. Think of all the debt out there in the world. Let's say PMBA issued 1,000 of its closest friends mortgages, many of which are subprime, and each of these people also start corporations and issue corporate bonds. For good measure, all 1,000 friends borrow money from their local bank. An entity will essentially buy all that debt, pretty it up into nice, distinct, little bundles of like debt, and sell it anew to investors, as bonds. (In the lingo of the day, they "securitize" it, that is, change something that is not a security into a security, or change it from one kind of security into another.) The entire package is the CDO. The income stream from the debt gives the investors who buy the CDO's bonds their returns, and the capital from the investors gives the CDO money with which to buy more debt. So the pool of debt obligations is the investors' collateral on their investment (loan)—hence the name collateralized debt obligation.

But, Pocket MBA, you say, all those different debts have a variety of risk levels. Who's going to buy into that mish-mash of uncertainty? Well, the CDO manager is smarter than thinking it can bamboozle anyone. What happens is that each bundle of debt in the CDO has a risk rating, just like any other debt obligation. And they can range from AAA all the way down to unrated. And the risk (and potential return) rises as you go down the scale of creditworthiness. The CDO will sell each of these rating levels of debt in separate tranches to different investors. (Ack, how can that term come up again? Chill, remember, it's French for "slice.") See Pocket MBA, Vol. 5, No. 20. It's kind of like the CDO has "A" shares, "B" shares and so on, except that they might be called "December 2008, 5% XYZ Corp. Series A bonds tranche." So you can invest in a CDO without investing in all the different debt obligations the CDO holds. There's a lot more to the structure of CDOs, but Pocket MBA recommends you to the download for that. Those are your basics.

It's easy to see how a CDO can work rather well; so long as the underlying debt obligations continue to be met, it's like taking candy from a baby from an investment standpoint. And that was the case during the 1990s and early 2000s. But as banks took the subprime mortgages off their books by transferring them to CDOs, it enabled them to lend out more money to more people, but eventually they were lending to people who couldn't pay back because the terms became more and more onerous as interest rates began to rise in 2006, but then even those loans ended up in the CDOs.

Success is a tough nut. Once any round of borrowers starts failing to pay, the assets within the impacted tranches of the CDO start to tumble in value, and that has a domino-like effect. And that's what happened with the mortgage-backed tranches of the CDOs we've been reading about. In essence, managers were borrowing money from investors (mostly hedge funds, pensions funds and insurance companies) to invest in the assets (mortgaged houses) that others had borrowed to acquire. And the previously low interest rate environment had allowed CDO managers to borrow money to buy more loans, using the CDO assets as collateral. Risky stuff, but the rest, as they say, is history, although in this case, the history is being made presently. As we have been witnessing, when the assets behind a CDO lose value, CDO managers have to sell other assets to cover their obligations, which starts a cycle that leads banks to begin refusing to accept the CDO assets as collateral for new loans. That leads to credit crunch, son-, daughter-, sister- and uncle- of credit crunch. It's pretty much become a family affair at this point

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