Friday, January 25, 2013

What a CDO 'Resurgence' Might Mean for Investors

By Tim Husson, PhD and Tim Dulaney, PhD

Kaitlin Ugolik at Law360 had an article on Wednesday discussing the recent "bump in demand for collateralized debt obligations."  CDOs are complex derivatives that pool assets together and split the risk of that portfolio into tranches which are then sold to investors.  CDOs have been implicated in the financial crisis of 2008 and have seen a strong drop-off in new issuances since, though that tide may now be changing.

According to the article, some lenders are predicting a large increase in CDO sales in 2013, "reaching as much as $10 billion."  The sources quoted emphasize the differences between new CDO issuances and the 'toxic' products of years past:
Instead of utilizing layers of complex derivatives in order to maximize gains — which ultimately maximized losses in 2008 — the products currently in demand are simpler cash-driven structures more akin to the format first developed in the early 1990s, often with fixed pools of assets that might pull in a lower yield, but are seen as safer in the long run. 
“The problems with the CDOs from the last decade had much more to do with the quality of what was put in than any structural feature of a CDO in and of itself,” Weiner said. “The lessons of the last decade have not yet been forgotten completely and therefore people are paying more attention to the quality of the assets being put in.” 
As a result, the major difference practitioners likely will see in 2013's CDOs versus their 2008 counterparts will not be their structure, but their underwriting, he said.
 While there were certainly lots of problems with the assets put into CDOs and other asset-backed securities -- see, for example, our work on warehousing in 2007 CLOs -- the CDO structure itself can be highly risky and extremely complex, even in its most 'vanilla' form, especially to investors in the bottommost 'equity' tranches.  In fact, valuation of CDO tranches can be extremely complex and is the subject of a large literature in quantitative finance.

So while financial institutions may again be finding CDOs an attractive way to raise cash, the events of 2007 and 2008 demonstrate that such investments are unlikely to be appropriate for any but the most sophisticated institutional investors.

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