CDOs plummet from grace

CDOs - those weird and wonderful investments that nobody understood but everyone bought. Some Australian banks had been peddling them with vigour before the crunch, but now they had become a source of outrage around the world.  Almost two years earlier, Insto uncovered some frightening facts about extensive buying of CDOS from NSW councils. That was early days, councils continued to mop up CDOS and when markets froze they were left with red ink and red faces. Even more disturbing is that many charities dabbled in structured credit, some facing up to losses and others settling with the banks eager to avoid severe reputation damage. While securitisation is a genuine financial innovation, finance historians will note CDOs as the embodiment of greed and deceit. 

Insto Bond Diary

***CDOs slammed (25 July 2007)***

As structured credit’s toxic waste rises to the surface, yield hungry investors in global credit are being reminded of the importance of liquidity.

Sales in structured credit products, Collateralised Debt Obligations (CDOs) in the US are reported to be down substantially from US$42 billion in June to US$3.7 billion in July, affecting liquidity and delaying debt raisings.

Last week saw the near-implosion of Basis Capital, the Australian based hedge fund. Much of the fund’s woes were attributed to the market value of their holdings of the lower tranches of sub-prime mortgage CDOs being revised substantially downwards.

Traditionally the historic cost approach was used to value assets. The prevalence of structured products such as derivatives has forced valuations to adopt the ‘marking to market’ technique in which the value of an asset is recorded at its market price.

However the illiquidity of products and the lack of clear price signals has forced funds to mark assets to models, which rely on numerous assumptions. The sub-prime mortgage crisis has exposed some of the shortcomings of marking to models.

The unease which has impacted the ‘mark to market’ of assets has had a knock on effect on corporate spreads, as risk is being ‘repriced’. 

‘These events forced investors to revaluate how comfortable they are investing in these markets. There are few reasons to buy and liquidity dries up,’ said an institutional fund manager.

The model is supposed to show the price that an asset would be trading at in the market. However, when Bear Stearns’ hedge funds were forced to unload their portfolio of sub-prime mortgage backed securities, driving down prices in the otherwise illiquid markets, this created large discrepancies between the model and the market’s valuations.  

“Pricing models don’t tell you where the supply and demand is. If you can’t sell something for a certain price, then it’s not the price,” said a local fund manager. 

“You can’t forget the liquidity premium you have to price in liquidity and make sure you are rewarded for holding illiquid securities,” he added. 

But some feel that the liquidity premium is what attracts investors to ‘illiquid’ CDOs. Institutional funds who are buying to hold are happy to pick up the premium as they do not require the liquidity. For them the investment decision is based on the level of the premium.

Mark to market losses do however present a challenge to investors.

‘If one had to go to an investment bank right now for a price on a CDO, they would tell you that the only price you can get is one you are not going to like,’ said an investor. 

‘We as a fund have to educate investors in a fund that in an extreme market breakdown, we are not going to mark to market. They have to be prepared to trust the fund manager,’ said the fund manager.  

Some observers say the inclusion of retail and high net worth investors is part of the reason for hedge fund Basis Capital’s woes.

‘If a fund has retail investors, no matter how large they are, it has to offer liquidity and market price,’ said a source.

Another contributing factor was the additional leverage the fund attained from separate bank lenders who made margin calls as the mark to market losses revealed themselves. 

‘By lending from the banks you effectively cede control of the fund. The lenders act in their own interests and not in the interests of the fund or its investors,’ said the source. 

‘There may have been nothing wrong with their assets. If it was their cash they could have just frozen the fund, and investors would probably have lost a lot less,’ speculated an observer.

CDOs are once again receiving bad press both at home and abroad. Reserve Bank Governor Glenn Stevens recently referred to CDOs as an example of reckless investing by councils, and other middle market investors.

Australia’s CDO market developed through the retail and middle market funds. The least sophisticated investors have been buying the most sophisticated products.  Research conducted by Insto discovered substantial level of investment in CDOs by NSW councils, with CDOs making up over 50 per cent of some council’s portfolios.

The enticement of juicy yield from products that technically fell within their risk mandates ensured a healthy appetite for CDOs. 

Stevens, however, questioned whether councils understood the real risks of investing in CDOs.  “Are they really cognisant of the degree of risk and the embedded leverage in those products,” he said. 

For institutional funds however, CDOs is an asset class that is here to stay.  The period of volatility is one where the good structures are sorted from the bad.

CDOs can be divided into two broad types – synthetic and managed. Synthetic CDOs are packaged into a closed structure and then set to sail. Managed CDOs have a captain that can steer the ship away from trouble.

The shift in preference for managed CDOs has been going on for some time, as investors are prepared to give up yield to ensure their exposure is monitored.

And while it remains a challenge to value CDO tranches, trading levels are apparently at levels not seen in years, which some say is presenting tantalising opportunities for real money investors to access the better products.

Said a fund manager: ‘We see this as an overdue and a healthy correction. It will widen spreads, force the market to look at credit quality, lead to a tiering of CDO managers, and create buying opportunities.'