EEK! 5 YEARS TO GO!
New member
I found this article from 2006 and thought it was interesting because it really show's the pyramid scheme structure of CDO's. Too bad nobody paid attention.
If Credit Market Tightens, CDO Boom Could Go Bust
By LIZ PEEK | October 10, 2006
http://www.nysun.com/business/if-credit-market-tightens-cdo-boom-could-go-bust/41204/
Feeling a little insecure about our grasp of Collateralized Debt Obligations, we dropped in on the Bond Market Association forum on the subject. Talk about jumping into the deep end of the pool! One speaker's actual sentence: "This year we did our first mezz synthetic ABS CDO." What was he talking about? For many of us, he might as well be speaking in tongues.
The problem with simply ignoring this bewildering market is that it is not about to go away. On the contrary, it is growing like mad. According to a report by Celent, "Since 1998, the CDO market has experienced an average annual growth rate of 150%. Celent estimates that the overall CDO market represents over $1.5 trillion and will grow close to US$2 trillion by the end of 2006."
Collateralized debt obligations are like bonds except that instead of being backed by the full faith and credit of a corporation, for instance, they are backed by various kinds of debt instruments. They are the outgrowth of investment products originally developed in the late 1980s to rescue the savings and loan industry.
CDOs are primarily taking the place of traditional bank lending. One market participant estimates that about two-thirds of all senior financing last year was being done through CDOs, instead of through bank loans. This observer is concerned that the shift loosens the ties between borrowers and lenders in an unhealthy way, which because of the strong economy and healthy credit markets, has not yet become apparent. That might not last.
Many middle market companies that have historically borrowed through their banks are now issuing CDOs. While strong demand may lower the costs of such funds up front, the relationship between lender and borrower is certainly changed. Now if a company has a financial wobble, not only will the stock get slammed, but the debt may be dumped as well. The true cost of such arms-length borrowing may not be visible for some time.
Another concern, according to Jay Diamond of Annaly Capital Management, is that "the sheer weight of demand for the underlying collateral has depressed risk premiums to virtually nothing." The market has never experienced a real credit pinch, according to Mr. Diamond, but it surely will.As Mr. Diamond points out, a small loss can easily wipe out the equity and lower rated tranches; very quickly the CDO manager can be forced to collapse the whole structure.
Such issues are why it is no longer enough to understand only stocks. Bonds used to be the province of the old or the embarrassingly conservative.
These days, however, the debt and credit markets are home to a lot of the coolest new ideas, many of which involve calculations beyond the average nuclear physicist. Though these are primarily the province of institutional investors, some funds targeting individuals are popping up.
In the 1980s, many savings and loans were on the verge of default, threatening the American dream of a home in every back yard. New investors in mortgages were needed to prop up the failing S&Ls. To attract new capital the industry began to collect up mortgages and offer investors the opportunity to take on a fraction of the pool that best met their needs. In other words, instead of tailoring the pool of assets for the benefit of the borrower, now the lenders' priorities were taken into consideration, and the pools of mortgages were sliced up by risk profile and maturity.
A life insurance company would presumably have a different risk appetite or time horizon than a pension fund, for instance. With the flexibility afforded through the new structure, both types of investors' needs could be met.
Today, CDOs come in a wide range of sizes and types. According to figures collected by Thompson Financial, issuance of CDOs through the first half of this year amounted to more than $177 billion globally. The backing for these instruments came primarily from structured finance obligations ($112.6 billion) and high yield loans ($58.1 billion), but also included some backed by investment grade and high yield bonds. Structured finance collateral can include securitized products including mortgage-backed securities (or the ABS CDO our speaker mentioned).
The increased variety has expanded the vehicles' utility and appeal to different kinds of investors, and been crucial to the sector's growth. Of this year's issuance, by far the majority have been long-term instruments. Also, the bulk of the CDOs have been so-called arbitrage instruments, where the investor hopes to benefit from the spread between the yield on the assets held (the collateral) and the financing costs of the liabilities, which usually have higher ratings. The spread, or value, is created by the sophisticated slicing and dicing, as the industry calls it, or the dividing into different tranches of the underlying pool of assets.
Any marketplace as jargon-prone as this one naturally creates a cult following. In the Bond Market Association presentation, speakers were somewhat derisive of the growing intrusion into the space by hedge funds. The development of synthetic CDOs using derivatives to further tailor the credit and cash flows of the issue is especially appealing to the hedge funds.
According to more than one panelist, the macro hedge funds, which typically make big bets on the directions of various markets, are currently betting against the mortgage market because they see real estate values coming down. They do not, according to some speakers, understand the intricacies of the CDO marketplace, nor are they capable of analyzing credits.
Undoubtedly, they will. The market is growing fast enough to entice new investors all the time, and to see the beginnings of a secondary market.There are already CDOs of CDOs, which is a bit mindboggling, but in effect they are simply funds buying up funds.There is also one fund (at least) called Polygon, which provides individuals with the opportunity to invest in the equity tranche of CDOs.
Now, let's return to the mezz synthetic ABS CDO: Are we all clear on that?
