Debt Free

Collateralized debt obligations, known in financial circles as CDOs, are part of the foundation of the debt market, and one of the reasons for the little difficulties said market is finding the going a bit rough these days. First developed in 1987 by Drexel Burnam Lambert (yes, those guys), a CDO is an asset backed (hence the term collateralized) security. Recently, one of the assets used to back them has been heretofore extremely profitable (for the lending institutions) home mortgage products taken by those of lesser credit stature. Due to their poor credit these individuals can be charged commensurately higher interest rates than those with a bit more luster on their credit.

CDOs are also what’s known as structured securities. This refers to the way the debt is set up. Not all participants face the same exposure to risk in such a financial instrument. Picture a CDO as a high rise building, with different risk exposures on each floor. The lower floor has the highest risk, and the highest floor has the lowest risk. Each floor is like a condo. It’s is purchased by different investors.

Why would these investors not all seek to purchase those levels on the top of the CDO, with the great view and the 12 foot ceilings (and the lowest risk)? Because, in the typical risk / reward relationship of investment instruments, the top levels of the CDO don’t receive the best return. Those at the lower levels, facing the highest risk, also enjoy the highest interest on their investment. At these lower levels CDOs can be extremely risky investments, and investors can lose everything they have invested. They are compensated for this risk by returns that regularly (until recently, for many) well exceeded 10%.

Who are these investors? They are much the same as with any other large debt instrument; pension funds, mutual funds, corporate and government retirement plans, insurance companies, large private investment funds, and banks. As you can probably guess from the types of institutions involved, we are dealing with absolutely huge amounts of money here. The 3-06 Fed report listed the total amount of outstanding debt backed securities in the U.S. alone at almost $35 trillion! Contrast that dollar amount with the equity markets, where approximately $50 trillion is in play in all of the world stock markets combined (data from the global trade association for stock exchanges).

These CDOs are one of the actual vehicles used by investors to acquire the mortgage debt made so famous in the media over the last few months. The investors, many from overseas, or as noted earlier, part of large financial groups, don’t just go out and buy somebody’s home loan. They buy securities (bonds) backed by the mortgages, including CDOs, which are made up of these bonds (securitized groups of many hundreds or thousands of such mortgage loans), packaged with other collateralized debt.

For a look at the actual math involved in a CDO (If you’re math averse, put your brain on ice first), check out this informative post by Accrued Interest

Why you should care about CDOs –
You should care about them because they are a foundation cornerstone of the mortgage backed securities market. As such they can have a large impact on the credit market as a whole. In addition, some observers feel that CDOs, because of their structure, are difficult to effectively risk analyze, and the risk can be mis-priced. That means the price doesn’t adequately reflect the associated risk assumed by the investor. That can lead to investors acquiring securities with a negative expected return.

Why would a large financial group or institution ever purchase a security with a negative expected return? After all, one would assume they would be in a much better position to analyze potential investments than your average person. They are, but due to the inherent complexity of a CDO, even some of the large investment groups sometimes have trouble  getting it right, because even they simply don’t have the depth of understanding required in these matters.

It gets better –
It has been theorized by some analysts that this lack of understanding has been capitalized on by some hedge fund managers. In order to generate their fund’s profits, they have been using a technique called credit arbitrage. That means they profit from the difference in two markets. More difference means more profit for the funds (grossly oversimplified). In order to maximize their profit they want to maximize the market difference. They can either seek to grow one side or shrink the other, possibly both. With arbitrage, risk is minimized by using simultaneous, or near simultaneous transactions.

A technique used by these managers to accomplish this Herculean task is to shake the confidence in the markets. Since credit market pricing is, in a large measure, based on confidence, lowering confidence creates a price collapse. With lower prices on one side of the equation, an arbiter can generate greater profit. That has been done in the case of the credit markets, according to some observers and insiders. So basically, a few fund managers aimed to destroy the world credit market for their gain, at your expense. For a more in-depth look at this phenomenon, take a look at this column in MSN money by Jon Markman.

Now that you’re good and pissed off, have a happy Thanksgiving (ignoring the whole genocide aspect of Thanksgiving for those of you unfortunate enough to have children in the Seattle school district).