July 2007

A new term has recently entered the private investor's vocabulary: CDO ("Collateralised Debt Obligation"). CDOs are essentially pools of loans, especially mortgages, bundled together into single securities and divided into "tranches" of different credit ratings.

Any credit defaults accrue to the lowest tranches first; when the lowest tranche (the "equity tranche", referred to by some traders as "toxic waste) is "filled", subsequent defaults will affect the second-lowest tranche, and so on.
 
Taking subprime mortgages (mortgage loans taken up by less creditworthy individuals) as an example, a pool of loans, which would individually be judged to be below investment grade, can actually attain a AAA rating for the highest tranche of the CDO, as the probability of all the loans defaulting during their lifetime is expected to be minimal and, since defaults accrue for the lower tranches and upwards, the top tranche should be risk-free.
 
Valuing CDOs is guesswork. Illiquid and seldom traded, they are composed of a number of different loans, some of which default, some of which are serviced, making an accurate valuation almost impossible. CDOs therefore tend to be valued according to "models" rather than market pricing.
 
Several hedge funds have run into problems lately because of a decline in the notional value of the CDOs they own, in the wake of a rise in subprime mortgage defaults and, perhaps more importantly, a huge increase in the perceived risk of all CDOs, and thus risk premiums. Risk is acceptable if realistically priced, but the fact that CDOs have clearly been inappropriately valued, undermines the value of portfolios that have invested in them.
 
While this might, at first glance, appear to be a problem confined to an obscure corner of the bond market, its potential significance is profound. There are, for example, economic implications. A reassessment of risk will inevitably lead to higher interest rates to attract CDO investors and make it more expensive for homebuyers to obtain new mortgages, thus placing a greater financial burden on consumers and leaving them less disposable income to spend elsewhere in the economy.
 
While some analysts predict an ultimate "credit crunch", whereby lenders are obliged to suspend new loan issuance until their balance sheets have been repaired, our assessment is less bleak. Although some CDO investors will suffer, and buying property will become harder for subprime borrowers, the financial markets as a whole should be able to pull through reasonably unscathed. Private investors should nevertheless be aware that their pension funds and insurance companies, as well as their investment funds, may be exposed to CDOs.