Scholtes and Gillian Tett have a long piece in the FT on risks in and to
the collateralized debt obligation (CDO) market – the market which seems
to be the center of attention and fears these days, in the wake of the Bear
Stearns brouhaha. There are some good points made in the piece, but I think
it’s worth teasing out exactly what the different risks in the CDO market are,
because even the excellent Tett is failing to make some very important distinctions.
- First, there’s the risk that holders of subprime mortgages will default
on their loans. This is a known and relatively easy to quantify risk. Subprime
mortgages issued in 2005 and 2006 already have high default rates, and those
rates are likely to rise even higher when the mortgages reach their second
birthday and higher adjustable rates start kicking in. The problem is that
the connection between subprime default rates, on the one hand, and CDO valuations
and default rates, on the other, is so complex that it’s very difficult to
say in a simple sense that a rise in mortgage defaults will lead to a rise
in CDO defaults. It’s worth remembering that the key risk in the market for
any mortgage-backed security is not default risk but prepayment risk, and
that a high mortgage default rate, in and of itself, is not necessarily particularly
worrisome from the point of view of a CDO holder.
- Second, there’s the risk that CDO tranches, especially the riskier equity
tranches and the ones with relatively low credit ratings, will start to default.
It’s very unclear, to me at least, whether this has happened yet, but I suspect
that most of the worries are that it might happen in the future. A key problem
here is one of transparency: with many CDOs investing largely in other
CDOs, it’s very difficult often to get a handle on what the underlying cashflows
are and how likely they are to be impaired.
- Third, there’s the discount which investors are currently demanding in order
to buy illiquid securities with precious little transparency. There’s talk
in the market that triple-A rated CDO tranches – which, we can reasonably
assume, are very unlikely to actually default – are getting bids at
270 basis points over Treasuries, or more. That huge spread is not a credit
spread; rather, it’s a good old-fashioned wide bid-offer spread on extremely
illiquid securities. CDOs are similar in some ways to private equity, in that
they tie up money for a long period of time and hope to provide excess returns
over that time. They’re not designed to be instruments which can
be liquidated easily or quickly. If investors start being forced to liquidate
their CDOs, then the price they receive might well be much lower than the
actual credit risk on those CDOs might suggest.
- Fourth, there’s what used to be called rollover risk. If investors start
liquidating their CDOs, that means there’s going to be a pretty large supply
of cheap CDOs on the secondary market. In turn that means that there’s going
to be much less demand for expensive CDOs on the primary market. And the steady
stream of billions of dollars which has been flowing until now from CDO investors
all the way, ultimately, to private equity shops, homeowners, and other consumers
of credit will dry up. This is the credit crunch that many people are so worried
about. And it can happen even if CDOs don’t get liquidated en masse,
if investors simply lose their appetite for new ones.
These four risks form a nice little circle. Subprime defaults can, in theory,
pass through into defaults on CDO tranches. That, in turn, can, in theory, trigger
CDO liquidations. That, in turn, could mean the amount of liquidity in the credit
markets drying up. And that, in turn, will mean that subprime borrowers find
it much harder to refinance – thereby increasing the chance that they
But while all the risks are real, the linkages between them all are far from
clear, and the different risks don’t necessarily cascade onto and exacerbate
each other in this way. They might – or they might not. If investors turn
out to have reasonably strong stomachs, they might not want to liquidate at
prices well below their entry points. And CDOs themselves, even the ones based
on subprime mortgages, might not default nearly as much as homeowners. And without
the passthrough mechanism of risks two and three, the vicious cycle loses a
lot of its teeth.
So there is cause for concern, to be sure. But there isn’t cause for panic.