Unpacking the Risks in the CDO Market


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

will default.

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.

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2 Responses to Unpacking the Risks in the CDO Market

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