Vipal Monga takes a look at the CDO and CLO markets, and asks: are they really dead? Or just taking a breather? He draws the conclusion that they’re very different animals. CLOs, he says, are crucial to the loan market:
CLOs represented almost two-thirds of primary demand for loans in the syndication market over the past three years. The loan market likely cannot function without them unless lenders decide to hold loans on their books.
Mortgage-backed CDOs, on the other hand, were driven more by greed than necessity.
The mortgage-backed CDO simply takes already-securitized CMBS and RMBS and repackages them. Their popularity, however, soared after managers discovered they could profit from an arbitrage between interest paid to their lenders and the higher interest they harvested from securitized bonds in their portfolios.
According to CapitalSource’s Szwajkowski, about 75% of CDOs created over the past few years were such arbitrage vehicles. The rest were buyers of so-called whole loans, meaning they acquired the mortgages before they were securitized, playing a role similar to that of CLOs in the loan markets. That arbitrage play is now moot.
I think this is a very important distinction. Yes, the demand for CMBS and RMBS will fall if repackagers and arbitrageurs exit the market. But if that happens, there will be a healthy consequence: the investors who were blindly rushing in to the CDO market will now be forced to buy the underlying MBS instead, leaving less room for confusion and opacity – and also making the MBS market, if and when it recovers, that much more liquid and transparent.