Saturday, July 14, 2007

Another Perspective on CDOs

This short article from the WSJ gives a different perspective on CDOs and suggests that everyone knew what was going on and you can’t lay the blame off on the rating agencies.

When Standard & Poor's and Moody's announced plans this week to cut credit ratings on billions of dollars of collateralized-debt obligations tied to subprime mortgages, many Wall Street critics howled, "Too little, too late."

A skeptic might howl back, "Be serious." Anyone buying these debt investments, which had become increasingly popular in the past few years, should have known full well they were riskier than they appeared to be at first blush. All they had to do was look at the price.

CDOs pool debt instruments, often including mortgage-backed securities. They're then sliced into risky and less-risky pieces by Wall Street managers. Because of how CDOs are structured, with some investors agreeing to take the first losses if a CDO's holdings turn sour, the rating agencies say it's possible to load them with junky assets and still get some decent credit ratings.

Investors never completely bought into this logic. They've long demanded that CDOs offer higher returns than similarly rated bonds. One year ago, for example, investors in CDOs with an investment-grade triple-B credit rating demanded roughly two percentage points more on their investments than did investors in more plain-vanilla mortgage-backed securities with the same rating, according to J.P. Morgan data. Their demands for returns were even great when compared with similarly rated corporate debt.

Lots of investors understood what they were getting into. They demanded more return because they saw there was more risk, regardless of the ratings.

Janet Tavakoli, president of Tavakoli Structured Finance in Chicago, thinks that ratings agencies should have kept closer tabs on the tainted mortgages that went into many CDOs and that some of the models they use to come up with ratings may have been flawed. But she also believes many investors understood that the mortgages, and the securities they ended up in, carried unknown risks.

"With the amount of research that was going on and the amount of information that was available in the news, you would know the risk was unprecedented, so you demanded a premium," she says. "There are a lot of sophisticated, deep pockets here that have things to answer for, and I'm sure they're delighted to have people blaming the rating agencies."

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