CDOs, Credit Derivatives, Capital Markets, Etc. – How It All Fits Together

Below are excerpts from an article in the NY Times that gives an excellent summary of the capital market insturments and how it all fits together.

. . . . . the global financial turmoil — set off by problems with subprime mortgages — has prompted a backlash in some quarters against such financial engineering (derivatives and structured products).

More broadly, it has led to a better understanding of the downside of spreading risk so well — it can be felt in all corners of the world, unsettling hedge funds, banks and stock markets as far away as Australia, Thailand and Germany. In effect, reducing risk on a global scale appears to have increased it for some players.

“The market appears to be finding it harder to truly understand the inherent and underlying risks involved,” said Chris Rexworthy, who was a regulator with the Financial Services Authority in Britain for 10 years before moving recently to the private sector.

The backlash is particularly sharp abroad, in countries that were surprised to find that problems with United States homeowners could be felt so keenly in their home markets. Foreign politicians and regulators are seeking a role in the oversight of American markets, banks and rating agencies. The head of the Council of Economic Analysis in France has called for complex securities to be scrutinized before banks are authorized to buy them.

In the United States, regulators appear to think that the new and often unregulated investment vehicles — which have shrunk the world and speeded up business in much the same way as the Internet — are not all inherently flawed.

This opinion is captured in an analogy offered by Peter Douglas, the founder of GFIA, a hedge fund research firm in Singapore. He likens using derivatives to power tools. If you know how to use them, he said, they are exponentially better and faster for building a house, compared with using hammers, screwdrivers and handsaws.

If you don’t, “you could drill a hole in your head," he said.

Funds and banks around the world have taken hits because they purchased bonds, or risk related to bonds, backed by bad home loans, often bundled into financial instruments called collateralized debt obligations, or C.D.O.’s.

The losses have often surprised the investors, and in some cases the funds and the executives of the banks, who were unaware of the extent of their risks.

The crisis extended as far as the $2.2 trillion money market that finances the day-to-day operations of businesses, as investors wondered whether the underlying assets were sound. “It’s amazing how much ignorance and fear are out there,” said Kevin Davis, a professor of finance at the University of Melbourne.

The confusion about these products lies in part in their complexity. Structured products are pooled assets that have been sliced and diced into ever more smaller, more specialized pieces.
They offered investors higher returns at a time when traditional fixed income, or debt-related products, were producing low returns.

As low interest rates fueled a lending boom to borrowers with weak credit, banks looked for new ways to package those loans, so they could sell more. A central building block to offset the risk was asset-backed securities, which are bonds backed by pools of mortgages or other income-producing assets, like student loans, auto loans, and credit card receivables.

Banks and other financial institutions pooled those asset-backed securities into new units, dividing them up again and issuing securities against them, creating collateralized debt obligations.

The idea took off, with new combinations that were further removed from the original asset. New creations included C.D.O.’s of C.D.O.’s, called C.D.O.-squared. There is even a C.D.O.-cubed.
According to JPMorgan, there are about $1.5 trillion in global collateralized debt obligations, and about $500 billion to $600 billion in structured-finance C.D.O.’s, referring to those made up of bonds backed by subprime mortgages, slightly safer mortgages and commercial mortgage backed securities.

Many of the products have proved to be highly problematic as the underlying assets — the subprime mortgages — have gone bust, revealing dangerous amounts of leverage in the securities that few people could value. As a result, they have become like a potent computer virus, leaving many people fearful that they too will be affected.

“A lot of risk in the subprime asset-backed market is embedded in, and amplified by, C.D.O.’s,” said Rod Dubitsky, head of asset-backed research at Credit Suisse.

Weaknesses in the system were laid bare, including ratings that did not accurately reflect risk and faulty assumptions on how diversified pools with multiple layers of leverage would react.

That in turn spooked investors in other markets, who started selling anything they thought might be risky, from stocks to loans, and in some cases putting their money into cash.

The combination of a subprime shock, “untested financial innovation and leverage has led to a confidence crisis,” said Pierre Cailleteau, Moody’s Investors Service chief economist in London.
The advent of radically more complex structured products coincided with another trend in finance: the explosion of credit derivatives, financial tools that enabled institutions like banks and hedge funds to try to hedge exposure to the huge credit market, like loans to corporations.

“Credit derivatives are the fastest-growing part of any bank,” says Derek Smith, head of flow credit trading at Deutsche Bank. He cited 80 percent growth in 2007 for his firm and average annual growth of about 40 percent for the industry.

Blythe Masters, a veteran of the credit derivatives revolution and the global head of currencies and commodities at JPMorgan Securities, added, “There has been a wall of money coming at the credit markets in the past five years.”

Credit default swaps (what are widely known as a credit derivatives) allow two parties to exchange the credit risk of an issuer, such as a company. For example, if an investor buys a credit default swap on General Motors, called buying protection, he or she makes money when the credit weakens and makes a lot of money if G.M. goes bankrupt.

In the meantime, the seller of protection makes a fee from the buyer and profits if the company’s credit improves.

Credit derivatives radically shifted the financial landscape for two reasons: they allowed banks to hedge some of their exposure to the huge loans they give corporations, and they have allowed investors to bet against, or short credit, as a hedge and to speculate.

For banks, shedding exposure to the credit risk of companies, or governments, or individuals, means not having to reserve as much capital for potential losses. That frees up capital to make even more loans — to homeowners, institutional investors, corporations or hedge funds.

The banks found a perfect partner in hedge funds, lightly regulated pools of capital with high fees that were looking for better returns. Insurance companies and pension funds also sought the higher returns, called yield, as interest rates hit historically low rates.

“Fundamentally, having 100 or 1,000 people with a slice of the risk is better than a bank holding 100 percent of the risk,” said Robert G. Pickel, chief executive of the International Swaps and Derivatives Association.

As the market for C.D.O.’s backed by structured products choked in recent weeks, the overall credit derivatives market has performed well, say some industry participants.

“Credit derivatives have done a good job at doing exactly what they should do: they have accurately and immediately reflected the markets’ pricing of risk throughout this crisis,” Ms. Masters said. But there has been a lot of pain. Investors purchasing derivatives are making a bet that the underlying stock or bond or loan is going to rise or fall, but they do not own it. Because buying a derivative requires much less capital than buying the loan or bond it is derived from, banks and traders can buy more of them than they could loans or bonds. That can translate into huge gains — or, in times of stress, outsize losses.

Some institutions are not parsing what products are riskier than others, but rather they are rushing for the door. First State Investments in Singapore has slashed its holdings in all Asian financial firms in recent weeks.

At this point “it doesn’t really matter what their exposure is” to subprime products through derivatives, said Alistair Thompson, the deputy head of Asia-Pacific equities at First State. “What concerns us is the sentiment” in the market, he said.

The surprises are certainly not over: there were whispers among investors in Australia this week that some local funds were still turning up unexpected subprime exposure because of credit derivatives, weeks after the problems first surfaced.

While that happens, markets are sure to remain skittish.

“Liquidity can just be turned off, and essentially it is a confidence game,” Mr. Thompson said.