CDOs – The Value and Pitfalls

The article below is a good summary of the value and problems with CDOs. As with most things that are man-made, CDOs have a value, but in the hands of some people (greedy) CDOs can turn into problems. Text in bold is my emphasis. From the WSJ:

Do CDOs have a future? Given the massive losses on collateralized debt obligations this year, the fate of these formerly lucrative investment products looks grim.

CDOs have caused problems before but nothing like this. They are responsible for nearly $50 billion of write-downs at major Wall Street firms, and have precipitated the ouster of Citigroup boss Charles Prince and Merrill Lynch’s Stan O'Neal. And CDOs are at the center of the credit storm ravaging global financial markets.

How did such a potentially toxic product get so out of hand? If handled correctly, CDOs can serve useful purposes. For example, one species, collateralized loan obligations, or CLOs, buys loans from banks, giving them capital to make more loans.

To fund the purchase of the loans, the CLO issues debt, which offers higher returns than traditional bonds. That is usually because the combined face value of the loans it buys is greater than the face value of the debt it issues.

CLOs have performed well for a decade or more. So it seemed natural for Wall Street to extend this model to other types of assets.

The trouble is, every time investment banks did so, excess soon took over. In the late 1990s, they rolled out deals backed by manufactured-housing debt -- loans to trailer parks, essentially. Others stuffed with high-yield bonds lured investors until 2001.

Both types subsequently crashed. In the aftermath, investors complained about bad structures, overselling and ratings-company incompetence -- the same things investors believe caused today's subprime-mortgage CDO meltdown.

Why the repeat performances? It is a mixture of greed and need. CDOs become most popular when bond markets are going gangbusters and institutional investors are desperate to find high-return investments to help them beat the indexes they are measured against.

But the fatal flaw with CDOs is that as investor demand for them increases, they need to compete for assets, which get more expensive.

The best of the latest iteration of CDOs, which bought asset-backed securities and are known as ABS CDOs, were created three or four years ago before the housing boom became a bubble. This was also when all manner of assets were cheap enough, whether bonds backed by student loans, car loans or credit-card debt. More recently, only subprime-mortgage bonds -- and other CDOs -- offered enough juice.

As the market boomed, greed set in. By 2006, investors buying the riskiest slices of ABS CDOs, called the equity, could virtually dictate their own terms. And investment banks were willing to bend over backward if it helped win the business of arranging a deal. One example: Rather than funding the highest-rated portion of a CDO with long-term debt, banks often used much cheaper short-term commercial-paper programs.

That saved the CDO money, meaning more interest could be paid to the equity investors. Some banks even agreed to step in if lenders suddenly snubbed the short-term debt. That is exactly what happened, and this "liquidity put" has landed Citigroup with $25 billion, and B of A with $15 billion, of exposure to commercial paper backing CDOs.

Others, like Merrill Lynch, set up auction-rate note programs, where every month the rate on the notes was set by an auction. But if no one bids, the notes morph into longer-term debt, which stays outstanding as long as the CDO does. Whoever holds the paper when the auction fails gets stuck with it.

Those are two mechanisms that have helped spread the CDO pain throughout the financial system. The extent of the suffering makes it hard to imagine, during this third and largest crash, that CDOs aren't at death's door.

But perhaps they can be salvaged -- if arrangers, lenders and investors accept that CDOs are better suited to less rampant markets. But judging from past experience, once the credit bulls start running, the lessons of 2007 could be conveniently forgotten.