CDOs: the market watches

Citation

Hart, S. (2007), "CDOs: the market watches", Journal of Financial Regulation and Compliance, Vol. 15 No. 4. https://doi.org/10.1108/jfrc.2007.31115daa.001

CDOs: the market watches

A speech by the Governor of the Bank of England, the collapse of two Bear Stearns hedge funds and a perceived tightening in the credit cycle have thrown the spotlight on financial structures known as collateralised debt obligations (CDOs) and the underlying securities from which CDOs derive their value.

The Governor, in his annual Mansion House speech on 20 June 2007, warned that “New and ever more complex financial instruments create different risks.” Citing the development of “exotic instruments” such as CDOs, he said “It has a distribution of returns which is highly sensitive to small changes in the correlations of underlying returns which we do not understand with any great precision.”

CDOs are financial structures which derive their value from a portfolio of underlying assets, typically corporate debt and asset backed securities (the Reference Assets). The structure takes an exposure to the Reference Assets using funding provided by investors, in turn issuing notes to the investors which pay a coupon with principal at maturity. The income stream and maturity values of the Reference Assets are intended to be sufficient to pay the coupons and principal on the notes. The notes themselves are sold in tranches – higher risk, lower rated tranches take the first hit in the event that any of the Reference Assets default and such tranches therefore carry a higher coupon to reflect those risks. The lower risk, higher rated tranches carry a lower coupon.

Expressions of concern about CDOs are not new phenomena. In 2005, the FSA expressed more general reservations about certain aspects of the credit derivative market, and in some respects, the current anxiety is merely an echo of those original concerns. Recent scrutiny of CDOs has arisen because of the serious difficulties experienced by the highly leveraged hedge funds owned by Bear Stearns which invested extensively in CDOs. To some extent the focus upon CDOs and the risks to which investors are exposed is misplaced. Bear Stearns' difficulties have arisen because the CDOs that the hedge funds invested in derived their returns from Reference Assets in the form of mortgage backed securities. However, these were securitised income streams from residential mortgages granted in the sub prime lending sector in USA which has been the hardest hit by the slowdown in the US housing market. Mortgage defaults in this higher risk sector have now fed through to mortgage backed securities which in turn have hit the value of the CDOs in which the hedge funds were investing.

The scale of the downturn in the US sub-prime lending market is not yet clear (although the Chairman of the US Federal Reserve put it at potentially $100 billion) and therefore neither is its impact on the bonds issued by that sector. The uncertainty is exacerbated by the fact that the value of Reference Assets underlying CDOs is assessed only periodically. It is therefore only when the downgrade or default on the bonds is deemed to have occurred that the value of the CDO's tranches is hit. It is at this point that the investor realises that it is sitting on a loss.

Whilst the full impact upon CDOs investing in mortgage backed securities derived from the sub-prime lending sector has yet to be felt, is it necessary for investors in CDOs more generally to be concerned, as the Governor suggests?

It is important to recognise that the current anxiety is a reflection of the difficulties faced by a certain class of Reference Assets, not CDOs themselves. There is nothing inherently wrong with a structure by which a party packages up its exposure to risk associated with an asset class and sells tranches of that risk to a third parties for a return. It amounts to no more than simply the sale and purchase of credit protection. The effect of this, as the Governor said, is that “risks are no longer so concentrated in a small number of regulated institutions but are spread across the financial system. That is a positive development ...” It is also worth remembering that CDOs, as a structure, were tested by the market in late 2001/2002 when many airline industry-related bonds defaulted and CDOs exposed to that asset class were hard hit. The effects were ultimately limited and the value of the CDO market continued to grow exponentially. Even in an increasingly pessimistic credit market, there are many CDOs, indeed the vast majority, where the Reference Assets are performing and the sectors from which they derive their value are holding up well. In this sense, concerns may be overstated.

That is not to say, however, that for financial regulators there are not issues of concern. First, general difficulties in a limited sector can have a wider impact if and when market confidence ebbs away. The contagion effects from defaults in one asset class can swiftly be felt in another if investor sentiment changes. Second, CDO structures have, over time, become more complex and sophisticated. For example, many CDO tranches are now re-packaged with other exposures by the initial investor and parcelled out to other market participants. In these circumstances, the ultimate investor may have great difficulty in assessing and quantifying the actual risks associated with the CDO exposures that they hold thus making it difficult to run a risk assessment of the potential contagion effects of a collapse in one sector.

So, will the current difficulties give rise to litigation and legal disputes in UK? On the one hand, it is almost inevitable that when financial losses occur, investors look to see if they have legal recourse. That is not a reaction unique to investors in the CDO sector. The focus of any such legal scrutiny is unlikely to be upon failings in the CDO's contractual documentation, which has improved significantly since the initial development of the sector as more investors have sought to take pre-contract legal advice, but take the form of analysing dealings in the Reference Assets and seeing, in a managed portfolio, whether the assets have been managed in accordance with the contractual obligations.

Whether legal claims in the CDO market become more prevalent is likely to be driven not by the fate of the US sub-prime lending market but by general economic and market conditions. In benign economic conditions such as those experienced over the last decade, it is easy for an investor to walk away from a loss and move on to the next transaction where the potential returns might well be greater than the effort required to pursue a legal action for a loss. In more difficult economic times, that balance changes.

The reality is that the selling on of risk is not, in itself, inherently risky and, in many ways, it is prudent. There is nothing unduly concerning about CDOs which are properly documented and in which the investor can make a clear assessment of the risks they are assuming, how those risks arise and the quantum of any losses that might be suffered in various stress scenarios. It is when the assessment of those risks becomes more difficult, or even impossible, that problems may arise. However, those problems are only likely to crystallise, in the wider market, if there is a general economic downturn.

Simon HartPartner, Litigation and Dispute Resolution, Reed Smith Richards Butler, London, UK