Monday, June 25, 2007

FW: Center of a Storm: How CDOs Work

Center of a Storm: How CDOs Work
June 23, 2007; Page B1

Mortgages are among the most widespread and simplest forms of financing.
So how is it that a bunch of home loans caused the crisis that has
gripped Wall Street for more than a week?

Because mortgages have morphed into something quite different on Wall
Street -- and some say more dangerous -- a trend that has accelerated
sharply in recent years. The two Bear Stearns Cos. hedge funds at the
heart of the crisis invested heavily in complex financial instruments
known as collateralized debt obligations, or CDOs, as a bet on the
mortgage market.
The Wall Street firm's wager under Bear executive Ralph Cioffi went
badly wrong after particularly risky home-loan borrowers defaulted in
record numbers as a result of lax lending standards and a slowing
housing market.
[R C]

But the funds' problems quickly became more than an issue for just
mortgage markets. Fears grew that other investors could suffer losses,
causing a ripple that would crimp lending and curtail the flow of
borrowed money that has fueled rallies in a variety of financial
markets. On Friday, Bear unveiled a $3.2 billion bailout of the funds
(see related article1.)

So what exactly are CDOs, the structures at the root of so much angst?
They are financial vehicles that bundle different kinds of debt --
ranging from corporate bonds, to securities underpinned by mortgages, to
debt backed by money owed on credit cards -- and cut it into slices.
These slices are sold to investors in the form of bonds. While the
slices contain the same debt, they differ in terms of which pay the most
interest and which are least at risk of losing money.

Slices that pay lesser amounts of interest are the last to get wiped out
by losses if there are defaults in the debt pooled in the CDO. Slices
that pay more feel pain more quickly. In other words, the CDO slice with
the lowest yield is at the front of the line on payday, but at the back
of the line when pink slips are handed out.

This is the way that some high-risk debts can be packaged to receive
investment-grade credit ratings.
That's a result of the CDO structure and the diversification gained by
bundling different debts. At the same time, CDOs use borrowed money to
amplify returns.

Although CDOs have been around for about 20 years, their use soared in
recent years. Investment banks in
2006 issued about $500 billion in CDOs, compared with about $84 billion
in 2002, according to research by Morgan Stanley. The popularity of CDOs
grew as low interest rates caused investors to embrace products that
offered the promise of higher yields.

Fans argue that CDOs allow investors to buy into higher-yielding
securities while taking on the same risk as they would with safe,
lower-yielding securities. They also say that CDOs are another tool that
allow financial markets to further spread risk so it isn't concentrated
in the hands of a few players.

But some investors think CDOs are an example of financial engineering
gone haywire. CDOs are "more sleight of hand" than a sound way to
generate diversified returns, said Brad Alford, founder of Alpha Capital
Management, an Atlanta-based investment advisory firm that caters to
wealthy families.
"They're a method for Wall Street to repackage securities as a way to
make more money."

Indeed, Wall Street has made millions of dollars in fees in recent years
by creating CDOs, selling them, servicing them and helping investors
trade them. The vehicles are generally used by institutional investors,
such as pension funds or hedge funds, not individual investors.

CDOs have generated debate because they are complex, and pose a risk
because they are several steps removed from the actual asset, or debt,
that is being packaged. Consider a mortgage. Jane Sixpack borrows
$100,000 from a bank to buy a house. The bank then pools Jane's loan
with thousands of other mortgages.
It then issues securities backed by this pool and sells those to
investors. Jane keeps making her payments to the bank, but her mortgage
is now owned by investors.

An investment bank creates a CDO, which is really just a company. The
CDO then buys some mortgage-backed securities, one of which holds Jane's
loan. The CDO then pools these with other mortgage-backed securities and
maybe some corporate bonds, slicing them up based on investor
preferences for yield versus risk.

The CDO manager sells portions of the package to other investors. In
some cases, other CDOs are the buyers.
There are even CDOs comprised of CDOs that have invested in CDOs.

The bundling of different debts, along with the fact that the CDOs are a
few steps removed from the debts they include, give rise to another
risk. It's tough to get an accurate price for CDOs, which don't trade in
active markets. When markets sour, the lack of available prices can make
it even more difficult to value a holding, or to get out of it without
taking a big haircut.

So investors often have to estimate the value of a CDO and have a lot of
leeway in how they do it. That's a worry for investors in hedge funds,
big buyers of CDOs. Hedge-fund managers make most of their money through
performance fees. This gives them added incentive to use price estimates
that work in their favor, even if they might not reflect the price at
which they could actually trade the CDO.

Or it could mean that the managers themselves don't know exactly what
their holdings are worth, because they are so far removed from the
underlying investment. In the case of Jane's loan, that means the CDO
buyer will have a tough time gauging whether she's a good risk or not.
And if she defaults, it may take a while before that affects the value
of the CDO, even though market conditions overall might have already

Write to David Reilly at david.reilly@wsj.com2
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