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What is a CDO?
Collateralized Debt Obligation, CDO, is a structured financial product that pools together several cash flow-generating assets. This asset pool is then repackaged into discrete tranches that can be sold to investors. It is known as such because the underlying assets such as bonds, loans and mortgages are debt obligations which constitute the collateral for the CDO. Risks of CDOs vary, usually according to soundness of the debts they represent.
Common wisdom has that these instruments which by their very nature are opaque, since it is very difficult to assess the quality of the assets they represent, were a major cause in bringing about the collapse of the financial system in 2008. Now, again in the last couple of years, very similar instruments have been gaining popularity amongst bankers. Why would financial institutions, already singed once by CDOs turn to these instruments again?
What is a 'Bespoke Tranche Opportunity?
In its new avatar, these instruments are known as 'Bespoke Tranche Opportunities'. The innovation this time is that these instruments are targeted at specific investors who decide to invest in instruments that are in tune with their investment strategies and appetite for returns, while balancing the risks undertaken.
These instruments are called bespoke because each instrument is basically a unique product. Investors pick and choose the assets they want to invest in, indeed actually 'design' the instruments. Tranche means that it is a part or portion of something bigger. This refers to a section of the private securities market. To date, the structures have been simple. They have a bundle of stable debts standardized into four and five year maturities. These contain static assets that are tracked by the international credit derivative index iTraxx. Writes Lisa Abramowicz in Bloomberg, "That's essentially a CDO backed by single-name credit-default swaps, customized based on investors' wishes. The pools of derivatives are cut into varying slices of risk that are sold to investors such as hedge funds."
Attraction for the markets
The past couple of years have seen these instruments make a mark on the market. These instruments seem to be the way that the market moves to meet increasing investor demand for higher returns. It also helps that these can be used to meet banks' regulatory capital norms. The bespoke tranche opportunity allows parties to transfer the return and risk of the supporting assets, without actually transferring the assets themselves. According to the webpage Ethics Sage, "Most investment managers control their risks by buying and selling protection on a single-name CDS or by linking losses to a corporate credit index like the CDX or iTraxx; therefore, they usually avoid taking positions in CDSs that cannot readily be traded."
These instruments are growing in popularity because they offer higher yields than other financial instruments. It also helps that they are relatively safe, since there have been no defaults of investment grade securities in the last few years. Bespoke tranches yield much higher returns than corporate bonds. This is particularly so if potential investors use borrowed money or if they zoom in on first-loss slices. Just as opportunities for returns is good, chances for losses are also equally great.
The deals are "attractive for credit-savvy investors in the post-QE credit picker's market," according to a January U.S. credit derivatives outlook by Citigroup Inc., referring to central-bank bond buying known as quantitative easing, or QE, according to Abramowicz in Bloomberg. "A tranche of a bespoke portfolio of credits can offer exposure to diversified risk with the possibility of leverage, credit enhancement and enhanced returns," according to a Jan. 23 e-mail message from a Goldman Sachs employee, reviewed by Bloomberg News.
The risks and rewards of investing
In an environment where investors are chasing shrinking returns or even negative returns, such 'products' are sure to fire the interest of cash rich investors. In fact about $20 billion worth deals have been struck in the last year. While bespoke tranches offer significantly higher returns since the portfolios can be handpicked, investors can also ensure that these instruments contain investment grade, high yielding and relatively safe debts. Many big name banks and financial institutions like, Citibank, Societe Generale, Goldman Sachs, BNP Paribas and Morgan Stanley are involved in arranging bespoke tranches.
Despite the precautions taken by financial institutions and careful vetting by investors there is no guarantee that these securities will not go bad in much the same way as CDOs did earlier. The earlier problem occurred because many new home owners had begun to default even on small debt obligations. As the worth of the underlying assets plummeted, the CDOs quickly lost value. Banks and investors were left holding worthless paper.
In the present scenario, prolonged low interest rates have prodded many investment banks to shop around for higher returns, even if they carry some risk. According to some analysts, there is also the risk of moral hazard. It is a hard fact that very few persons have been severely punished for causing the financial collapse in 2008, except for monetary fines. Some investment bankers may now feel that even if they end up committing improprieties in their headlong chase for margins, the worst they would face would be more fines. They have little fear of going to jail.
Then and now
Yet some things have changed. "The difference between now and prior to the financial crisis, in my opinion, is that there is a much higher level of awareness of the risk level involved in these kinds of securities," Robert R. Johnson, president and CEO of the American College of Financial Services in the Philadelphia area. "The problem then was that these securities were marketed, and rated by the rating agencies, as AAA quality. Then they were purchased by unsophisticated investors who didn't know what they were buying."
This time around investors are much more informed about the products that they are buying. Of course there will always be some people who walk into these sophisticated financial products with eyes closed. Yet, undeniably, customers today are not only better informed about the quality of the underlying assets, in fact they even choose which assets should go into the package.
"No one is putting a gun to anyone's head and making them invest in these kinds of securities," Johnson says. "If investors learned anything from the financial crisis of 2007-'08, it should've been to invest only in financial instruments you understand." (US.News Investing May 23, 2016)
The sceptic's view
Sceptics always frown when they hear the phrase "this time it's different". More often than not, eventually one realises that this time is no different from the last. New semantics, but same results. Its all very well for us to think that this time, complex BTOs are only being bought by sophisticated investors. But, when these sophisticated investors leverage their bets on near zero interest rates, and pile onto more and more of these complex products, the systemic risk does increase. All you need is for a sudden downturn in the housing market in the US, and suddenly these sophisticated investors may not look that savvy any more.
Any problem becomes systemic when it gets too large to contain. BTOs need to be tracked far closer than CDOs were in the last decade, to ensure they don't become so large that they present a systemic risk to markets like their earlier avatar did.
Share your thoughts and perspectives
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