Over the last few weeks, there has been a lot of talk about financial derivatives, collateralized debt obligations (CDOs), collateralized loan obligations (CLOSs) and subprime debt. Regrettably, a great deal of this talk has predicted "the end of the financial world." While problems have developed, talk of wide-spread fallout is pretty exaggerated. Below I will explain why.
CDOs and CLOs are two of the newest developments in the structured finance markets. While there are understandable concerns about these new structures, structured financial products have already demonstrated their effectiveness over the last 25 years. There is no reason to think they will behave differently now.
First, let's explain a few of the basic ideas behind these products.
The basic premise of these investments is simple: pool a group of similar assets to diversity the risk and then parcel out the risk to separate investments carved from the pool. Let's create a simple hypothetical deal to explain this concept. We'll start with a $100,000, 30-year five percent mortgage. After the mortgage closes -- that is, after the borrower and lender have signed all of the paperwork and the borrower is "officially" a borrower -- the lender will usually sell the loan to an investment bank. The investment bank will then pool this mortgage with similar mortgages (same interest rate, maturity etc...) and create one giant pool. This process of pooling asserts can occur with literally anything that has a cash flow -- account receivables, loans, bonds -- you name it, and it can be pooled and carved into separate bonds or cash flows.
Suppose the investment bank creates a pool worth ten million dollars. That means there are now 100 mortgages in the pool. The basic investment concept of diversification tells us that a problem with a few of the loans will not impact the overall performance of the entire pool. Suppose five homeowners in this pool eventually default. There are still 95 mortgages that are making payments on time. This limits the problems created by the five loans that defaulted.
Let's add a complicating factor to this scenario. Suppose there is a problem with a larger percentage of the loans -- say 10 percent or higher. This is when the concept of "structured finance" comes into play. The investment back will create different bonds from the large pool and allocate the pool's payments to these different bonds at different times and at different rates.
Here's an example using the previously mentioned pool. Remember, we have a giant mortgage pool worth ten million dollars, and the pool is made-up of 100 mortgages each worth $100,000 that pay five percent interest. The investment bank will "carve" the ten million dollars into three different "tranches." For all practical purposes, each of these "tranches" is a bond.
Investment banks will usually create three types of bonds from these pools. The riskiest bond is usually called an equity bond, and when there are problems with the underlying pool, most of its loses are allocated to this bond. Using our previous, hypothetical example, suppose 10 percent or 10 of the mortgages in the pool are in default. The equity portion of the bond will absorb all of these losses. As a result, the other two bonds are still receiving their regular payments.
Let's suppose the number of defaults increases to 20 percent, so that 20 mortgages in the $10 million pool aren't making payments. The investment bank will now allocate most of the losses to the equity bond, but will also allocate any spillover losses to the mezzanine bond. This is the next riskiest bond in the structure.
Finally, there are investment grade bonds which are the last bonds to be hit by defaults. Because of the concept of diversification, this bond will usually not experience any problems.
So to sum up so far, we have two separate ways the risk from the underlying loans is diversified. The first is by pooling a group of assets into a larger, single pool. This limits the impact when a percentage of the underlying loans experiences problems. The second is by allocating the risk of defaults to specifically designed bonds that absorb the losses, protecting the senior, higher rated bonds.
Most of the problems with synthetic investments have occurred when a money manger made really stupid decisions. The recent Bear Stearns situation is a classic example. There the manager was highly leveraged; for every dollar invested he borrowed nine dollars. Simply put, that's about one of the dumbest ideas I've ever heard. If the market goes up you're a genius. If the market goes down, you've lost everything.
The Bear situation illustrates why I think the CDO and CLO situation will not have an extremely adverse impact on the markets or the economy. Most money managers take their fiduciary obligation seriously; they don't make wild bets on the market. They will allocate a small portion of their portfolio to riskier assets. If these assets drop in value, the small allocation percentage insulates the rest of the portfolio from extreme downside risk.
That is not to say there won't be problems. I would expect there to be a few more really stupid managers out there is a position similar to the Bear situation. These managers' funds will take big hits and the funds may have to liquidate.
In addition, it's important to remember that new financial developments usually come with predictions of doom. When the black-scholes option pricing method came out in 1973 it was going to be the start of all sorts of financial evil. Now that model is a standard tool of risk management that has been successfully implemented by most money managers.
The same is happening now. While there will be problems, the problems will occur because an individual manager made a really stupid decision by taking on way too much risk. As mentioned above, CDO and CLO structures are designed to mitigate risk. And that is what I fully expect them to do.