CDOs have been much in the news lately, because of the subprime mortgage mess. Mortgage loan losses, especially among subprime mortgages, have shaken the real estate markets and contributed to the 311 point drop in the Dow Jones Industrial Average on July 26, 2007. While the market turbulence and losses have gotten plenty of headlines, what has been less discussed is how the market for CDOs increased risks and likely exacerbated current problems.
CDOs, as you may know, are entities (usually trusts) that hold pools of mortgages and other loans. The stream of payments (interest and principal) from this pool is subdivided into different segments called "tranches" (which is French for slices). Each tranche has different rights to the stream of payments from the pool. The highest tranche has the best claim, and is the most expensive to buy while offering the lowest rate of return. That's because it also has the lowest risk of nonpayment. As one descends through the tranches, claims to the stream of payments from the pool become ever more subordinate, prices drop and potential rates of return increase. But risks of loss also increase, so you can do very well or very badly in the lowest tranches.
How do the banks that package CDOs sell these things? It's easy enough to understand why someone might buy the highest tranches. They are often comparable to highly rated corporate debt (although the rating agencies seem to have been caught slightly flat-footed by the drop off in the mortgage markets). But where do buyers for the riskier tranches come from?
Some investors seek out risky investments. Hedge fund operators look for risky investments because they have to beat the S&P 500 in order to attract investor money. Pension funds, university endowments and other institutional investors, often seen as bastions of investment prudence, also seek out risk. Here's why.
The 1929 market crash and subsequent Great Depression cured an entire generation of any interest in risky investments. Even the go-go days of the 1960s didn't involve anything approaching the derivatives boom that led to the creation of CDOs. Starting in the 1970s, an idea evolved that taking some degree of risk was good. A well-rounded investment portfolio, it was argued, should include a speculative fillip, something that could boost returns above the boring level of the S&P 500. Sure, greater risk could lead to losses. But if the amount of the portfolio invested in dicey bets was confined, to say 5% or 10%, then the investor would have a good chance of being better off.
The idea that increasing risk was good was marketed by hedge fund operators and other market players who sold risky investment opportunities. Gradually mainstream institutional (and wealthy individual) investors began to accept the idea. Money flowed into the "alternative investment" sector. The hedge fund industry boomed.
As more money flowed into hedge funds and other alternative investments, they needed to find risky investments. After all, a hedge fund operator who claimed to be an investment genius couldn't put his investors' money into S&P 500 index funds. He had to find something that made him look like he deserved the annual 2% of assets and 20% of gains he charged his clients.
The result was that demand for risky investments grew. CDOs, among other things, attained popularity. Subprime mortgages, with their apparent higher risk levels, looked like a good play. They had higher interest rates because they were riskier. But the rising real estate market of the early 2000s usually gave the borrower an escape hatch--if the borrower couldn't repay the loan (especially after an increase in monthly payments), he or she could refinance or sell the house, and the rising real estate market would make that easy. In this way, subprime mortgages appeared to have low risks, even though they were priced as high risks. In the minds of a money manager, that meant they were cheap in comparison to the risks they supposedly had. And if they were cheap, it would make sense to buy a lot of them and generate larger profits. The CDO was a convenient way to sell these high-risk loans to the investment community.
One thing about institutional investors is that they have a lot of money. Even if they divert only 5% or 10% of their portfolios into alternative investments, the result would be a flood of cash. And that's what happened. Money flooded into the alternative investments market. The banks packaging CDOs began looking for more subprime loans. Commissions paid to mortgage brokers for subprime loans increased, and gave them the incentive to steer more customers into subprime mortgages. No doc loans and low doc loans, popularly known among mortgage bankers as "liar loans," became more commonplace. These loans often wouldn't have been made in the past. Now, though, since they weren't being held by the loan originator, but were being sold--first to the banks packaging the CDOs, and eventually to the investors who thought they should be taking more risk--no one had an incentive to exercise caution. The borrowers thought--perhaps erroneously, perhaps because of fraud--that they were getting a good deal. The mortgage brokers collected big commissions while selling the doggy loans to someone else, so they thought they had offloaded the risk. The banks packaging the CDOs made more money with each new deal, while passing the risk onto investors. The hedge funds and institutional investors thought risk was good, so they wanted to buy more risk. Many hedge funds borrowed heavily to buy even more subprime mortgages (or their CDO derivatives), thinking that the more leverage they used, the greater the return on capital they would achieve. The use of leverage magnified demand for subprime loans.
The result was that a ton of imprudent, reckless, ridiculous, and downright stupid mortgage loans were made. The numbers are perhaps impossible to determine at this point, but the rising default rates show that the losses are and will continue to be very large. Because risk came to be seen as a good thing, the market responded to demand and provided more risky investments. A lot more. It literally paid the mortgage industry to create a lot of bad loans. Now there are a lot of losses that have to be suffered.
The sheer quantity of losses is having systemic impact. The bond market is fleeing toward high quality debt and the stock market is becoming more turbulent. Will the world collapse? No. No need to freshen up your secret stocks of batteries, distilled water and freeze-dried food. But the pain will probably increase before it decreases.
The idea that some risk is good for your investment portfolio is a valid idea in a textbook sense. Historical financial data can be used to demonstrate, in a mathematical way, that you would have been better off with a bit of risk during the last 25 years than without it. But the last 25 years have been exceptionally good ones for the financial markets. The 25 years from 1929 to 1954 were little more than break-even, after adjusting for inflation. Past performance is no indication of future performance.
But what happened in the subprime mortgage and CDO markets wasn't just the manifestation of a boilerplate disclosure in the prospectus for every SEC-registered securities offering. We're where we are today because the idea that risk is good became fashionable--too fashionable. And prudence fell out of fashion. Skirts can be made shorter, but there's a limit to how short. And there's a limit to how much risk is good. Investor appetite for risky investments--fueled by incautious marketing by Wall Street--created the monster that we now must deal with. Since the CDO market and hedge fund industry are essentially unregulated, it's unclear how things will play out and who will ultimately hold the bag. One senses that the legal profession will feast; but many others will have a taste of Oliver Twist's gruel.
Skirts eventually became longer, and financial prudence is making a belated re-appearance. Prudence would be advisable for individuals as well as institutions.
Crime News: bad boys sentenced to do the funky chicken. http://www.wtop.com/?nid=456&sid=1201466.
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