Critique of Impure Reason: CDO Anyone? I'll Take Two, Please!

In a perfect world CDOs would have been the perfect investment: for the same level of risk (as distinguished purely by rating, of course) you get more reward, by way of the additional spread or yield on your investment.

Where certain investors -- including pension funds from the US to Europe to Australia -- saw the word "ARBITRAGE" flash in bold red across their screens and quickly rushed to beat the market, others lingered and assessed the risks more closely.

Wisely and slow. They stumble that run fast.

In sum, some investors looked around to find the highest yielding asset that fits their fund's rating criterion (and so they'll necessarily outperform the market, at least for the short-term, and perhaps secure themselves a pat on the back and an increased bonus). Others asked themselves: "Well, even if I can come to terms with the rating agencies' approach to rating these assets -- that the have accurately measured default probability or expected loss, as the case may be -- what else am I paying for, say, relative to a corporate bond? And is it worth it?"

CDO Risks

Without further ado, here's what they're paying for, in terms of risks and expenses, over-and-above the vanilla corporate bond alternative:

• liquidity, or illiquidity risk;
• model risk and/or complexity risk;
• spread or yield risk (somewhat similar to that of a corporate bond);
• interest rate risk;
• payment timing risk (prepayment, extension risk, lumpy payment risk);
• tranche pricing volatility;
• rating methodology changes (given the "newness" of the asset class);
• a slew of operational costs (to monitor/model/mark your position); and
• a host of accounting risks and legal risks that we'll leave for another day

Additionally, certain CDOs brought with them foreign exchange risk, certain basis risks and portfolio market value risks. Leveraged accounts, buying CDOs, took the burdensome funding risk and rating downgrade risk. (This is all not to mention the risk that the rating agencies may be wrong in their assessments of default probability and loss given default.)

While you can't necessarily model the "cost" of each of these risks, and what you should be paid for absorbing each, individually, they are nevertheless quite tangible risks. Especially now.

Ideally, perhaps, a sophisticated investor with strong analytical capabilities might model the deal, run various sensitivity scenarios based on her internal opinion, interview the manager -- and decide that upon sufficient review of the documents and the various "dangers" they allow for, she is is willing to take the risks involved in the investment relative to the yield it provides. It would be suboptimal to say, well, "this looks good to me and geez it pays a whole lot of yield at that rating level, so let's buy it, close our eyes, and hope for the best."

Why? Well essentially you're being paid a hefty reward for being right in your modeling assessment of the deal and in your determination that you can, as a fund, stomach the collective risks of the instrument. If you don't perform the necessary credit analysis, you're not earning your wage: you're rolling the dice or guessing. Tough times, and the volatility they bring, have a sneaky way of separating the guessers from those who performed a thorough analysis, bringing to the fore any portfolio-level risk or support weaknesses, and thereby magnifying certain of the risks of OTC instruments:

• increased illiquidity particularly hurts those buyers who are holding their securities as available for sale (AFS);
• low interest rates decrease payments derived from bonds with LIBOR-based coupons; and
• payment uncertainties, model complexities, and accounting and legal risks and costs accentuate the imbalance between buyers and sellers, driving prices further down. (To compound the matter, lawsuits may discourage both the sale and the purchase of complex securities.)

"Unmodeled," almost qualitative, risks proliferate

- S&P has corrected its ratings on, among others, Founder Grove CLO Ltd., Archstone Synthetic CDO II SPC, and WISE 2006-1 PLC's CDO Notes. Their reason: modeling errors

- S&P has corrected its ratings on, among others, Lorally CDO 2006-2, Tranched Investment-Grade Enhanced Return Securities 2004-11, Longshore CDO Funding 2007-3 Ltd., and Quartz CDO (Ireland) PLC. Their reason: administrative errors

- Moody's and S&P have both confessed to finding errors in their CPDO models

Resources:

1. Arturo Cifuentes on modeling complexity
2. Professor Joseph Mason on the difference in default likelihood between CDOs and similarly-rated corporate bonds
3. On the level of analysis performed by pension funds and endownments prior to purchasing CDOs

(P.S. Feel free to share in the comments section below if you feel we've failed to mention any major risks.)