Banker Liverpudlian Stew Disguises CDO Scraps as Tasty Morsels

Mark Gilbert

Mark Gilbert, London's bureau chief for Bloomberg News, poses for a photograph in London, on Sept. 15, 2009. Photographer: Chris Ratcliffe/Bloomberg

Since its inception, the derivatives market has echoed the fairground hawkers’ call to “scream if you want to go faster.” Among the new derivatives, collateralized-debt obligations (CDOs) were particularly hot.

To make a CDO, bankers bundle together a package of other kinds of securities, such as corporate bonds, asset-backed securities (ABSs) or credit-default swaps (CDSs) that are tied to company creditworthiness or mortgage performance.

By carving the resulting collections into slices of differing quality, the creators can make the riskiest portions absorb any losses on the underlying assets first, thereby cushioning the higher-rated slices.

No Clear Idea

As with almost every other investment vehicle, CDOs were designed to reward investors according to the amount of risk they took. Those who bought lower-risk securities typically earned a smaller rate of return from successful investments than did those who took bigger risks, who received either a larger payoff if the investment performed well or nothing at all if the investment failed.

Trouble was, no one had a clear idea of just how risky any given slice was or any sense of how to quantify and value that risk.

In the same way that Liverpudlians disguise overripe meat and vegetables by cooking them to mush in a stew called scouse, investment banks, rating companies and plain old market peer pressure turned the investments inside most CDOs from inedible chunks of the financial markets into bite-size morsels palatable to pension fund trustees.

No pension fund -- and only a few other investors -- would buy a structured transaction whose worth depends on what happens to the stock market and company creditworthiness, which way commodity prices go and whether the wind blows on a Sunday. They did, however, happily purchase CDOs that offered strong credit ratings and the promise of top-flight returns.

Risk Appetite

For the game to work, everyone involved had to turn a blind eye to the less-than-stellar track record assembled by the rating companies that assessed CDOs.

And they did -- until CDOs’ poor performance became impossible to ignore. Of the CDOs that started with AAA ratings in January 2002, 16 percent had lost that top grade by November 2004. Almost 14 percent of second-tier (AA-rated) securities were cut, and nearly 17 percent of CDOs with third-tier (A- rated) grades were cut.

Those early CDOs, which typically contained vanilla corporate bonds, were hurt by a swift deterioration in average creditworthiness, combined with some hefty one-off defaults, including those of Enron Corp. and WorldCom Inc.

Demand Soars

Memories, though, proved short, and demand for CDOs soared as credit-rating cuts on corporate debt became rarer. (The economy was growing, and most companies had enough cash to cover their debts.)

In 2004 in Europe alone, Moody’s rated $56 billion in European collateralized debt backed by default swaps. That was a 20 percent gain over the previous year, according to figures provided by the company at the start of 2005.

By 2006, the derivatives printing presses were stamping out $503 billion of collateralized debt for the rating companies to grade, up from $274 billion in the previous year and $144 billion in 2004.

In April 2007, Moody’s announced a fourth-quarter profit increase of 20 percent, as revenue from rating structured- finance transactions leaped to $251.5 million, a 44 percent gain over the same period in 2006. Almost half of Moody’s total 2007 sales of $583 million came from its structured-notes business, dwarfing the $115 million it made by analyzing company creditworthiness.

Fatally Flawed

Risk appetites increased, and CDOs became even more exotic and complicated. Structured-product specialists worked to broaden their appeal by tying CDO values to a broader range of underlying markets, some even creating theoretical bets that were tied to abstract prices.

To grade these new financial instruments, rating companies used methodology that was fatally flawed from the start. It was based on induction, the process of inferring a general law or principle from the observation of particular instances. But the particular instances the rating companies chose did not incorporate the lessons of previous housing booms, nor the nonexistent histories of some new, theoretical bets.

Instead, rating companies used the brief price history of the derivatives market as a benchmark to assess its likely future price performance.

Indigestion

The most egregious example of derivative market excess came with the invention of the constant-proportion debt obligation, known as a CPDO. In June 2006, Dutch bank ABN Amro Holding NV issued a 38-page marketing brochure describing a security called Surf: “the first CPDO; a breakthrough in credit investments.”

CPDOs were the credit derivatives market’s hottest alchemical method for transforming plumbous yield premiums into the gold of market-beating returns. The marketing literature and associated research reports suggested that the newfangled securities were the holy grail of investing -- heads, you win; tails, you don’t lose.

CPDOs were an abstract bet on the likelihood of defaults in the corporate bond market. With their values tied to credit- default-swap indexes, the securities promised to deliver as much as 2 percentage points more than money market rates during their 10-year life spans.

That was worth about 5.6 percent at the three-month money market rates that prevailed when CPDOs began attracting attention in November 2006.

Alphabet Soup

At the time, German government debt, deemed the safest fixed-income investments in the European markets, yielded just 3.7 percent annually. No wonder CPDOs looked irresistible.

Those remarkable rates of return were made possible by the magic of derivatives, which leveraged the initial bet by a multiplier of 15.

The leverage turned average punters into high rollers with the potential for fantastic gains -- and losses. When times were good and a CPDO looked set to meet its payment obligations, sponsoring investment banks could reduce their market bets.

When times got tougher, banks increased those wagers to boost the security’s net asset value. Credit-rating companies issued CPDOs top ratings for both interest and principal payments.

The alphabet soup cooked up by the derivatives chefs -- boil some CDOs, toss in a dash of ABSs and a soupcon of CDSs, season with CPDOs and serve with a garnish of overly optimistic ratings -- was sufficiently toxic to poison the entire financial system.

Just Deserts

Capitalism itself ended up looking sickly and anemic. Belatedly, investors discovered the truth of one of billionaire investor Warren Buffett’s aphorisms: Unraveling a derivatives trade, the so-called Oracle of Omaha had said, was like trying to carry “a cat home by its tail.”

Wall Street had invented a machine that could recycle just about anything that generated a cash flow. It had a growing, reliable source of supply from the housing market, sufficient to keep the merry-go-round spinning. And shifts in both the investment banking culture and the investing landscape created a willing coalition of buyers and sellers.

To contact the writer: Mark Gilbert in London at magilbert@bloomberg.net