Collateralized debt obligations (CDOs), the bad boys of the financial crisis of 2008, are coming back.
CDOs are securities that hold different types of debt, such as mortgage-backed securities and corporate bonds, which are then sliced into varying levels of risk and sold to investors. With the Federal Reserve committed to keeping interest rates low, investors — such as pension funds seeking higher returns — are driving demand once again for these structured securities, which are riskier but provide more bang for the buck than safer bets such as Treasuries and investment-grade corporate bonds.
This year, Deutsche Bank launched an $8.7 billion CDO in two tranches with payments ranging from 8% to 14.6%, garnering strong interest from investors, according to a January 24 story in Bloomberg News. In the U.S., firms such as Redwood Trust have started selling CDOs backed by commercial real estate for the first time since the credit crunch, Bloomberg reported in a January 14 article.
Brian Reynolds, chief market strategist at Rosenblatt Securities, told CNBC on January 31 that investors are on a hunt for higher payouts such as those in corporate bonds. But because demand for these bonds is outstripping supply, “we’ve begun to shift to structured finance” again, favoring securities such as CDOs.
In the last two quarters of 2012, global outstanding collateralized loan obligations, a type of CDO, surged to $384 billion after showing sequential declines since the fourth quarter of 2010, according to the Securities Industry and Financial Markets Association. “Now we’re going to see a surge in CDO issuance,” Reynolds said. “These are the same instruments that were used in the last credit boom.”
It was a boom, however, that preceded the financial crisis.
After 2008, demand for CDOs holding home mortgages dried up in the aftermath of the subprime housing bust. But now, unhappy with low returns from such financial vehicles as bank savings accounts, investors are showing a new appetite for these complex securities — not necessarily those holding lesser-quality residential mortgages but other types of debt.
As proof of the chase for higher returns, Reynolds pointed to record low yields in high-yield, or junk, bonds. Indeed, sales of global junk bonds rose to a record $133 billion in the first quarter, driving the yield down to its lowest level ever, according to an April 5 story in The New York Times.
But the environment is far different today for CDOs than in the years leading up to what was dubbed the “Great Recession,” the worst financial downturn since the Great Depression. Not only are lenders far more cautious, regulators seem to be waking up, capital requirements are tightening and investors are chastened.
“The way they are coming back is not a significant problem at this point,” says Susan Wachter, Wharton professor of real estate and finance who warned of an impending real estate crisis years before the financial meltdown. Her testimony is part of the Financial Crisis Inquiry Commission’s report analyzing causes of the crisis, which was commissioned by President Obama and Congress. “The problem with the CDOs is that they were mispriced when they were issued in 2005 and 2006,” she adds. “They were underpriced for risk.”
Not the Same Market
While CDOs acted as gasoline in a fire that engulfed financial markets globally, they may not have been such a big catalyst if the environment had been different.
Over the last 30 years, financial markets have become more linked globally; technology has transformed the speed, efficiency and complexity of financial instruments and transactions; access to financing has become broader and cheaper than ever, and the financial sector has grown into a much bigger player in the economy, according to the Commission’s report, which was released in January 2011.
In early 2000, low interest rates made loans cheap and freely available, fueling a housing boom and mortgage refinancing. Home prices skyrocketed, and speculators began flipping houses. Banks and other financial institutions began pooling these home mortgages together into residential mortgage-backed securities (RMBS), and sold shares of them to investors.
When homeowners paid their mortgages, the money would flow through to the investor. Banks not only made money on the sale of RMBS, but they transferred the risk of a mortgage default to the investor. Spotting opportunity, investment banks further repackaged these mortgage-backed securities into CDOs. They created different levels, or tranches, of investment depending on the investor’s appetite for risk. Investors around the world bought them.
But these CDOs mostly held mortgages that were rated lower than AAA by credit ratings agencies, providing a higher return to investors because they were riskier, the Commission said. However, the CDO itself usually attracted a higher rating because it grouped together different mortgage-based securities. The belief was that this diversification provided additional safety. “The hypothesis was to take a BBB tranche of mortgage-backed securities and diversify this tranche across different issuers to have a more diversified portfolio, and become a triple A,” Wachter notes.
Theoretically, it sounded good. But it turned out to be a false belief. To properly diversify real estate, the homes must be in different geographies, because a housing market slump in Southern California might not be occurring in Boston. The problem was that investment banks diversified across different securities backed by real estate that sometimes was concentrated in the same markets.
“It was wrong. From the beginning, there was no real diversification of risk,” Wachter says. As a result, the CDOs were assigned higher ratings by credit ratings agencies when, in fact, they were riskier than they were perceived. Meanwhile, investment banks kept churning them out and pocketing high fees, passing on the risk of defaults to investors.
Investment banks also created other CDO offshoots, such as CDOs that invested in other CDOs — referred to as “CDO Squared” — and synthetic CDOs that allowed multiple bets on the same securities. The result was that the impact of a mortgage default would be magnified. From 2004 to 2007, Goldman Sachs packaged and sold $73 billion in synthetic CDOs that included more than 3,400 mortgage securities, with 610 appearing at least twice, the Commission said.
Further lulling investors into a false sense of security was another instrument — the credit default swap, or CDS. It acted like an insurance policy that paid the investor back the full amount of the investment if the debt should default. In exchange, the company that issued the credit default swap was paid premiums by the investor.
Although the credit default swaps acted like an insurance product, they were actually over-the-counter derivatives. Thus, firms like AIG — whose exposure to credit risk through the OTC market during the crisis amounted to half a trillion dollars — were not required to set aside any capital to cover potential losses. And since AIG was the backup payer for investors — big pension funds, banks and others — the government decided to bail it out when the housing boom ended and mortgage defaults climbed. Not doing so could have created a domino effect of failures throughout the financial system.
Could CDOs Wreak Havoc Again?
The CDO may have gotten a black eye during the financial crisis, but it is not an inherently flawed security, some experts say.
“CDOs and CLOs (collateralized loan obligations) are not going to go away, because in principle they are powerful risk management devices. They allow for diversifying of risk that otherwise would be quite concentrated,” says Kent Smetters, professor of business economics and public policy at Wharton. But during the crisis, CDOs were being created for their own sake, he notes. The motivation was not risk management. Now, CDOs are more in tune with their actual purpose, which is “risk diversification, not risk amplification.”
Investors also have learned their lesson. “The hope now is that there are going to be smarter and more informed buyers out there,” Smetters says, adding that he would like to see most CDOs go through a clearinghouse, because the presence of an intermediary could improve transparency. For that to occur, however, CDO contracts will have to become more standardized. “Until that happens, only a small fraction [will go] through a clearinghouse,” he said. “But over time, there will be more.”
According to Smetters, the ratings agencies are mainly to blame for what took place during the financial crisis. “I do think the ratings agencies did a very poor job,” he says. “Even when things looked scary, they were still definitely making things look rosy.” He cites the Abacus CDO scheme perpetrated by Goldman Sachs as one instance of the ratings agencies’ culpability. In April 2010, the SEC charged Goldman and one of its vice presidents with fraud for selling a synthetic CDO called Abacus filled with subprime securities, but without disclosing to investors that a hedge fund that helped select the mortgages was shorting them. The SEC said investors lost more than $1 billion in the scheme. Goldman paid a record penalty of $550 million. “They got these contracts rated, and large layers of the deal were rated AAA,” Smetters points out.
But regulators recently sent a big signal to credit agencies that such negligence will not be tolerated. In February, the U.S. Justice Department sued Standard & Poor’s for $5 billion, alleging that the ratings agency defrauded investors by inflating ratings and understating the risks of mortgage securities in order to gain more business from investment banks that issued them. S&P said the lawsuit is “meritless.”
In addition, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, for all its perceived flaws, requires issuers of asset-backed securities such as CDOs and CLOs to retain “an economic interest in a material portion of the credit risk,” according to the SEC’s website. The ability to pass on the risk to investors during the financial crisis made financial institutions less conservative and contributed to the meltdown. “No one in this pipeline of toxic mortgages had enough skin in the game,” the Financial Crisis Inquiry Commission’s report said. “They all believed they could off-load their risks on a moment’s notice to the next person in line. They were wrong.”
Meanwhile, the Basel III accord struck in 2010 raised bank capital standards globally in response to the crisis so that they will have more set aside to offset losses. The agreement, reached voluntarily by a committee of global regulators and central bankers, had initially set a deadline of 2015 for banks to maintain higher levels of capital. But the deadline was pushed to 2019 after it became apparent that some banks in Europe and U.S. could not meet those standards without significantly cutting back credit to businesses, according to The New York Times.
While there were many culprits in the crisis, Allen notes that a major contributor was the Federal Reserve’s easing of interest rates that flooded the market with cheap credit. “That had a big role to play. It’s the government that causes a lot of the risk with its quantitative easing…. We don’t have enough safeguards against that.” While the Federal Open Market Committee could serve as a check, what little dissent that arises is often marginalized, he adds.
Allen cites another example of questionable government intervention: Since the 2008 crisis, the Federal Reserve has been buying agency mortgage-backed securities in the market — those guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. On March 20, the Fed said it would continue to buy $40 billion of these securities a month and longer-term Treasurys at $45 billion a month.
“These actions should maintain downward pressure on long-term interest rates, support mortgage markets and help to make broader financial conditions more accommodative,” the Fed said in a statement. “The committee will continue its purchases of Treasury and agency mortgage-backed securities until the outlook for the labor market has improved substantially in a context of price stability.”
But according to Allen, such an approach is misguided. “It’s fine to intervene at the height of a market crisis” but not five years later, he argues. The Fed is “distorting the market” in the interest of boosting job growth. And for all its efforts, the Fed is not fixing the problem of anemic employment gains. “The jobs report is a good example that they’re not solving that,” Allen points out. On April 5, the U.S. Bureau of Labor Statistics reported that non-farm payrolls in March increased by 88,000 — just a third of February’s jobs gain.
Commercial vs. Residential
CDOs may be coming back, but investors are looking for a different type of debt: Commercial — instead of non-agency residential — mortgage-backed securities (CMBS). CMBSs hold the real estate debt of shopping malls, apartment buildings and other businesses, which did not suffer the same degree of downturn in the crisis as residential properties.
“[Private label, or non-agency] residential mortgage-based securities are practically dead in the water. [The market for them is] now down to $5 billion or a little bit less,” Wachter says. “Commercial mortgage-backed securities are back. [The market for them is] still a fraction of what it was, but it’s back.” More importantly, she adds, “it’s back in a way that is more sensible or carefully underwritten.”
Some financial institutions, such as Deutsche Bank, have repackaged riskier loans on their books into CDOs to sell to investors as a way to raise their capital ratios. The investment bank’s $8.7 billion CDO contains a mix of residential mortgage-backed securities, commercial loans, corporate CDOs and other asset-backed securities, according to Reuters. At the end of 2012, the bank’s core tier 1 capital ratio rose to 8% from under 6% a year earlier. Co-CEO Anshu Jain confirmed to CNBC in January that the bank placed riskier assets into a CDO and sold it to a hedge fund.
Such CDOs “are repackaged inventory,” says Jack Guttentag, Wharton emeritus professor of finance and co-director of the Samuel Zell and Robert Lurie Real Estate Center’s International Housing Finance Program. “What you have are outstanding securities frozen in portfolios…. But things have stabilized, and the default rate has started to come down. You have the potential for a market.”
As for CDOs containing subprime home loans, “they may not be back for another generation.”