FTSE Global Equity Index Series

CDOs trace their origins to the late 1980s but the market
really took off in 1996; (see, for example, data for CDOs
rated by Moody’s in Figure 1: CDOs: Dramatic Growth to
Record Levels in 2004).The early transactions were cash flow
CDOs that allowed financial institutions to lay off credit
risk through repackaged high-yield bonds but the structure
soon spread to other asset classes. In today’s market, the
assets most commonly securitised are high yield corporate
loans and asset backed securities, but collateral extends
from investment grade bonds to bank and insurance
company preferred stocks and real estate.
Cash flow CDO transactions dominated the market in
the United States until the past couple of years, according
to Drew Dickey, managing director and head of the
structured credit team at Babson Capital Management,
LLC. The absence of actively traded cash collateral bred a
synthetic market in Europe, where credit risk was
concentrated in banks rather than bonds. A synthetic CDO
holds high quality near cash collateral and adds credit
exposure through a portfolio of credit default swaps, which
are effectively put options on default risk.
CDOs challenge the efficient market hypothesis: why will
investors pay more when the overall risk in a CDO equals
the sum of the risks in its collateral portfolio? The structure
adds value by facilitating the transfer of credit risk. Bill May,
a managing director in Moody’s derivatives group, cites
CDOs based on middle market bank loans as an example.
The individual loans are relatively small and unrated; an
institutional investor cannot afford to monitor enough
companies to build a diversified portfolio. The lenders, who
do track the companies, repackage the loans into CDOs,
although they retain some exposure to each loan so
investors know the sponsor has some skin in the game if a
loan goes bad. In effect, CDO investors outsource the credit
research and monitoring.“It gives investors an opportunity
to invest in an asset class that they could never do on their
own,”says May,“And it gives these small companies access
to capital they could otherwise never get.”
Artificial restrictions that require many investors to hold
only rated instruments contribute to the repackaging
arbitrage. “These portfolios are fairly diverse,” says Sivan
Mahadevan, executive director and head of structured
credit research at Morgan Stanley,“You can get investment
grade ratings for a lot of the tranches that have even a little
bit of subordination.” Rated CDO tranches command a
premium because they appeal to a broader market.
Senior CDO tranches find a home among pension funds,
insurance companies, banks, and conduits set up by banks
that use the high-quality assets as collateral to support
commercial paper issued to money market mutual funds
and other cash market investors. The mezzanine notes go
to insurance companies, banks, mutual funds and hedge
funds. Equity tranches appeal to banks and insurance
companies looking for assets that offer leveraged returns
relative to their regulatory capital requirement. Other
investors willing to accept the risk (including hedge funds)
buy equity for the high potential return.
FTSE GLOBAL MARKETS • JULY/AUGUST 2005
Drew Dickey, managing director and head of the structured credit
team at Babson Capital Management
CDOs challenge the efficient market
hypothesis: why will investors pay more
when the overall risk in a CDO equals
the sum of the risks in its collateral
portfolio?
The allocation of losses in a CDO pool turns the equity
and mezzanine tranches into leveraged plays on default
risk – with price volatility to match. Hedge funds
compounded that volatility by trading on margin. When
the expected correlation between the equity and
mezzanine tranches broke down, margin calls loomed as
funds faced mark-to-market losses on both sides. “If you
buy something on mark-to-market leverage you tend to
give up the freedom to have your own view of the world,”
Babson Capital Management’s Dickey says, “You can
think that pricing is completely absurd. It might be absurd.
But that doesn’t really matter when you have to put up
more collateral.”
In theory, correlation refers to the probability that if one
credit in a CDO pool defaults other credits will also default.
In practice, correlation is not a measurable input to the
pricing model, according to Dickey. Companies don’t
default often enough to generate reliable data on credit
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