Professor Jayanth Varma has posted his Financial Express oped on his blog, in which he tells us that a CDO is just a small bank, while a bank is a really big CDO:
In 2007, when the first problems emerged in CDOs, people thought that these relatively recent innovations were the cause of the problem. Pretty soon, we realised that a CDO is simply a bank that is small enough to fail and conversely that a bank is only a CDO that is too big to fail.
Both banks and CDOs are pools of assets financed by liabilities with various levels of seniority and subordination. As the assets suffer losses, the equity and junior debt get wiped out first, and ultimately (absent a bailout) even the senior tranches would be affected. In retrospect, both banks and CDOs had too thin layers of equity.
This is actually an incredibly strong insight. We are so used to thinking of a bank as an organisation and a CDO as an exotic security that it seems like a revelation when you realise that actually both have the same sort of balance sheets.
So if CDO’s weren’t the problem, what was? Bad credit practices in general. That said practices were probably caused by too much cheap money sloshing around is left unsaid.
It is becoming clear that what the US is witnessing is an old-fashioned banking crisis in which loans go bad and therefore banks become insolvent and need to be bailed out. The whole focus on securitisation was a red herring. The main reason why securitisation hogged the limelight in the early stages was because the stringent accounting requirements for securities made losses there visible early.
Potential losses on loans could be hidden and ignored for several quarters until they actually began to default. Losses on securities had to be recognised the moment the market started thinking that they may default sometime in the future. Securitised assets were thus the canary in the mine that warned us of problems lying ahead.
So basically, the exotic instruments were symptoms and not the disease. I’d add here that securitising mortgages into CDOs rather than pure pass-through certificates probably created an extra level of complexity, though.
Ajay Shah often talks about how financing through exchange driven markets (whether for bonds or equity) is preferable to financing through banks which are forced to deal with much more illiquid levels of risk. If you accept that as a basic assumption, then if a CDO is a virtual bank, it represents a throwback in the evolution of finance. Oh dear.
The problem is that investment banks were still able to create and sell CDOs rather than selling a simple package of pass-through certificates on mortgage-backed-securities. Hopefully, this is a generational thing that will die out soon – now that every chhappar in the world is getting an MBA, a CFA, and at least a basic knowledge of financial instruments, the power that investment banks have over purchasers of securities may dissipate once this glut of finance professionals starts trickling into treasury and fund management offices where they can do their own structuring, dammit.
Of course, the stranglehold that I-banks have over issuing securities is unlikely to go away. So we should have strong regulations to ensure that they only sell vanilla products and the customers do their own structuring.
Before I forget, do read the whole thing, especially for the last few paras, where Prof Varma talks about why we should embrace securitisation and the advantages it has given to American consumers.
A CDO is a “credit derivative” only in the sense that it gives you pure exposure to credit performance when you buy into the “equity” tranche.Prof Verma is spot-on..a CDO is really only a company which invests in a diversified pool of fixed income assets and sells debt and equity to finance the same.One importance difference is that in this case the financing is non-recourse,and the “equity” tranche performance has a front loaded performance profile.Basically such a structure allows insurance companies/pensions etc which have ratings restrictions to still put on a leveraged play on credit.And yes,the term non-recourse financing is cheap relative to market,and the CDO is set up as a SIV,so it’s off-balance sheet in some cases(which allows banks to lever up and show better ROE on their quarterly results).