If you cover an apple with the skin of an orange, the apple will look like an orange but will remain an apple. What if you cover a debt with fanciful layers of high sounding financial terms such as collateralized debt obligations? The debt will remain a debt. But as the experience of the recent past shows, it is easier to sell junk debt to investors of all kinds by repackaging it in the form of collateralized debt obligations. Let’s try to understand a few basic things about this through our friends Jinny and Johnny.
Johnny: Hi, Jinny! I always wanted to ask you about one term that I frequently keep on hearing. I hope you will tell me about that today.
Jinny: You can ask about any term without any formality.
Johnny: Tell me, Jinny, what are collateralized debt obligations?
Jinny: Collateralized debt obligations, or CDOs in short, are a type of securities instrument that are backed by a portfolio of fixed income assets such as bonds or loans. They are called structured credit products that owe their existence to the creative juices of the financial world. An investment in CDO is basically an investment in the cash flows originating out of the assets backing them. The assets could be of different credit ratings arranged into different tranches or slices. The tranches at the top enjoy the highest credit rating, such as AAA or equivalent, whereas the middle tranches enjoy a credit rating between AA and BB.
The tranches at the bottom could be totally unrated. Credit ratings of different tranches are done by the issuers of CDOs on the basis of assessments made by credit rating agencies. Cash flows from different assets are distributed to investors in different tranches as per their seniority. Investors in the tranches having the highest credit rating are the first to receive cash flows followed by investors in the middle and lower tranches.
Illustration: Jayachandran / Mint
Tranches at the bottom are more risky in the sense that any loss arising from default of assets is first borne by them.
But the tranches at the bottom offer higher returns in the form of greater cash flows than tranches at the middle or top. Investors in the middle or higher tranches carry a better chance of survival but if the losses are high, then they too take the hit. This is what makes CDOs a complex instrument.
Johnny: In what way can CDOs help the financial market?
Jinny: As you may be aware, all lenders of money face the risk of borrowers not repaying the money, which in financial terms is known as credit risk. CDOs help lenders in providing money on credit to pass on the credit risk to a wide variety of investors. The originator of credit risk gets back the money which it can use for making new loans. CDO investors step into the shoes of the original lender and receive the future cash flows. This is called “slicing and dicing” of the credit risk — all in all, an interesting recipe. Lenders first originate the credit risk by providing loans to a variety of borrowers. Then they pool different loans together and sell them off in the form of CDOs.
Pooling loans of different kinds together is the real challenge of making attractive CDOs. You have loans of different maturities, amounts and credit risks.
How would you repackage the whole thing to make it attractive for investors with different preferences? Some may be short-term investors looking for quick profits; others may be looking for a stable cash flow in the long term. The challenge for you is to make a dish which is sweet from one side and sour from the other. This requires a great deal of financial creativity.
Johnny: If CDOs are so useful, then why are they blamed for causing trouble in the financial market?
Jinny: There is no problem as long as the party keeps going. Investors in CDOs are happy to get their cash flows and the originators of CDOs are happy in recycling new kinds of risks through new, exotic instruments. The problem starts once the party stops. Everywhere, you see investors getting crushed under the weight of falling CDOs. What went wrong? Well, the originators of credit risks might have been so busy in their game of slicing and dicing that they forgot to make a true assessment of risks. The toxic instruments might have changed so many hands that it is difficult to know who is going to die next. This kind of uncertainty leads to a credit crunch in the financial market.
But, you may ask, what were the investors doing? They were supposed to invest in CDOs with their eyes wide open. Then you realize that many investors actually lacked the competence to make a true assessment of the risks involved.
Johnny: That’s really sad, Jinny. I think there must be a way out to make CDOs more useful for the financial market.
What: Collateralized debt obligations (CDOs) are securities instruments that are backed by a portfolio of fixed-income assets such as bonds or loans.
How: Assets backing CDOs are arranged into different tranches based on their credit rating.
Who: Lower tranches offer higher cash flows but they are the first to suffer a loss.
To read all of Shailaja and Manoj K Singh’s earlier columns, go to www.livemint.com/realsimple
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com