Bloomberg writer Mark Gilbert says that the trouble with collateralized debt obligations (CDOs), which slice bundles of asset-backed securities into different risk-reward classes, is that no one has a clear idea of how risky any given slice is or any sense of how to quantify and value that risk.
This uncertainty was papered-over by strong credit quality ratings issued by the likes of Moodys, Standard & Poors and Fitch, which purportedly analyzed the CDOs. For the game to work, Gilbert, says, everyone involved had to disregard the dubious track record of these rating companies. He could also have said that the rating agencies had to inflate their ratings for the game to work, and they have been sued for doing just that.
The early CDOs were hurt by a swift deterioration in average creditworthiness and defaults, including those of Enron Corp. and WorldCom Inc. Of the CDOs that were rated in January 2002, the rating agencies had to cut approximately the ratings on 16 percent of the AAA rated CDOs, 14 percent of AA-rated CDOs, and 17 percent of the A-rated CDOs within three years.
Nevertheless, demand for CDOs soared as the economy grew. By 2006, $503 billion of collateralized debt was issued for the rating companies to grade, up from $274 billion in the previous year and $144 billion in 2004.
The most egregious example of this derivative market excess, according to the article, was the newly invented constant-proportion debt obligation, known as a CPDO, which was touted as “a breakthrough in credit investments.”
CPDOs provided a way to bet on the likelihood of defaults in the corporate bond market. Their values were linked to credit default swap indexes, and promised to deliver as much as 2 percentage points more than money market rates during their 10-year life spans.
Those remarkable rates of return were made possible by leverage, multiplying the effect of an initial bet by a factor of 15.
Belatedly, Gilbert writes, investors discovered the truth behind one of billionaire investor Warren Buffett’s homely aphorisms: Unraveling a derivatives trade is like trying to carry “a cat home by its tail.”
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 35 occasions. Page Perry’s attorneys are actively involved in representing investors in cases involving collateralized debt obligations. For further information, please contact us.