The CDO Is Back, But It's Different This Time


Yves Smith points to an FT report on the return of the much-reviled CDO:

Investment banks, including Goldman Sachs (GS) and Barclays Capital (BCS), are inventing schemes to reduce the capital cost of risky assets on banks’ balance sheets, in the latest sign that financial market innovation is far from dead.

The schemes, which Goldman insiders refer to as “insurance” and BarCap calls “smart securitisation”, use different mechanisms to achieve the same goal: cutting capital costs by up to half in some cases, at the same time as regulators are threatening to force banks to increase their capital requirements.

BarCap’s structures involve the pooling of assets from several clients into a secured financial product that can be sold on to other investors and rated by a credit rating agency, potentially reducing the capital allocated against the assets by between 10 per cent and 50 per cent.

Danger! Warning! Caveat Emptor!

Are banks immediately rushing to drink the same hemlock spritzer that just did them (and you) in?

Yes, says Yves:

The amusing bit is these news structures are argued to be “transparent.” If you buy that, I have a bridge I’d like to sell you.

If you have a dog’s breakfast of assets, some of them tranches from other deals, and then you tranche that, what good does transparency do? It’s a complicated mess to analyse. Opening the hood does not make it any more comprehensible to anyone other than an industry expert equipped with specialised software and access to sources that help him come up with default and loss probabilities. Most investors and all regulators will find them impenetrable. Which is precisely the point. I wonder if the assertion of transparency is Emperor’s new clothes in action, designed to cow those who can’t fully grasp the workings of these vehicles.

Maybe. But we’re going to have to say something regrettable and suggest that this time it will be different. Creating structured products out of trash assets won’t be a problem for a few reasons.

For one thing, buyers were just burned big-time on these, so even if the banks want to go back to the same trough, it’s hard to believe buyers will. Whatever buyers do emerge will certainly perform a much higher level of due diligence than they did last time around, rather than leave so much to third parties.

Beyond that: The reason this all went to hell once is that asset values relating to housing proved to be wildly over-valued. It wasn’t that the CDO or CDO-squared wasn’t transparent, it was that the housing market collapsed.

Sure, people recognised that the riskiest tranches of these products were exposed to some housing market risk, and would suffer the first losses, but obviously the magnitude of this crash caught almost everyone by surprise. While valuing these products proved difficult, it can’t have been the real issue, since plain-old vanilla assets related to housing also crashed wildly. Think of the reverse: if the problem with the CDO was that it was too hard to value, then you’d have expected more accurate, long-sighted values with more traditional products.

And more generally, it’s unlikely that the source of the problems this time will be the same as it was last time. Banks and investors will always find a way to impale themselves. But they’ll find a new way to do it and this won’t be it.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.