The complex security design of collateralized debt obligations is arranged and administered like a managed fund, allowing issuers to refinance the purchase of debt instruments by repackaging them into different slices of risk and maturity. Despite their global prominence CDOs have been notoriously subject to allegations of insufficient transparency.
In light of a less favorable credit environment, a very peculiar situation appears to unfold in the CDO market. At the moment, the large public stock of leveraged investments carries the vestiges of times when poor returns on conventional products and default rates below the historical experience encouraged more risk taking for yield. As the coincidence of an increasing global cash surplus and a limited supply of traded debt lowers investment returns relative to asset values, a higher risk premium from a shift in mean-variance efficiency requires even lower risk aversion for the same expected returns -- at a time when default risk is likely to increase. High liquidity-induced demand from CDO managers for scarce reference assets, such as bonds and credit-default swaps, has further tightened spreads of these "investible" securities. Compressed spreads, in turn, have lowered traditional arbitrage gains of CDO managers due to higher asset costs and precluded the timely adjustment of debt prices to adequately reflect economic conditions.
Against this background, structural provisions to maintain credit quality, such as the ability of CDO managers to substitute badly performing assets, seem prudent and provident; however, if poorly executed, they could possibly induce a principal-agent problem between CDO managers and investors. When investor demand for CDOs fails to offset higher funding costs, the prospect of rising default rates and lower risk premia curtails the capacity of CDO managers to sustain investor repayments without relinquishing some of their own arbitrage gains. Otherwise, less compensation for risk invariably would spur greater risk taking, whose higher sensitivity to credit conditions is exacerbated by the leveraged security design of subordinated CDOs.
No Gains From Manageable Portfolios
In advent of rising default rates, CDO managers would be compelled to divert funds away from under-performing portfolio assets to safer but highly coveted and more costly territory (or accept higher hedging costs). However, in efficient markets, this dynamic asset allocation should make risk-neutral managers indifferent (if we ignore transaction costs), because the ability of CDO managers to weed out certain reference assets comes at a premium. Under worse credit conditions better asset performance now implies a lower risk premium and is harder to come by, making CDO mangers no better off than before. Consequently, risk-averse CDO managers would need to adjust their mean-variance return expectations.
Even if managed CDOs might generate abnormal returns by virtue of greater responsiveness to changes in default risk, the significant economic implications of higher structural risk and moral hazard from both asset substitution and cash flow risk must not be overlooked.
More Leverage From Perpetual Structural Innovation For Yield
Alternatively, CDO managers might choose greater leverage to maintain sufficient yield as the credit cycle begins to turn and more downgrades and defaults suggest rather more senior investment. CDO markets typically effect greater leverage by means of ongoing structural innovation that contributes to a further narrowing of spreads. Recent market developments testify to "structural substitution" in complex hybrid CDOs. After CDO-squareds led to the narrowing of mezzanine spreads in the CDO market, leveraged super-senior tranches with mark-to-market loss- and spread-based triggers emerged in a significant number of synthetic CDOs. Most recently, investment banks with significant mezzanine ABS inventory also began to employ leveraged super-senior tranches in synthetic CDOs as an alternative method of hedging specific--and not diversified--mezzanine tranche exposure by offloading senior risk instead of selling credit protection or delta hedging. With the leveraged super-senior concept becoming exhausted, CDO managers are now introducing overlay structures that bring in other sources of risk, such as foreign exchange rates, inflation and commodity price linkages in order to juice up investor yields.
Moral Hazard From Asset Substitution And Marked-To-Market Collateral
If CDO managers are unable to stem the tide of rising defaults, inflated asset prices of marked-to-market collateral would help obfuscate lower-than-expected asset performance and maintain performance-based management fees through artificial arbitrage gains. Overstated asset prices could lower the required performance of CDO managers and provide residual income if the repayment of investor return was subsidized by initial investment funds for overpaid CDO tranches.
Another potential structural pitfall in subordinated cash CDOs arises from the retention of an equity claim by CDO managers, which adds to the negative effects of broader credit deterioration on incentive compatible behavior. While most middle and higher-rated tranches are sold, CDO managers are frequently exposed to the equity tranche, which absorbs first losses and, hence, represents the riskiest element, the so-called toxic waste of CDOs. At the same time, equity establishes a residual claimant on cash flows generated from securitized assets if excess spread does not accrue to the benefit of any note holder and is not available to absorb losses. In this situation a conflict of interest between CDO managers and senior note holders arises if credit conditions suggest a higher chance of losses to exhaust the loss bearing capacity of management-held equity interest. So if CDO managers are not precluded from causing a deterioration of portfolio quality, they might become more inobservant in their asset choice by accepting higher asset correlation and riskier high-spread assets into their portfolios in order to sustain arbitrage gains. A riskier investment strategy implies a higher probability of CDO managers claiming residual income from excess spreads if asset prices overstate eventual defaults in the future. Unfortunately, the default correlation of portfolio assets increases significantly for marginal changes in asset correlation when CDO managers trade off low exposure by senior tranches against higher upside gains from riskier investment in this case.
Risk Measurement Of Synthetic CDOs And Concentration Risk
CDO managers would traditionally hedge issued CDO tranches by selling credit protection, i.e. going long credit risk via CDS on each portfolio position. This full hedge is equivalent to refinancing the credit risk of all reference assets underlying the CDO. The popularity of bespoke, single-tranche CDOs as mezzanine horizontal risk slices of entire CDOs has complicated hedging strategies, however, and has made synthetic CDOs more susceptible to the misrepresentation of actual exposure.
With all unsold tranches being retained by CDO managers, single-tranche synthetic CDOs invite trading desks to ignore the fact the exposure of the arranger is actually equivalent to the notional amount of residual tranches. CDO managers typically delta hedge issued mezzanine tranches. This partial hedge implies a marginal credit bet based on an assumed optimal hedge-ratio for the necessary amount of credit protection to be sold on a vertical slice of risk of the total notional amount of securitized assets. Although unsold tranches of synthetic single-tranche CDOs exist only in theory, CDO arrangers are still exposed to equity-like risk that is not fully hedged. Moreover, a partial hedge on single-tranche CDOs is more sensitive to changes in asset correlation than a full hedge, especially when compressed spreads exacerbate the effect of asset volatility. So the trading book's income from CDS might be insufficient relative to the risk taken.
To make matters worse, managers of single-tranche CDOs usually reference established CDS indices, which leads to higher concentration risk across similarly referenced CDOs. As deteriorating credit conditions curtail the scope of high quality assets, concentration risk will be more difficult to avoid. Higher concentration risk also aggravates the coverage of leveraged CDO tranches when high asset volatility during times of stress may upset the very correlation assumptions underlying the hedge ratio and the estimated conditional default probability. If traders are forced to adjust their hedges over time as the creditworthiness of constituent names deteriorates, they might incur losses on hedging positions on issued tranches; yet, rising spreads on sold credit protection of riskier CDO tranches benefit hedges of single-tranche CDOs. However, hedging long CDO tranches becomes more costly for capital market investors, which also face concentration risk from diversifying within the CDO space, because many CDOs include the same reference names as collateral assets.
Conclusion
Overall, the flexibility of synthetic structures, which allows CDO managers to employ wads of derivative arrangements, entails significant agency costs from moral hazard especially in an environment of uncertain credit conditions. Capital market confidence in the efficient administration of managed CDOs requires a high degree of transparency about the benefits and drawbacks associated with the choice of collateral composition. Incentives for asset substitution exist when higher default rates and lower risk premia leave CDO managers scrambling for costly reference assets to accommodate plenty of investor funds pouring into the market. Amid alarming signs of several imminent CDO downgrades, the CDO market merits close surveillance as indicator of greater credit risk volatility if higher default rates no longer warrant the high debt prices both the strong supply of CDOs and high investment demand from global cash surplus have supported for so long.
This week's Learning Curve was written by Andreas Alexander Jobst, economist at the international capital markets department of the International Monetary Fundin Washington, D.C.
