Sellers of protection in collateralized debt obligations should realize the limitations of rating agency analysis and undertake their own analysis before investing. Steve Baker, director at CDC IXIS Capital Markets North America in New York, told delegates that while ratings agencies require onerous stress tests, the process is not perfect and deals can be structured to pass the tests. It is impossible to stress test every potential outcome and investors need to understand these limitations, he said.
One of the factors that may impact a CDO, but which investors could miss, is the product's hedging strategy, Baker explained. Hedges are typically built into structures specifically to pass ratings agency stress tests, he added. Where hedging is not perfectly matched, however, it may hinder as well as help. Higher than projected defaults can also be a problem, he noted. Even if a CDO has not experienced defaults, a change in interest rates could contribute to a change in ratings. As hedges are typically not listed in deals, however, investors need to approach the dealer in order to obtain this information.
