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Lessons from the first CDO issues

Explosive was the word used to launch the first-ever CDO conference in Auckland recently.

Wednesday, October 22nd 2003, 6:54AM
Explosive growth of products and explosive growth in the market were the positive themes being referred to. And of course, there were also references to the potential toxicity of CDOs (Collaterised Debt Obligations) in the hands of retail investors, as well as the important message of understanding risk.

The first few issues of retail CDOs have successfully raised more than $300 million.

The conference was a good chance for those in the retail market to pause for thought and reflect on the early lessons.

Some of the key points which came out of the conference include:

The rating process – It’s increasingly complex and a rating doesn’t give advisers and investors a detailed understanding of a CDO, so don’t rely on it too heavily. Two CDOs with the same rating can have quite different levels of sensitivity to default, because of the make-up of the basket of bonds.

Liquidity – Two of the three retail issues in New Zealand have been listed companies and despite the recent nature of the issues, retail investors are already trading the shares. The message from the wholesale camp is to be wary. These are not trading instruments and should be treated as a ‘hold to maturity’, plus they’re tricky to value. If credit turns sour, liquidity dries up fast and it will be difficult to get out.

What’s best static versus managed CDOs? It’s a bit like arguing the toss between passive index trackers and an active fund, with some added layers of complexity.

Valuations – They are complex, a function of credit spreads, correlations, recovery rates, interest rates etc. So it’s important to understand these intra-relationships.

Subordination and risk – That’s the buffer that protects investors from initial defaults and it’s crucial to understand the consequences of companies defaulting beyond this level, which acts as a ‘safety net’. While unlikely on a historical basis, the downside risks are heavily geared once this initial protection level is broken. It’s this factor which that makes a CDO fundamentally different from a standard fixed interest investment.

A credit event – Defining what constitutes a bond default is easy, applying it is not. It seems that the processes put in place following a default need to be quite different for the retail market and advisers need to understand the case behind this.

Diversification – Crucial for financial advisers to consider. The Macquarie and ABN AMRO Amro issues had quite a large overlap in the basket of corporate bonds. These companies now acknowledge their future products need to be different.

Stress testing – Another important research technique that the retail market must embrace. It simply means looking at the behaviour of the bonds in different scenarios to test how robust the CDO is.

And one of the most important questions of the day: “Can retail investors ever understand CDOs?” And the honest answer was “no - not now and probably not ever”.

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