Over the past year or so, nothing has grown faster than demand for synthetic collateralized debt obligations. In the past several weeks, a drumbeat of warnings has emanated from the likes of the International Monetary Fund, Standard & Poor's, and a top official at the U.S. Federal Reserve.
Then, last week, on the heels of its dramatic downgrading of General Motors Corp. and Ford Motor Co. to junk status, S&P, which is generally considered the rating agency most skeptical of synthetic CDOs, downgraded several CDOs arranged by Deutsche Bank Securities - putting others on negative watch - because they were exposed to GM debt. The subsequent hair-trigger unwinding of some CDO positions showed how nervous CDO investors are these days. Merrill Lynch immediately issued a fixed-income strategy report saying: "We expect a rush to the door to be painful."
"One of the questions people have to ask themselves is, how will these synthetic instruments behave in times of stress?" says Leslie Rahl, a former Citibank risk expert who now runs Capital Market Risk Advisors, a risk consultancy in New York. Normal risk modeling only approximates normal markets - the real test comes in extreme markets. And as Rahl likes to say, "We have a once-in-a-lifetime crisis every three or four years."
Participants in credit derivative and CDO markets, of course, have their own view. Some say that all the risks of these instruments are well known, that risk management systems are adequate, and that critics simply don't understand the new instruments. "People are naturally afraid of new innovations," says a market participant. "They haven't taken the time to understand synthetic CDOs."
That last observation may not apply to critics such as the IMF and S&P, but it might with another, unintended party: investors. A Fed official said last month that perhaps 10% of synthetic CDO investors "do not really understand what they are getting into."
The market for synthetic CDOs has certainly grown very large, very fast, but coming up with reliable numbers is chancy, as many deals are done privately and are never reported to anyone. A rough proxy for synthetic CDOs is the figure for credit default swaps proffered by the International Swaps & Derivatives Association and adjusted to avoid double counting. As measured by their "notional" value - the par value of bonds and loans they represent - outstanding credit default swaps have soared exponentially in the past three years. Less than $1 trillion at the end of 2001, they increased more than eightfold, to $8.4 trillion, by the end of last year, adding nearly $6 trillion in the previous 18 months.
Synthetic CDOs and credit derivatives are helping to spread credit risks far and wide, which helps keep the banking system strong. But as in any new over-the-counter market, pricing is all over the lot, a fact that keen-eyed professionals love to exploit. And discrepancies between pricing, hedging, and actual risk may be lodging risk where it isn't currently discernible. "It creates a kind of shell game - you don't know where the credit risk is anymore," says one derivatives analyst.
"Are investors really getting paid enough for the risk?" asks Janet Tavakoli, whose Chicago-based firm, Tavakoli Structured Finance, advises investors and banks and whose latest book, published in 2003, is Collateralized Debt Obligations and Structured Finance. "All of this credit derivative technology allows us to obscure what's really going on."
Reminiscent of the catastrophe that struck California's Orange County when it invested in derivatives in 1994, both cases indicate that many buyers of synthetic CDOs do not have adequate ability to assess risks and prices themselves. "A number of institutions are not so skilled at evaluating the risks, which means that many of the spreads being paid are insufficient," says McKinsey & Co.'s Arno Gerken, who consults for financial institutions out of McKinsey's Frankfurt office. And since the CDOs in both cases were set up before the current synthetic CDO boom, more such lawsuits are probably going to appear in the future.
Wave of anxiety
As a result, some heavyweight organizations have recently issued a series of warnings. In summing up recent financial trends, Rodrigo de Rato y Figaredo, head of the International Monetary Fund, at the beginning of April cited currency moves and the decline of the U.S. dollar as his first concern. Then he stated: "low short-term interest rates are encouraging investors to move out along the risk spectrum in their search for absolute or relative value. The search for yield has contributed to the compression of inflation and credit risk premiums and encouraged the rapid growth of structured products, including credit derivatives. The combination of compressed risk premiums, and the rapid growth of complex and leveraged instruments that lack transparency, is a potential source of vulnerability that merits attention."
Four days later, Gerd Hausler, who heads the IMF's international capital markets division, followed suit in remarks at the Bank of England. After noting a number of factors that could cause bond yields to rise and credit spreads to widen, he zeroed in on liquidity risks that could exacerbate losses in the credit markets. "The liquidity risk is particularly acute in all areas with narrow markets,' but particularly relevant in the area of complex and leveraged financial products, including credit derivatives and structured products such as collateralized debt obligations." Hausler then ticked off several specific problems, such as pricing anomalies, the opacity of the market, the fact that risk management systems have "not been through a live test," and whether counterparties would hang in and absorb the shocks if investors suddenly all "rush to the exit at the same time."
During the same period, S&P, considered the most skeptical of the rating agencies about CDOs, warned that the same corporate credits are reappearing in CDOs, an "overlap" that suggests insufficient diversification and increased systemic risk if one or more of those companies defaults. A week later, Michael S. Gibson, the U.S. Federal Reserve's chief of trading risk analysis, weighed in with yet another concern. "What we are hearing from market participants is that there is a minority of CDO investors - perhaps 10% - who do not really understand what they are getting into."
But the knee-jerk defense of some market participants - that those who fear innovations such as synthetic CDOs don't truly understand them - hardly applies to the Fed and the IMF, both of which are beneficiaries of an excellent study done under the auspices of the Financial Stability Forum. An international group whose members include both the IMF and the Fed along with 23 other financial authorities, from the Bank for International Settlements and the World Bank to the European Central Bank, the FSF is chaired by Roger Ferguson Jr., who is also vice chairman of the Fed's board
The FSF study is by far the best elucidation so far of the market for synthetic CDOs. It carefully steers clear of any alarmist language, and in many ways it counters some prevailing anxieties. For instance, the study finds no "evidence of hidden concentrations' of credit risk," except perhaps at the monoline insurers, that provide credit guarantees and presumably know what they're doing. But the study does highlight 29 specific areas of concern, from possible market illiquidity and overconcentration of market making in a few Wall Street banks to untested assumptions in risk models and an overreliance on credit ratings in lieu of investors' own risk analysis.
Insufficient risk analysis is at the heart of the pricing anomalies in synthetic CDOs and credit default swaps, and stories abound about pricing discrepancies. For instance, many buyers don't understand that a credit swap premium or the coupon rate on a CDO tranche is negotiable.
"There's a lot of give [in pricing]," says Tavakoli of Tavakoli Structured Finance. She tells of wanting to buy a senior tranche rated triple-A, but she felt the subordination was insufficient to warrant the triple-A rating. "I said, this wouldn't merit a triple-A by Moody's [Investors Service],' and the salesman said, well, if you want more spread, you can have it.' I said, yes, but I would want the spread at a double-A' - that is, I wanted a higher coupon rate. And he said, you can give me a bid at a double-A level." She advises clients to be tough on pricing.
Tavakoli also advises clients not to rely blindly on credit ratings. "The rating agencies have a hard time keeping up with the new products that we're creating," she says. "They do their best. But even if they did keep up, the rating agencies themselves have different ways of looking at the credit risk. So you'll often find that Moody's, S&P and Fitch [Ratings] have systemic differences between each other. It's wise for investors to educate themselves well on what those differences are and what price they should ask for."
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