Monday, October 14, 2013

Collateralized Debt Obligations - A Hard-Learned Lesson for Wall Street

Remember collateralized debt obligations or CDO's.  They're back!

These toxic gems, spawned by the creative minds of Wall Street very nearly brought the world's economy to its knees back in between 2007 and 2009.

Wall Street bundled together assets consisting of many different types of loans, ranging from aircraft leases to auto loans to credit card loans to residential and commercial mortgages, each with their own level of risk and reward (interest yield).  Boosting the entire game was the decline in interest rates in the mid 2000s; fixed income investors including individuals, governments and pension and investment funds who wanted higher yields than what government bonds had to offer were clamouring for something that would provide a reasonable return.  Somehow, even though many of theses CDOs contained high risk/low collateral mortgages aka subprime mortgages, the issuers managed to cajole credit ratings agencies into assessing many of these securities as AAA.  Those tranches that received lower ratings were often rolled into other CDOs, compounding the problems that eventually caused the near collapse of the world's economy.  According to the Federal Reserve Bank of Philadelphia, total write-downs on CDOs will be in the neighbourhood of $420 billion or 65 percent of the original issuance.

So, has a chastened Wall Street learned its lesson?  Apparently not.

Here is a bar graph showing the growing volume of CDOs issued since the obvious collapse in 2008:

From its 2007 level of $481.6 billion, global CDO issues fell to $4.336 billion in 2009 as investors soured on what turned out to be a terrible investment.  That's a drop of 99.1 percent!

That said, since 2009, the global issuance of CDOs has started to creep back up again as Mr. Bernanke's Grand Experiment with zero interest rates has slaughtered returns on fixed income investments.  Since its nadir in 2009, the issuance of CDOs has risen back up to $62.335 billion in the first three quarters of this year.  If the quarterly trend experienced during the first three quarters of 2013 continues, there will be roughly $83 billion in CDOs issued in 2013, a rise of 43 percent from 2012 and 1910 percent from its nadir in 2009 as shown on this graph:

While the volume of CDOs in 2013 is still tiny compared to what was issued in 2006 and 2007, the trend looks good for Wall Street and bad for Main Street.

Back in January, according to Bloomberg, Deutsche Bank of Germany issued $8.7 billion worth of CDOs yielding between 8 and 14.6 percent depending on the degree of risk that investors were willing to take.  That's a huge jump in yield compared to the measly 2 or 3 percent on Treasuries (which aren't looking quite as risk-free as they used to!)  With a yield like that, you can see why CDOs are so tempting to investors.  Deutsche Bank was using the funds raised through the sale of the CDOs to boost its Tier 1 capital ratio.

While the new issuance of CDOs has not reached anything close to the dangerous levels seen in the mid-2000s, the growth trend is suggesting that at some point, the global economy could be in for round two of the crisis.  At the very least, Wall Street certainly leaves us with two impressions; one, that we'll find them wherever there's and two, that they never learn from the painful lessons of the past and that they are only too willing to create another crisis that may require a bailout.

1 comment:

  1. They should have never been bailed out in the first place.