Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

The CDO’ization of everything

Six years ago, when the global financial crisis began, Collateralized Debt Obligations (CDOs) were regarded as the villains that were the source of all problems. Today, the clock has turned full circle, and CDO like structures have become the solution to all problems.

  • All government rescue packages around the world were structured like CDOs. The typical recipe was as follows: all problem assets were pooled into a CDO like structure (for example, Maiden Lane); the pool was tranched; the beneficiary institution held the equity tranche (first dollar of loss subject to a modest limit); and the central bank or government held the senior piece. The toxic assets disappeared from the balance sheet of the tottering TBTF institution which therefore became solvent (or a little less insolvent). The central bank then embarked on unconventional monetary policy actions that boosted asset prices and ensured that the senior piece became worth par.
  • The same strategy was adopted for dealing with sovereign debt crisis in the eurozone. The European Stability Mechanism (ESM) like its predecessor the EFSF, was a CDO like structure that received a AAA rating because of over collateralization though its sponsors included a number of beleaguered nations whose creditworthiness was hardly pristine.
  • Of late, the strategy has been adopted retrospectively to failing institutions in Europe. Post facto, banks have become CDOs with lower tranches being written off in typical CDO style without a formal bankruptcy process. The Dutch bank SNS Bank (and SNS Reaal) were turned into CDOs by government decree overnight. On January 31, 2013, you might have thought that you had lent money to SNS Bank; on February 1, you were told that you were actually holding a tranche of a CDO, and that this tranche has now been written down to zero (The decree actually called it expropriation). Meanwhile, the bank continued to operate normally and the depositors were fine because they were holding a senior tranche that was still unimpaired.
  • The strategy has been pushed even further in the Cyprus package. In this case, the depositors were told that their tranche was also impaired.
  • The clearing corporations that were the oases of stability during 2008 have also joined the game. They are now openly saying that their obligation to guarantee all trades is not really a guarantee anymore. If your trade has been novated by the clearing corporation, then you actually hold a highly senior tranche of a CDO: if the losses eat through all junior tranches, then first your mark to market gain will be haircut, and if that is not enough then your contracts will simply be torn up at some settlement price that ensures the continued solvency of the clearing corporation. After that, the clearing corporation will continue to operate normally. The Bank of England recently published a Financial Stability Paper entitled “Central counterparty loss-allocation rules” by David Elliott which describes in gory detail how far this process has progressed around the world.

The biggest innovation in the CDO was actually a contractual bankruptcy process that is lightning fast and extremely low cost (see my blog posts on the Gorton-Metrick and Squire papers that argue this in detail). The world is gradually coming around to realizing that normal bankruptcy does not work for the financial sector and the contractual CDO alternative is far better. In 2006, I wrote that the invention of CDOs has made banks and other legacy financial institutions unnecessary. The crisis seems to be turning that speculation into reality.

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2 responses to “The CDO’ization of everything

  1. Gopal Balakrishnan May 17, 2013 at 11:51 pm

    Sir, when we talk about various types of investors in any company whether its a preferential share investor or an investor in equity without voting rights or a bond investor there is already an underlying acceptance of the risk to loses being different for each class.

    So in a way even before CDOs became fashionable the tranches were already in place.

    Is your argument that since the new reality that even government bonds are not really risk free any kind of guarantee even if it is government made is more like a senion tranche in a CDO rather than an guarantee?

  2. Jayanth Varma May 20, 2013 at 12:16 pm

    The key difference that I see is the ability to bypass the normal bankruptcy process and writedown tranches automatically. Corporate equity of an insolvent company is worthless, but it takes a bankruptcy court to write it down to zero. In a CDO, it is automatic.

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