However, once you start to incur a loss on a CDO position, it can become very
severe very quickly, Adelson says. Therefore, investors should not assume that a
CDO tranche rated, say, BB, carries the same risk as a company with the same
credit rating. The two behave very differently under stress. “It’s more of an
all-or-nothing bet.” (Click image to enlarge)
The challenge lies in determining just how risky this bet actually is. In the
case of a CDO exposed to corporate collateral, for example, the risk depends on
how closely the credit qualities of the underlying companies move in line with
each other—in other words, how correlated they are. Measuring something as
esoteric as corporate credit correlation is extremely difficult and somewhat
subjective. “There are people who spend a great deal of time trying to assess
those correlations, and some do it well and some do it less well,” says Dean
Smith, New York–based portfolio manager with investment company Highland
Financial Holdings.
As CDO markets have matured, so too has the complexity of the products on offer.
For the last several years, the biggest growth area has been in synthetic CDOs,
which are backed by a pool of credit derivative exposures to companies, rather
than by actual corporate bonds. The most sophisticated financial institutions
have developed the ability to create just a single, tailored tranche of such a
synthetic instrument in response to an investor’s specific needs, obviating the
need to build an entire CDO capital structure and finding investors for all the
other parts. These single-tranche synthetic CDOs were among the instruments that
hurt the hedge funds exposed to GM and Ford. While banks have been churning out these instruments on a regular basis for
private investors for the past two years or so, some experts say caution is
warranted. “If you are not experienced and resourced to participate as a
professional, then you will regret it,” Dickey warns. The exposure of most private investors to the synthetic CDO market will most
likely be indirect, via investment in hedge funds. But as events earlier this
year showed, the market is so unpredictable that even these supposedly savvy
operators can take a hammering in it. Ultimately, those private investors
considering an investment in CDOs, and especially in single-tranche synthetic
CDOs, must seek out the most experienced advisors possible, and should bear in
mind that the sheer complexity of many of these instruments means that even
top-flight advisors may not fully understand their risks. John Ferry is an Edinburgh, UK-based journalist who specializes in writing about
financial markets and investments. Additional Information
 A Guide to CDO Structures
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