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| Risk & Reward: Products/Strategies |
On Second Thought...
John Ferry
01/01/2008
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Richard M. Nixon advised that we should never look back. In
this article, we roundly ignore his suggestion and revisit several investment
products and strategies that we critiqued in past issues. Unfortunately, the
street buzz that led us to write about some of these opportunities in the first
place proved premature. The subprime fiasco dampened the performances of most
of these products, causing investors to head for the hills. Yet a few
opportunities continue to hold promise... at least for now.
Original publication dates:
"Risky Business," November 2005 "Gimme Shelter," April 2007
Conventional Wisdom
Then: Hot opportunity!
Now: What’s that smell?
Worth’s first coverage of credit
derivatives and complex structured credit products came with a warning from Marc
Freed, a fund of funds manager and the managing director of New York–based
Lyster Watson & Co.: This type of investing is inappropriate for
high-net-worth investors, he said. He also said his firm does not invest in
hedge funds that are heavily involved in structured credit because it perceives
them as "illiquid in difficult markets."
After the summer of 2007, that reads as prescient advice.
Complex structured credit products and their various spin-offs
were at the heart of the financial crisis that erupted last summer. One of the
first signs of stress in the market came from funds that had borrowed money to
invest in collateralized debt obligations (CDOs), which are used to create
credit products. Some CDOs were exposed to repackaged subprime mortgage loans
that were in trouble.
CDOs and other structured credit products pool a number of
individual credits before repackaging them and selling the redesigned bonds to
investors. The CDO takes the aggregated risk of all its credits and slices it
up so investors can buy different classes—known as "tranches"—of securities.
Within a CDO structure these various classes come with different seniority
relative to other classes, so that, for example, a "senior debt" tranche will
be assigned an AAA ranking by a rating agency. This means it is considered
very safe relative to tranches lower down on the capital structure, which are
the first to absorb any losses should the underlying credits start to default.
Buying into collateralized debt obligations at levels lower down the capital
structure creates successively riskier investments.
As the CDO market got bigger and more sophisticated, banks put
together investment structures that referenced credit default swaps, a type of
credit derivative, instead of actual cash bonds. These "synthetic" structures
have an advantage for the CDO issuer in that just a single tranche can be
tailored and sold in response to investor demand, rather than an entire capital
structure. The advent of synthetic CDOs fueled the rush to securitize and
distribute credit risk. Structured credit products became extremely popular,
particularly among institutional investors. Their appeal lay in what seemed
like relatively high coupon payments for the perceived risk.
However, this appeal evaporated as subprime default rates
increased. At that time, there were two major problems. First, because subprime
debt had been sliced, diced, repackaged and sold so many times, no one was quite
sure where much of this risk ultimately lay. Second, investors wanted to know
how much their CDO investments with subprime exposure were worth. But because
CDOs are only thinly traded, there is no real market price for them.
In order to assign value to the debt, rating agencies, banks
and hedge funds put together models to estimate the worth. In the trade, this
is known as "marking to model" rather than "marking to market." Marking to
model has suddenly become very controversial because the rating agencies
actually sell ratings for CDOs. Because of this, some experts believe that there
is an inappropriate incentive for the agencies to give high ratings. In the end,
the lack of transparency and uncertainty surrounding CDOs caused the complex
securitization industry to go into lock-down mode, which resulted in CDO
structurers suffering a crippling loss of credibility.
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