The Wrong Incentives Killed CDOs, But CLOs Will Live On

by: Prince of Wall Street

An interesting article by Vipal Mongra, entitled "In death, afterlife", appeared in The Deal on Monday speculating about the future for Collateralized Debt Obligations [CDOs]. In the article Messieur Mongra speculates how CDOs may fare in comparison to other products/strategies that were pronounced dead, only to rise again from the ashes. Most notably, the article points out how wrong many prognosticators were when they predicted, based on a wave of corporate defaults and broken deals, that LBOs and junk bonds would be gone forever. The tone of Mssr. Mongra’s piece seems to suggest that once this turmoil has passed, mortgages will begin to be repackaged under a different name than CDOs, then sold to investors. The Prince must mostly disagree with this prediction. The best quote in the article must go to an unnamed originator of structured finance vehicles:

"I firmly believe that you’ll never see a CDO of asset-backed securities again but I also firmly believe we’ll eventually see another repackaging of mortgage-backed securities. It just won’t be called a CDO."

Well of course he or she is going to say that. This person may not have a job in a few months if he or she believes differently. The Prince is now going to touch another assertion made in the article.

In fact, one can argue strongly that the CDOs at the heart of the crisis are not even necessary to the functioning of the mortgage markets. "The reality is that [mortgage-backed] CDOs never had to exist," offers one debt investor.

This comment seems suspect since it is hard to believe that all those subprime, state income, NINA, etc. borrowers would have been able to get into houses, if the mortgages were not going to get repackaged into MBSs, which would then by bought by CDOs.

The Prince in all his posts related to mortgage securities and the credit crisis has consistently focused on incentives and the behavior they elicit. Before we turn back to the future prospects for CDOs, let’s take a detour to worship at the altar of The Prince’s favorite blogger, Equity Private of Going Private. This was the first financial blog that the Prince began to read religiously. Equity Private’s focus on deconstructed situations based on incentives consistently yields interesting insights. For recent proof of his focus on incentives, check out this excerpt from his recent post lambasting Sun Capital’s overreaching:

The reality is that firms like Sun have been victims of their own overreaching and the nature of the incentive structures and fund raising cycles in private equity. Given my views on the nature of human nature…

Man is basically lazy. Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence of self-destructive behavior). Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.

…even the novice Going Private reader will understand my focus on incentive structures (both designed and resulting from unintended consequence) and the behaviors that they, well, incentivize. As such, it should be easy to see why the only prompting I need to start shaking my head is the "management fee" section in Sun Capital Partner’s Private Placement Memorandum.

The existence of CDOs provided incentives to parties at all levels of the mortgage industry to make decisions that have now led to our capital markets being undermined.

Let's start with the originators

Consider our first part in the chain of the mortgage industry’s industrial organization: the broker/wholesale originator. The existence of Wall Street banks hungry to buy mortgages from these originators to repackage into MBS or into CDOs, created incentives that gave originators every reason to say yes to prospective borrowers and no reason to say no. The existence of someone else to pass the risk onto of loans made with poor lending standards gave originators no reason to say no. At the end of the day, if the quality of the loans was awful the originator would not be on the hook and would most likely have no skin in the game. CDOs created incentives for mortgage originators to be accomplices to blatant fraud on loan applications, occupancy fraud, the creation of Option ARMs, and the creation of stated income loans among many other faults. It is not surprising that it was hard to hear the voice of common sense when the chant of "Close’em Close’em Close’em" is filling many of the chop shops that originated these subprime loans. However, The Prince strays with that last comment since human beings don’t follow common sense, they respond to incentives.

Consider the second part of our chain: the investment banks and the rating agencies. The only way they were going to make money here was originating CDOs full of loans they had bought from originators. They would then collect the management fees for these CDOs. The rating agencies rated the top tranches AAA so many of the investment banks thought that a good size chunk of that tranche should not be originated but held on their balance sheets. The rating agencies had no incentives to probe CDO issuance deeper because they were not going to be financially harmed by their ratings being wrong. The only thing the ratings agencies stood to lose by not doing their homework was some credibility if their ratings proved to be faulty. It is difficult to weigh the value of this credibility in an industry so uncompetitive that it only has three market participants (but that is a different post on a different day). Wall Street banks had every incentive to believe the ratings that their CDOs were getting stamped with because investors bought up the debt based on these ratings. What did the banks care? They were going to get rid of these toxic mortgages by selling the various tranches to investors that were hungry for yield, while keeping only the most senior tranches for themselves. The Prince is sure many a structured products salesman used the sales pitch, which is very similar to the junk bond sales pitch invented by Michael Milken, that by combining many poor credit quality mortgages into a CDO, the investor could earn a good return based on how much risk they were willing to take. This is the case because surely not all the mortgages will default. Well now we see the AAA section of the ABX trading at 65-70% of par. That sales pitch seems laughable in hindsight.

The role of the sophisticated investor

Finally we come to our final link in the chain. The institutional "sophisticated" investors that bought CDOs. Investors had every incentive to satisfy their clients by earning superior returns in a low return environment. CDOs offered such an opportunity to earn high returns and select the level of risk that the investor was comfortable with. Investors took comfort in their belief (or the salesman’s pitch) that diffusion and portfolio diversification had ameliorated risk. There were other misconceptions out there. For example, Keith Styrcula, chairman of industry group Structured Products Association, says, "The triple-A rating lent the impression that the underlying assets [the mortgages themselves] were also triple-A." Furthermore, we had SIVs buying these assets by borrowing short-term and lending long-term through the purchase of CDOs. The managers of these SIVs though had very little incentive not to pursue this over-leveraged strategy, since their holdings were not on the balance sheets of their banks, and they were operating with relatively little oversight. If anything is going to change in this market, it is that investors will take away some of the agency of CDO managers. Investors will tighten controls on managers investing their money. In most CDOs, managers had five-year windows to trade securities in their portfolios. This allowed the managers to sell defaulted bonds for new ones that were better-performing. This was all done to supposedly maximize gains for investors. In practice this meant investors could not be sure of what was exactly backing the CDOs, as their managers shifted investments. Investors didn’t do their homework on the credit quality of the mortgages that composed the tranches of the CDOs they were buying, because they did the lazy/easy thing and just believed the rating agencies. Investors pursued the behavior of buying CDOs for their high returns, because that is what the incentives they were facing suggested. When it turned out that the risk borne by the tranches they bought was much higher than they estimated, they found little comfort in the banks' and ratings agencies' simply saying, "We made mistakes."

So basically every party in the mortgage industry followed the behavior that their incentives dictated. By behaving in this way, they all led us to the mess we currently face. If the incentives that drove the behavior of the actors in the mortgage industry remain unchanged, then The Prince will guarantee that CDOs or CDO-like instruments by another name will never rise like a phoenix from the ashes.

Now CLOs are another story. Over the summer many CLOs were forced to sell corporate bank debt and high yield debt they owned (mostly related to companies that were taken private) to meet margin calls on the mortgage assets they held. CLOs were the largest demanders of buyout related debt issuance. In fact, CLOs represented almost two-thirds of primary demand for loans in the syndication market over the past three years. They have been absent from the market since the turmoil began this summer. CLOs will come back because the leveraged loan and high yield corporate debt markets have properly aligned incentives, but are merely going through a repricing of risk right now. Investors in these forms of debt are pushing back against the buyout shops and taking aim at the covenant lite/PIK toggle terms of these debt instruments that made them very unappetizing for investors. There is also certainly a level of contagion going on in the leveraged loan market as well. Many firms that own buyout related debt may be selling this debt, not because they think it has become less valuable, but because they must meet margin calls on their mortgage related portfolios.

The Prince also believes that since most PE shops got such great terms with wide covenants and PIK toggle characteristics, that we will see less corporate defaults by sponsor-owned junk-rated companies during this cyclical downturn than in past downturns. To distinguish CDOs from CLOs we need look no further than the fact that CLOs have continued to return money to investors, as the rate of corporate defaults has remained below the 4% historical average. So CLOs have not had to write down the value of their portfolios, since they operate as cash flow vehicles. Another good example, is the fact that CLOs only buy loans as primary purchasers of whole loans offered by banks that lend to companies or sponsor-owned companies. CLOs do not buy repackaged securities like CDOs did when they bought MBSs. The leveraged loan and high yield debt markets are discounting these securities in anticipation of much higher defaults than The Prince sees on the horizon. There are probably some good deals available in these two markets for long-term investors, if the investors know the credit of the underlying company very well and believe that they will get their payments without a default. Much of this paper is trading so far off of par that The Prince finds it difficult to think of adverse scenarios in the future which could justify these prices. CLOs will return, especially those that mainly focused on buying buyout related debt. The incentives which drive the players in the CLO space are appropriate, but those that drove CDOs could only lead to ruin. Let’s just hope the destruction wrought by CDOs doesn’t continue to have knock on effects throughout other parts of the credit markets.