An Important Crossroads For CDOs

by: Accrued Interest

We've spent a lot of time talking about the CDO market, mainly because its one of my favorite subjects. (Click here for a primer on how CDOs work.)

We stand at an important crossroads for CDOs. Banks, brokerages, and investors of various types have been hit hard by poor performance in the CDO product. I am on record as saying that CDOs were a primary source of helium for the housing market bubble. And yet I stand before you today to say that the CDO product is ultimately a positive for the economy. If we can figure out a way to eliminate some very deep and yet very solvable problems with how CDOs are structured and marketed, CDOs can be a source of liquidity and a very appropriate vehicle for various investors.

So this will be part one of a indeterminate series of solutions to the problems in the CDO market, and by extension, the ABS market. I don't want to spend a lot of time talking about what's gone wrong in the CDO market, because that's been pretty well covered. Also, I know that some of the solutions proposed below could not be implemented over night. Others would require investors to start demanding certain concessions from CDO arrangers. But hey, the beauty of the blogosphere is that an arrogant jerk like me gets a forum to preach his message. So here it goes.


The beauty of securitization is that risk becomes dispersed, as opposed to dangerously concentrated in a few places. The downside is that it creates a disconnect between the initial decision makers on a risk and the ultimate bearers of that risk. In subprime loans, mortgage originators had no apparent incentive to make good loans as long as they knew they could sell the loan into a pool. The same would hold true for commercial loans. As long as the bank assumes the risk can be passed on to someone else, what's the motivation to make good loans?

There is a relatively simple solution here. Force loan originators to retain more risk. This could be achieved in a variety of ways. It should be noted that MBS originators generally retain a certain amount of risk, called the servicing spread, which is usually on the order of 50bps of coupon. In essence that means that when the loan is sold into a pool, the originator gets the PV of the loan's cash flows less 50bps of interest. In total dollar terms, that usually amounts to something like 2-3% of the loan's overall risk being retained by the servicer.

But here is the problem with the servicing spread model. It still allows for woefully undercapitalized firms to remain involved in the mortgage market. An originator like New Century could just keep pumping out enough loans to make up for whatever losses it was taking in servicing, or else just sell the servicing rights to a bigger bank. Management just assumed they would personally make enough money to live comfortably regardless of what eventually happened to the firm.

What would have worked better is if originators had to take risk on both the top and bottom of the capital structure. First, you increase the servicing spread to at least 100bps on non-GSE pools. Then servicers would be required to write a letter of credit on the senior-most tranche of the pool. A letter of credit (LOC) is in essence a guarantee to pay principal and interest if the pool defaults.

The result of this is that investors in so-called low risk tranches would become more aware of the credit worthiness of the originator. Investors would invariably prefer higher-rated originators over lower-rated ones, because the LOC attached would be more valuable. This would either force the lower-rated originators to improve their capital situation or get out of the business. This would also force originators to put their own necks on the line when it came to the pools they originate. Investors would have more confidence in the whole system, since they know that the originator is standing behind the loans they make. The originator's incentives are aligned with the investor.

The same concept could be applied to the non-residential ABS, where the structure could be exactly the same. In the bank loan world, the loans aren't typically tranched prior to being put into a CLO. But banks could still retain more of the loan as a "servicing fee" which would improve the alignment of risk.

Here is a modest proposal: the ratings agencies simply shouldn't rate CDOs at all.

Look, its better to know what you don't know than to think you know something that you actually don't know. You know? Basically by rating the senior CDO tranches Aaa/AAA, Moody's and S&P were saying that they knew those securities were very low risk. Too many investors took it as a given that Moody's and S&P understood the risks embedded in these structures. Now its clear that basically no one fully understood how quickly subprime lending could all fall apart. Its time for a little humility in modeling. Yes, Monte Carlo simulation is the best way to analyze CDO pools, and the 2007 experience will undoubtedly allow the quants to build better simulations. That's all fine. But let's face it, a model is just a model, it can never incorporate all the complexities of real life markets.

So if the ratings agencies would simply admit this, then investors would go into CDO investing knowing what we don't know. That isn't to say that the ratings agencies would have no role in the CDO market. They could provide independent information on the deal's legal elements and opine on the deal manager's qualifications. This would be quite useful to investors who generally don't understand the obtuse reams of lawyereese populating offering memoranda, and who don't have the time to do site visits would CDO managers.

Furthermore, the ratings agencies could still model CDO deals in their Monte Carlo simulators for a fee. Investors could then run the Monte Carlo themselves, inputting default and recovery rates, default patterns, and correlation as they see fit. Rather than getting one or two perspectives on what the default/recovery/correlation patterns should be, investors could impose their own stresses. Some of this capability is available on sites like ABSNet, but obtaining access to a deal can be difficult and expensive. It should be where investors can have access to deal modeling in an open and relatively inexpensive manner. The days of information on CDOs being closely guarded needs to end.

Eliminating formal ratings from the CDO world would also foster more competition among those offering credit analysis on a deal. Currently it costs between $500,000 and $1 million to get a CDO rated by both Moody's and S&P. If a CDO arranger only needed to hire one of the two, and the ratings agency merely commented on the perfection of the legal structure, and assured investors that the collateral manager is reputable, I'd say the cost of would drop to less than $100,000. The CDO arranger would then need to find multiple firms to model the deal's cash flow into a Monte Carlo simulator. But this may or may not be the big two ratings agencies. If investors were allowed to personally compare various simulations of a deal's performance, the barriers to entry in the ratings business would plummet. Investors could easily pick out a modeler who was too generous to the CDO arranger, because that model would stick out compared with others. Currently Moody's and S&P basically tells investors to "trust them." If the models were more open and the inputs were modifiable, then we wouldn't need to "trust" anyone. Trust creates a giant barrier to entry. Openness tears that barrier down.

Besides, if a deal really needs a rating, then obtaining either a LOC or insurance policy would be more appropriate. If someone like Bank of America wrote a LOC on a CDO tranche, then the tranche would be legitimately be Aa-rated, rather than having a phantom Aaa rating.

So hopefully this is a start. Look forward to your comments.