CDOs Return

by: Felix Salmon

Accrued Interest has a very good post in defense of CDOs, explaining that they make a lot more sense than SIVs or hedge funds playing in the credit space:

In most cases, SIVs collapsed not because they took on too much in cash flow losses, but because no one would buy their commercial paper anymore. In other words, the SIV arbitrage relied on the continued confidence in the SIV portfolio. Once that confidence was gone, regardless of what was actually in the portfolio, the SIV was toast. The very same thing happened to countless hedge funds and other leveraged vehicles in recent months. Any vehicle that relies on short-term funding is banking entirely on the continued support of short-term investors. Once that's gone, the whole structure is destroyed. A CDO doesn't have this problem. Generally speaking, the funding of a CDO is locked in at issuance.

Let's compare and contrast for a moment. A CDO equity investor, the one who only gets whatever is left over after all debt holders have been paid, is making a highly leveraged bet on credit losses within the CDO's portfolio. But that's the only bet being made. An investor in a hedge fund relying on repo financing is making a bet on both the portfolio and continued access to financing. Why should investors make two bets when they could make only one?

Now might well be an excellent time to start investing in junior or even equity tranches of CDOs: They're paying healthy rates of interest, and the default rates priced in are very high. If you think the credit markets have overshot, then buying CDO tranches is a pretty sensible way of trying to monetize that opinion. Just be sure that you're buying CDOs made up of old-fashioned bonds, and not CDOs made up of much more dangerous things like CDSs. Those can turn very nasty.