Collateralized debt obligations: who's to blame when the market blows up?

• Author: Sumerlin, Marc

Who is to blame? That undoubtedly will be the question we will be asking about the excesses of the current credit cycle. The events of late June show that one of those questions will be why we didn't look more closely at the financial engineering that could take a pile of CCC-grade credits and turn a significant portion into investment-grade securities without reducing the overall level of risk in any material way. Wall Street of course was reacting to a fundamental challenge--and opportunity. Since 2003, the riskless rate of return has been abnormally low as central banks kept overnight rates low for a long time after a brief deflation scare in the United States and a prolonged scare in Japan. With pension funds and other institutional investors needing to hit 8 percent returns in a 4 percent world, the demand for innovation was there. Pension funds had to find a way to take on risk without looking like they were.

What they needed was an asset class with low volatility. Low volatility produces all kinds of good results from traditional ways of analyzing financial products, and provides good marks from the ratings agencies as well. Limited transparency and limited market liquidity have often resulted in producing what appears to be low volatility. The illiquidity in the assets requires model pricing, which has numerous subjective inputs. Models are almost inevitably less volatile than reality because it is difficult to factor in gap risk and behavioral response.

Models have the added advantage of no one actually having to put up their own money. Indeed, there is a widely circulated story of an old-timer in the market who was putting in a particularly low bid on an illiquid and new-fangled derivative security. The seller of the security, who doubtless was a quantitative wiz compared to the old-timer, argued back that his model said that the security was worth so much more. The old timer's response: "Then sell it to your model."

Once a product's price has low volatility, Wall Street can simply apply leverage to produce what looks like very high, very attractive risk-adjusted returns. The final step in this process is to add opacity by allowing the products to be managed after they are sold so that the investor never knows exactly what collateral is behind the structure. It is alchemy at its best, and it is called the Collateralized Debt Obligation market.

The investment banks and rating agencies involved in selling these products were able to...