Center of a Storm: How CDOs Work

Center of a Storm: How CDOs Work Mortgages are among the most widespread and simple forms of financing. How did a bunch of home loans caused the crisis that has gripped Wall Street for more than a week? Two BSC hedge funds bet heavily in complext financial instruments known as CDO, which performed poor when home-loan borrowers defaulted in record numbers. But fund's problem quickly developed into a broader market issue. Fear grew that other investors could suffer, causing a ripple that could crimp lending and curtail the flow of borrowed money that has fueled rallies in a variety of financial markets. What exactly are CDOs, the structures at the root of the angst. They are financial vehicles that bundle different kinds of debt -- ranging from corporate bonds, to securities underpinned by mortgages, to debt backed by money owed on credit cards -- and cut it into slices. These slices are sold to investors in the form of bonds. While the slices contain the same debt, they differ in terms of which pay the most interest and which are least at risk of losing money. Slices that pay lesser amounts of interest are the last to get wiped out by losses if there are defaults in the debt pooled in the CDO. Slices that pay more feel pain more quickly. In other words, the CDO slice with the lowest yield is at the front of the line on payday, but at the back of the line when pink slips are handed out. At the same time, CDOs use borrowed money to amplify returns. Fans argue that CDOs allow investors to buy into higher-yielding securities while taking on the same risk as they would with safe, lower-yielding securities. They also say that CDOs are another tool that allow financial markets to further spread risk so it isn't concentrated in the hands of a few players. But some investors think CDOs are an example of financial engineering gone haywire. CDOs are "more sleight of hand" than a sound way to generate diversified returns, said Brad Alford, founder of Alpha Capital Management, an Atlanta-based investment advisory firm that caters to wealthy families. "They're a method for Wall Street to repackage securities as a way to make more money." Indeed, Wall Street has made millions of dollars in fees in recent years by creating CDOs, selling them, servicing them and helping investors trade them. The vehicles are generally used by institutional investors, such as pension funds or hedge funds, not individual investors. CDOs have generated debate because they are complex, and pose a risk because they are several steps removed from the actual asset, or debt, that is being packaged. Consider a mortgage. Jane Sixpack borrows $100,000 from a bank to buy a house. The bank then pools Jane's loan with thousands of other mortgages. It then issues securities backed by this pool and sells those to investors. Jane keeps making her payments to the bank, but her mortgage is now owned by investors. An investment bank creates a CDO, which is really just a company. The CDO then buys some mortgage-backed securities, one of which holds Jane's loan. The CDO then pools these with other mortgage-backed securities and maybe some corporate bonds, slicing them up based on investor preferences for yield versus risk. The CDO manager sells portions of the package to other investors. In some cases, other CDOs are the buyers. There are even CDOs comprised of CDOs that have invested in CDOs. The bundling of different debts, along with the fact that the CDOs are a few steps removed from the debts they include, give rise to another risk. It's tough to get an accurate price for CDOs, which don't trade in active markets. When markets sour, the lack of available prices can make it even more difficult to value a holding, or to get out of it without taking a big haircut. So investors often have to estimate the value of a CDO and have a lot of leeway in how they do it. That's a worry for investors in hedge funds, big buyers of CDOs. Hedge-fund managers make most of their money through performance fees. This gives them added incentive to use price estimates that work in their favor, even if they might not reflect the price at which they could actually trade the CDO. Or it could mean that the managers themselves don't know exactly what their holdings are worth, because they are so far removed from the underlying investment. In the case of Jane's loan, that means the CDO buyer will have a tough time gauging whether she's a good risk or not. And if she defaults, it may take a while before that affects the value of the CDO, even though market conditions overall might have already changed.