The 1980s brought
about the so called ‘tranching’ structure in home mortgages which was so
successful that it encouraged the introduction of Collateralised Loan
Obligations- beginning, simply, as pools of mortgages, tranched to appeal to
different types of investor. CLOs are a form of derivative in which payments
from ‘middle to large sized firms’[i] loans are pooled together, and then
redistributed to different owners in ‘tranches’. These tranches (coming from
the French, ‘tranche’-slice) are similar to bonds in that they are small pieces
of an establishment’s debt that can be higher risk with higher ‘coupons’ or
‘senior claim’ levels, or be lower risk with lower senior claim levels- this
process is called senioritisation.
The risk, in the case of CLOs (and other types of Collateralised Debt
Obligation-CDO) is in the establishment defaulting on their loan. With a CLO,
however, in the case of a firm that was already at high risk of defaulting, a
default would lead to a much larger effect on those who own higher coupon CLOs.
There are a number
of problems with CLOs, and derivatives in general, which shall not be discussed
until the question of ‘Why?’ is asked. Why should people invest in CLOs? CLOs
can offer an alternative for those who do not wish to buy bonds, or preferred
stocks especially for those to whom debt and equity is of interest. CLOs, can
also offer a way for investors to balance their portfolio of derivatives at a
lower cost, much like a security-backed Mutual Fund would do for an investor in
the stock market. They also allow those who want to have their portfolio in the
middle-ground between high-risk and low-risk as there are still tranches that
will be rated at BBB rating- in the same sense, this type of security can offer
more or less security in its different tranches. Another benefit to these is
when fungible assets are included in the leverage positions and their
amortization, but the fungible assets actually turn out to be over-valued: this
can mean that the higher coupon for the higher risk that comes with greater
leveraging was actually an overestimation. Due to this over-estimation,
investors can gain larger returns for a lower risk: Warren Buffet is an example
of an investor, renowned for his eye for solid investment opportunities, who
purchased a CLO, through Berkshire Hathaway. These types of transactions also
helped develop the market for CDSs (Credit Default Swaps), and CLNs (Credit
Linked Notes). CDSs are a form of insurance that can be taken out against bonds
taken from the coupon value that insure that the premium is fully paid upon
maturity, even if the bond is defaulted against- these feature in what are
known as ‘Conventional CLOs’. Synthetic CLOs are those which are transferred to
a third party in return for a CLN- a CLN is another type of security by which
investors take on a higher risk for the direct obligation of the issuer as it
essentially has a CDS integrated into it.
In the case of
those that were distributed before the crash of 2008, they were not perceived
as at all risky and an opportunity with relatively low risk and high gains is
one that very few speculators will pass up. The majority of these CLOs were
highly rated because of a compound error that had occurred due to a slackening
of the regulations and standards among crediting agencies such as Moody’s and
Standard and Poor’s for large companies simply taking out loans, their risk was
underestimated, causing the overall risk that each CLO would take on. On top of
this, the rating of each of the individual tranches’ risk - due to that same
fall in standards- was underestimated- thus, even extremely high-leverage
positions would be seen as relatively low risk of defaulting. Further to this,
Felix Salmon pointed out, in 2007, in an article for The Economist[ii] that many CDOs and CLOs actually had stakes
in other derivatives of varying risk, thus adding a third layer to compounded
problem. This meant that, when a loan that would have been a larger proportion
of the lower-risk tranches fails spectacularly, the more ‘conservative’
investors would be at a loss. The main problem with this is that conservative
investors like the ‘Grahmites’ pension fund managers, and if these people lose
money, they will probably lose vast sums due to their huge portfolio sizes.
Also, because these CLOs can be extremely wide reaching: Alan Greenspan
(Chairman of the Fed until 2006) said that, these complex derivatives spread
the risk throughout the globe, and Buffet retorted in asserting that they
connected the solvency and risk of people across the globe, rather than
concentrating it in central banks- this was the catalyst to the downturn. He
believed that if Bear Stearns did not have a “derivatives book, my guess is the
Fed wouldn't have had to do what it did”.
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