Collateralized Debt Obligation (CDO)

Today I was watching the questioning of Credit rating agency chiefs by the Congress members. They had to justify on why the rating calls could not pick up bad instruments much before the system collapsed. All I heard was diplomatic answers to the questions from the members of the congress. None of the answers would conclusively result in solutions to avoid such events in future.

While hearing all of this, there is one more instrument, which is Collateralized debt obligation (CDO) which could result in the ripple effect from the failure of a Credit Default Swap (CDS). A CDO is an instrument where debt of firms is clubbed together. What makes this instrument sweeter is the was in which they are packaged; the debt of 100 or more companies is clubbed together such that the companies with a higher default risk are compensated by companies with lower ones. This results in higher credit rating eventually. Wachovia tells Bloomberg that $254 billion worth of CDOs have defaulted so far. Today in the questioning the President of the credit rating agency division in Standard & Poor’s, who joined the firm in September last year told the Congress people that on an average the model of rating of instruments was revised as many as 2.5 times in a year. One could very well infer here that the experts could have caught the bad debt and the resulting systemic collapse well before, as the model would have evolved with respect to changing (deteriorating) economic conditions. Even though these instruments can be very complex in nature, hence difficult to rate; definitely it should not be used as an excuse by people who make a living off rating these instruments. Now a buyer of these instruments has no direct exposure to the underlying debt / loan instruments but relies solely on the ratings assigned to the CDO as a whole and would fail to correctly access his risk exposure.

The banks in Iceland too have been reported to have heavy exposure to the CDOs and it’s sad to see reports such as an entire country going bankrupt. As reported in Bloomberg, Barclays Capital estimates that 70 percent of synthetic CDOs sold swaps on Lehman. So it is not hard to understand what kind of mess Lehman was in. As selling the CDO is relatively simpler due to nature in which they are packaged, the seller normally an investment bank would make a commission. On the other hand it allows firms to pool their debt and hide away their losses. What makes this instrument more prone to failure is the mark-to-market accounting basis. The domino effect would come now as the CDOs have part exposure to fixed income products in the form of a Credit Default Swap (CDS). The CDS mess has already become like a folklore and will be used as case studies in times to come.