Warren Buffett on the Credit Ratings, CDOs and Mortgage Backed Securities, Debt & Equities

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• published: 22 Aug 2013
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Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed-income underlying assets. CDO securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk. CDO can be created as long as global investors are willing to provide the money to purchase the pool of bonds the CDO owns. CDO volume grew significantly between 2000--2006, then declined dramatically in the wake of the subprime mortgage crisis, which began in 2007. Many of the assets held by these CDOs had been subprime mortgage-backed bonds. Global investors began to stop funding CDOs in 2007, contributing to the collapse of certain structured investments held by major investment banks and the bankruptcy of several subprime lenders.[1][2] A few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that CDOs, other asset-backed securities and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the subprime mortgage crisis in 2007, this view has gained substantial credibility. Credit rating agencies failed to account adequately for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs with the highest possible grade. Many CDOs are marked to market and thus experienced substantial write-downs as their market value collapsed during the subprime crisis, with banks writing down the value of their CDO holdings mainly in the 2007-2008 period. The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation on June 22, 1990.[3][4][5] A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles. CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Economist Mark Zandi of Moody's Analytics wrote that various factors had kept interest rates low globally in the years CDO volume grew, because of fears of deflation, the bursting of the dot-com bubble, a U.S. recession, and the U.S. trade deficit. This made U.S. CDOs backed by mortgages a relatively more attractive investment versus, say, U.S. treasury bonds or other low-yielding, safe investments. This search for yield by global investors caused many to purchase CDOs, trusting the credit rating, without fully understanding the risks.[6] CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDOs declined from 2000--2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets; yet the credit ratings of the CDOs did not change.[7] In addition, financial innovations such as credit default swaps and synthetic CDOs enabled speculation on CDOs. This dramatically increased the amount of money that moved among market participants. In effect, multiple insurance policies or wagers could be stacked on the same CDO. If the CDO did not perform per contractual requirements, one counterparty (typically a large investment bank or hedge fund) had to pay another. Michael Lewis referred to this speculation as part of the "Doomsday Machine" that contributed to the failure of major banking institutions and smaller hedge funds, at the core of the subprime mortgage crisis.[8] There are allegations that at least one hedge fund encouraged the creation of poor quality CDOs so bets could be made against them. http://en.wikipedia.org/wiki/Collateralized_debt_obligation