More on the CDO Put

I got a couple of great questions in the comments section on the CDO Put and since I'm a lazy blogger, I'll just make a new post out of them.

1) "... isn't it the same as saying that if a stock goes down, then everything else being equal, purchasing this stock at a lower price becomes more profitable, so money will flow to this stock and therefore there is a limit how far it can go down?"

No, because I'm speaking of new CDOs being created, not the price of existing CDO tranches. Also because the CDO Put doesn't really limit downside, merely create strong resistance at a certain point. See below.

2) "the cash flow is unchanged, but the present value of the cash flow (probably) changes (if you discount it at a rate including an appropriate risk spread). Couldn't you say the same thing about a traditional bond -- that the cash flow is unchanged when interest rates rise?"

In a way, yes. But a traditional bond is a single credit, or put more technically, its idiosyncratic risk. A CDO is a portfolio of credits, thus systemic risk. Idiosyncratic risk can rise tremendously, but systemic risk can logically only rise so much.

3) (This is the important one). "If spreads widen, it’s presumably because the price of risk is going up. If the price of risk is going up, then the required return on the very high risk, highly levered equity tranches should go way, way, way up. So the fact that the actual return goes way, way, way up doesn’t necessarily make it a better deal. Quantitatively, it may turn out to be true, given reasonable risk-aversion parameters, etc., that it does become a better deal, but proving that would require a lot of messy math (and a bit of economic theory)."

This is right, and the consequences of what my economist friend is saying is that the CDO Put will only hold so long as it is viewed that default risk is relatively contained.

Let's say that credit spreads generally move 30bps wider, and that improves CDO equity returns by 250bps. The extra 250bps is attractive enough to sell the equity, and certainly CDO managers and IB's are happy to make fees, so the CDO engine revs up and creates new demand for credit, thus preventing spreads from drifting wider.

However, let's say that credit spreads are 300bps wider because there is widespread fear of deflation and accounting fraud (see 2001-2002). CDO equity can't get cheap enough and the CDO engine goes into park.

Witness sub-prime related deals today. According to Merrill Lynch the following are "base case" CDO equity return. This is not the actual return, but more the hypothetical return based on where collateral spreads and debt tranches are. I watch this closely and have come to think of it as the "advertised" CDO equity return. In other words, that's the return a generic CDO "would produce" if defaults come in at a historical average level, and hence indicative of what model returns CDOs are being marketed with.

For Mezz Structured Finance (which are mostly residential MBS), the 2006 average was 11.6%. Today it is 65.4%. Let me say that again.

Today it is 65.4%.

This number is so ridiculous as to be meaningless. It is telling you that one could create a new CDO of sub-prime MBS and if defaults were historically normal and if recovery was historically normal, the equity would return over 65%.

By demanding such an outrageously high base-case return, the market is saying they expect defaults and recovery to be substantially worse than historical norm.

Does this disprove the CDO put? No, it just means there are limits. Once the market is tossing out historical norms for defaults and recovery, the CDO put is no more. That's what's happened in the sub-prime market.

But nothing of the like is happening in the loan market. That's because the broad market doesn't expect a wide contagion from sub-prime. So although credit spreads have widened modestly since February, CDO spreads, from AAA to equity are unchanged.

The world of awash in liquidity, and the CDO market is part of that. As long as there are buyers of the AAA and equity tranches, the CDO market will continue to support credit spreads.