Jul

20

The basic reason for why there is a CDO problem is the same reason why there was a "derivatives problem" in the 1990s.

It lies in the principle-agent problem.

In many forms of investing, the agent is highly incentivized to take risks with others' capital. Sometimes, this is a good thing. Many investors seek out risky hedge funds, and want their capital at risk.

Often times, this is not the case. Pension funds, endowments, and insurance companies might place a high degree of importance on preservation of principle, and will seek to limit the amount of risk-taking.

Investment managers for these assets may still have an incentive to take excessive risk. Even if there is no direct performance fee, a manager (internal or external) will be rewarded for good performance. If there is bad performance, that manager can just walk away (it's not his capital at risk).

Thus, pools of money implement investment policies and various risk controls to try to minimize the principle-agent problem.

For example, the average pension fund (except for a carved-out piece that might be in hedge funds) will not allow its equity for fixed income managers to use leverage. That keeps the risk down. The pension fund might limit the amount of equity investment in tech stocks to keep risk down. The pension fund might limit the amount of money that fixed income managers can invest in low quality bonds.

But, the individuals doing the investing still have the desire to take risk at the expense of the beneficiaries of the assets.

So what happens? Wall Street invents new products that, while serving legitimate purposes, also serve to mask leverage.

So what is it about CDOs? By dividing them into tranches, one can take the same underlying credit, but magnify the returns based on the level of support in the tranche. From the perspective of the agent who seeks out leverage (since personal upside is big and downside small) the difference between the high support and a low support tranche is essentially leverage — a difference in expected return based upon the bet on how the loans will perform.

Since it is a relatively new product, the agents are able to pass these leveraged bets by the principals.

After this year, it won't happen any more.

Then Wall Street will come out with a new product and the cycle will start all over again.


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1 Comment so far

  1. michael webster on July 22, 2007 10:10 am

    As Charles Ponzi stated, the problem is “how can something which is quite unsound as an investment nevertheless be made attractive as a gamble, but to essentially risk adverse individuals?”

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