Phorgy Phynance

Even more on credit from NP

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Another 16 hour day! Phew! Kick @$$!!

Anyway, although I should be sleeping, I decided to compose another stream of consciousness over at NP.

“In my opinion, the CDO market is history.”

[From RRP:]Eric, this is the kind of stuff that you say that drives me nuts.

Come on. Admit it. This is exactly the worry that has driven you to drink and you know it Wink

Look at it from the flip side. You’re a pension fund or university endowment. Why would you invest in CDOs? Because they have a good credit rating and provide an attractive yield compared to other AAAs. Do you really think these guys are going to continue falling for the same joke? Do ratings agencies have any credibility left? How can a pension fund manager look at their retired investors in the eyes and tell them that CDOs are as good as GE debt? Senior citizens are losing their livelihoods. That smells like political action to me.

The ONLY reason for the existence of CDOs as far as I can tell is “ratings arbitrage”. That boat has sailed.

There is no doubt the underlying cashflows are good, but the justification for the existence of tranches is diminishing. Why invest in something that the smartest people on the planet do not understand when you could invest in the same cashflows with less hokus pokus, i.e. untranched structured products, e.g. vanilla MBS, ABS? In crises, it seems the more exotic fringe products disappear and the surviving assets will eventually become commoditized.

I think the CDO market is going to effectively disappear because the newly found liquidity premium will swamp out even the most optimistic present value analysis making it uneconomical to issue. I could certainly be wrong.

I do not know the mechanism by which this could occur, but just thinking aloud, it makes a certain amount of sense for a servicer to repackage a CDO into a more palatable structure. That way, they could at least make a market even if it isn’t selling voodoo to senior citizens.

Having said all that, if the liquidity premium does force a drastic reduction (or complete halt) in CDO issuance, then those with the guts to buy up whatever is left at bargain basement prices will make a total killing as long as they have the patience (and freedom) to sit back and collect the cashflows (with no intention of selling). If I had the luxury of a lot of cash sitting around, I would be circling over head.

Good night and keep up the good fight!

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Written by Eric

August 21, 2007 at 12:00 am

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