Risky derivatives return in new form
COLLATERALISED debt obligations, or CDOs, the complex financial instruments that cratered disastrously in the financial crisis, are back.
The market for the instruments, which were based on subprime mortgages, shrank from $520-billion (about R5.2-trillion) in 2006 to just $4.3-billion in 2009 after the housing bust.
Warren Buffett once called CDOs “financial weapons of mass destruction” because of their riskiness.
This time round, the investment has shifted from a mortgage-based CDO to a “collateralised loan obligation” or CLO— a cash-generating asset structured similarly to CDOs, consisting of loans to businesses.
Financial institutions have issued $50-billion in CLOs in the US in 2013, estimates the Loan Syndication and Trading Association, a trade group. The association estimates that the industry will issue $70-billion worth in the US overall in 2013 and $100-billion worldwide.
Goldman Sachs, Morgan Stanley, Barclays and Citigroup are among the banks most active in structuring CLOs in 2013. Citigroup alone has sold about 20 this year.
Still, observers note the comeback is only partial. “There’s an uptick, but it’s still small compared with the pre-crisis peak,” said Campbell Harvey, a finance professor at Duke University in the US.
CLOs are structured financial products in which financial institutions pool loans of varying risk and market the securities to investors.
The securities can be sliced into tranches of different underlying loan risk levels. The riskiest “junior” or “equity” tranches — which were at the heart of the financial crisis of 2008 — remain popular with speculative funds because they pay higher yields.
“With interest rates still very low and borrowing costs so cheap, some investors are searching for risk,” said Ruben Marciano, a trader at Société Générale.
An analyst who specialises in CDOs said the investments were better bets when they contain loans from different sectors. — Sapa-AFP