Simon Hoyle on Bear Stearns's CDOs
From the Sydney Morning Herald:
Crash course in too much leverage: In the case of the S&L industry, lenders were not paying enough attention to risk management because the Federal Reserve guaranteed their losses - so while plenty could, and did, go wrong, the S&Ls were not held accountable for their actions. And Leeson was approving his own derivatives trades - so there was no risk management there at all. In the wake of these problems, it would have been foolish to avoid applying to the local credit union for a home loan, or to stop using derivatives for legitimate trading and hedging purposes.
In the same way, when National Australia Bank discovered in early 2004 that it employed a team of rogue foreign exchange dealers, you'd have been mad to stop travelling overseas because you suddenly thought currency markets were too dangerous. And when the US's fifth-largest investment bank, Bear Stearns, announces it is putting up as much as $US3.2 billion ($3.7 billion) to bail out its asset management business, which runs hedge funds that invest in the bonds of so-called collateralised debt obligations (CDOs), investors should not automatically shun CDOs. Rather, they need to look more closely at why the bank and its funds got into trouble.
At the epicentre of the Bear Stearns troubles is leverage.... One of the Bear Stearns funds is leveraged 20 times.... [B]laming CDOs per se for the Bear Stearns situation is like blaming the car for crashing, not the driver....
Ibbetson says there are three levels, or tranches, in a CDO. The first tranche is generally referred to as investment grade, the second level is referred to as non-investment grade (and both of these are debt), and the third is the equity tranche....
It turns out that default risk is not the only risk that bonds issued by CDOs are subject to. Like any debt instrument, the value of the bonds depends in part on movements in interest rates and credit spreads. In the Bear Stearns case, it was an increase in credit spreads that brought the funds undone.... When credit spreads increased and Bear Stearns was forced to sell their CDO bonds to meet margin calls, they found that liquidity had dried up and those assets were subject to a fire sale....
Ibbetson says there are three parties who need to shoulder blame for the current imbroglio, and all are equally culpable: Bear Stearns for leveraging the fund so highly, banks for lending the money to enable the leverage, and investors for buying into an investment that they really should have known could be exceptionally risky.
