Collateralised Debt Obligations (CDO) are similar to other securitised debt such as Asset Backed Securities (ABS) and Mortgage Backed securities (MBS). CDOs are usually tranched. What does this mean? Tranche comes from the French word for a slice or wafer (la tranche). Perhaps the easier way to think of this is rather than a traditional slice of cake, it is cake made up of delicious layers. Each layer of the cake is made up of debts, each layer being risky than the next.
When you buy a CDO you are not quite certain what went into the mix. There will be high quality debt (unlikely to default), some pretty average and some perhaps quite toxic. Much like an appetising cake, the baker will make it look as attractive and desirable as possible. How can you ensure the baker of the cake hasn’t really sold you a low quality scraps out of the trash, cleverly presented to look like a great quality investment? Each ingredient in the cake comes with what is effectively a certificate of quality – a credit rating. So, with independently verified assets/ingredients promoted by a banker/baker with a good reputation your worries are over? If only it was that simple.
Credit R
ating Agencies, such as Moodys, Standard & Poor or Fitch are perhaps not quite as independent as one would hope. They are paid by banks to rate their debts – the credit rating agencies compete to win this lucrative work – an immediate conflict of interest. During the financial crisis of 2007 it became apparent that some subprime debt was being ‘optimistically’ rated by some of the agencies. As a result the changes introduced by the USA’s 2010 Frank Dodd Act was partly designed to reduce the chance of conflict of interest by Credit Rating Agencies and banks.
By slicing and mixing up poor debt with good quality debt in a CDO, banks were able to gain a better credit rating on the whole CDO with the help of the Credit Rating Agencies and sell it to unsuspecting investors. Much like a baker hiding some rotten old fruit in their cake mix, some of these ‘investment grade’ CDOs turned out to be quite toxic.What can we learn from this? The world of finance can be a bit like baking. It might look tasty and attractive, but after you’ve eaten it – you may be left with worse than a bad taste!
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