CDOs: A phantom menace?

October 5, 2016 admin

When done well, reintroducing Star Wars to legions of fans of the original movies makes sense. That same sense of wonder and excitement I felt as a kid in the theater watching Star Wars: A New Hope in 1977 is what I was reminded of when I saw the 2015 “reinvented remake,” Star Wars: The Force Awakens, directed by Star Wars superfan J.J. Abrams. It was new, with the best of today’s CGI, but tapped into all the right nostalgia points and witty banter of the first Star Wars film.

Happily, I saw my beloved R2D2 and C3PO make a comeback. But are some comebacks in today’s financial markets too much of a risk? A September article in Bloomberg suggests CDOs — collateralized debt obligations — may be making a comeback. A decade ago, many risky investments in the U.S. subprime housing market via CDOs were given AAA and similar ratings, but were essentially junk — and they triggered between $400 billion to $600 billion in bank write-downs during the global financial crisis just eight years ago.

Has this generation so quickly forgotten the indelible words of Michael Lewis in his 2010 book on the matter, The Big Short, and on which a 2015 movie was based:

To assure the big investors who had handed their billions to him that he had their deep interests at heart, the CDO manager kept ownership of what was called the “equity,” or “first loss” piece of the CDO — the piece that vanished first when the subprime loans that ultimately supplied the CDO with cash defaulted. But the CDO manager was also paid 0.01 percent off the top, before any of his investors saw a dime, and another, similar fee, off the bottom, as his investors received their money back. That doesn’t sound like much, but, when you’re running tens of billions of dollars with little effort and no overhead, it adds up. Just a few years earlier, Wing Chau was making $140,000 a year managing a portfolio for the New York Life Insurance Company. In one year as a CDO manager, he’d taken home $26 million, the haul from half a dozen lifetimes of working at New York Life.

Now, almost giddily, Chau explained to Eisman that he simply passed all the risk that the underlying home loans would default on to the big investors who had hired him to vet the bonds.

Even with the best of intentions and expertise, are some financial risks too big to take — again? Is our collective memory ultimately too selective?

Like numerous Star Wars fans, I’d rather forget the prequel episodes ever happened. It’s what many may feel about the global financial crisis. But it did happen, and we haven’t fully recovered from it yet. And, certainly, even the worst of the Star Wars movies didn’t cause a fiscal meltdown. Let’s hope the return of CDO investing isn’t the phantom menace we’ve seen before.

Jennifer-Molloy91x119The views, statements and opinions expressed in this article are those of the author and are not necessarily those of Institutional Real Estate, Inc.

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Jennifer Molloy is senior editor of Institutional Real Estate Asia Pacific.

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