Are CDOs voodoo finance?

Johnson and Kwak claim:  “The fact remains that at least some CDOs boosted financial intermediation by tricking investors into making investments they would not otherwise have made–because they destroyed value.”  They described the process of tricking investors as “the magic of a CDO”.

And Economic of Contempt responds:  “This is usually how CDOs are portrayed these days: they’re obviously voodoo finance … But as you can see, the idea that the senior tranche would be “safe” isn’t at all ridiculous—after all, there’s almost always some level of subordination that will make the senior tranche a safe investment.”

Of course, this is not actually a response to the claim that “some” CDOs destroyed value. EoC doesn’t claim that for every single CDO there is a level of subordination that will make the senior most tranche a AAA investment, because EoC knows very well that for certain classes of CDOs (e.g. mezzanine ABS CDOs) there is no level of subordination that will turn the senior most tranche into a AAA investmnet.

Furthermore even when one deals with those CDOs for which it is true that there exists some level of subordination that makes the senior most tranche AAA, as EoC himself notes, the problem is that each CDO defined a specific level of subordination at which the investment became AAA.  In recent years this level was usually set at a ridiculously low level.

Finally investment banks claimed to be able to price these CDOs accurately enough to sell them as investments to their clients.  Of course, the truth was that very few investment banks (i) made appropriate allowances for the likelihood that mortgage defaults would be highly correlated when the housing bust finally arrived — which would have resulted in higher fair market yields for every tranche and rendered many CDOs non-viable economically as recognized by the folks at JP Morgan (who apparently concluded that “the idea that the senior tranche would be ‘safe’ ” is ridiculous when you’re talking about mortgage based CDOs); and (ii) apparently didn’t do the loan level research necessary to accurately price CDOs — or they would have found lots of fraud in recent vintage CDOs that included subprime RMBS.

So in answer to the question:  Are the CDO issuance practices of 2005 – 2007 accurately described as voodoo finance?  The answer is yes.  Because some fortune teller in an investment bank was claiming (with advice from the rating agencies) to be able to (i) determine subordination levels for AAA and other tranches with extraordinary accuracy; (ii) to be able to predict future correlations, even though two-bit investor is warned that “past performance may not be a good indicator of future performance” and you’d think the investment bankers had been around long enough to learn that simple rule and (iii) to be able to accurately price a composite asset without doing extensive research on the underlying individual assets.

What’s ridiculous is the claim that people like Johnson and Kwak are giving CDOs a bad name.  The investment banks were able to do that all by themselves.

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1 thought on “Are CDOs voodoo finance?”

  1. CDOs were originally products that were designed to turn safe assets into riskier and higher-yielding assets. This actually works, up to a point. Then they were mindlessly turned on their head and used for supposedly converting subprime mortgage MBS into AAA paper.

    I think people often looked only at the level of “credit enhancement” that a mezzanine tranche was subject to, signified by the probability of any loss at all. What was easily forgotten was the sudden severity of the losses that occurred after crossing that initial threshold.

    Through this severe nonlinearity, CDOs were the perfect generators of information asymmetry. Their exponential popularity was a warning sign, as trade happens fastest when both sides of the trade think they are making a great deal.

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