It’s widely recognized that structured finance was used to arbitrage regulations. Less well recognized is that fact that structured financial products were also used to arbitrage the ignorance or the ego of investors.
CDOs — at least in the quantity they have been issued in recent years — are inherently suspect as innovations that add economic value. The reason for these doubts are simple: If the assets underlying the CDO are priced to reflect fundamental values and all of the CDO tranches are also priced to reflect fundamental values, then what the CDO as a product brings to the market is the opportunity for investors to choose their preferred level of credit risk exposure to the assets in the CDO. To believe that CDOs are a value adding financial innovation one must also believe that the gains from this division of credit risk into tranches are more than sufficient to cover the multi-million dollar cost of creating the CDO.*
The question is whether investors actually demand that wide variety of exposure. The CDO needs different investors who want (i) a very safe, diversified portfolio of assets that pay a yield just a little higher than Treasuries and (ii) a relatively high fixed income return on a product that concentrates risk — and is likely to behave more like equity than a bond, and a range of possibilities in between.
Thus, the very concept of a CDO (as a product that distributes risk in an economically efficient manner) requires that there exists a full spectrum of investors who prefer different levels of risk including equity (the first loss position), equity-like risk with fixed income returns (the lower mezzanine tranches, that are unlikely to get any recovery in case the deal goes bad), and low risk, low returns on a diversified portfolio (the senior tranche — or super senior tranche in a hybrid or synthetic CDO). In practice it seems to be relatively rare that all the different groups of investors exist for given CDO, because the banks frequently end up holding at least one of the tranches.
If it is not the case that the full spectrum of investors exists and that the gains from serving the needs of these investors more than cover the fees of creating the CDO, then the “value” of the CDO is likely to come from selling to one or more groups of investors a product whose risks they do not understand. While a CDO that arbitrages such misunderstandings is likely to be very profitable for the investment bank that issues it, these profits clearly do not represent economically efficient allocation of risk. In fact, after the recent crisis there is support for the view that trade in mispriced CDOs actually reduces social welfare.
Some more specific examples have popped up on the web recently:
(i) Felix Salmon has a post up on: super senior CDOs. As I commented there
I think the reason the super senior “had” to exist in the 2006-2007 environment is because that’s where the risk was most underpriced. Many of the CDO “investors” were interested in high yield AAA assets, that is the leveraged senior, but not super senior segment of the CDO. But if market makers had tried to sell protection on this segment of the CDO only, that protection would have tended to be expensive for the same reason that it paid investors well relative to the super senior.
Selling packages that included large super senior tranches allowed the structured financiers to earn their salaries by keeping costs down for protection buyers, while also meeting the needs of CDO “investors” looking for high yield assets. Unfortunately they ended up warehousing large quantities of the residual super senior risk in the banks.
(ii) In a series of posts on Goldman’s Abacus CDO, Steve Waldman discusses another case of welfare reducing structured finance. He argues that the Abacus CDO that is the subject of the SEC lawsuit allowed Paulson (the hedge fund manager) to take out a short position on subprime that was significantly underpriced relative to a comparable position on the public ABX markets. By hiding the fact that the CDO was selected as a short vehicle for Paulson, Goldman induced ACA Capital, IKB and ABN Amro to take on the offsetting long position for compensation well below that available on public markets — this leads one to conclude that these counterparties did not understand that they were just serving as a cheap means for Paulson to take on a position comparable to shorting the ABX.
Effectively Waldman argues that Goldman used this Abacus CDO as a vehicle to create information asymmetry in the market.
(iii) Critics of structured finance have long argued that many of these “innovations” are profitable precisely, because they are carefully designed to exploit misinformation and hubris in financial markets. Satyajit Das takes this view in his book, Traders, Guns and Money and gives a multitude of examples. Two classic cases: in 1993 Proctor and Gamble thought it was lowering its cost of funds when it entered into a transaction that involved the sale of interest rate puts; in the early 1990s Orange County tried to raise its investment returns by entering into highly leveraged interest rate swap transactions. Both of these cases ended up in court when interest rates rose and vast sums were lost.
It’s hard to believe that this needs to be stated, but here goes: When a financial product is used to arbitrage misinformation or hubris, it does not contribute positively to economic welfare. When such transactions result in bankruptcies there is little question that they are harmful to economic welfare.
These transactions do not add valuable pricing information to the economy for the simple reason that the basis of the transaction is a failure to understand the product. If prices created by such transactions are viewed by other participants in the economy, they may lead to further misallocation of resources.
When structured finance innovations are designed to arbitrage misinformation, the markets in these products are inefficient and are likely to generate significant economic costs via unnecessary bankruptcies. For this reason it is important to shine a light on these markets, not only through clearing and exchange trading of standardized products, but also by requiring delayed public reporting of transactions and transaction prices for those products permitted to trade over the counter.
*Note that tranched MBS are not necessarily subject to the same criticism because they distribute prepayment risk across investors — that is, the tranches are differentiated by their expected maturity — and thus they cater to the fact that different investors have different investment horizons. In my view it’s much more intuitive that investors can be distinguished by their maturity preferences, then by their desire to take on different levels of credit risk.