Risky financial crisis derivatives return in new form

Collateralized debt obligations, the complex financial instruments that cratered disastrously in the financial crisis, are back

Robert Khuzami, Director of the US Securities and Exchange Commission's Enforcement Division, departs after announcing that the SEC has charged 6 former top executives of Fannie Mae and Freddie Mac with securities fraud, alleging they approved of misleading statements claiming the companies had minimal holdings of higher-risk mortgage loans, including subprime loans in Washington, DC. Win McNamee/Getty Images/AFP

NEW YORK, United States – Collateralized debt obligations, the complex financial instruments that cratered disastrously in the financial crisis, are back.

The market for the instruments, which were based on subprime mortgages, shrank from $520 billion in 2006 to just $4.3 billion in 2009 after the housing bust. Warren Buffett once called CDOs “financial weapons of mass destruction” because of their riskiness.

This time around, the investment has shifted from a mortgage-based CDO into a “collateralized loan obligation,” a cash-generating asset structured similarly to CDOs, but consisting of loans to businesses.

Financial institutions have issued $50 billion in CLOs in the US in 2013, estimates the Loan Syndication and Trading Association, a trade group. The LSTA estimates the industry will issue $70 billion-worth in the US overall in 2013 and $100 billion worldwide.

Goldman Sachs, Morgan Stanley, Barclays and Citigroup are among the banks most active in structuring CLOs in 2013. Citigroup alone has sold about 20 of the instruments this year.

“There really isn’t a CDO market anymore,” but “the CLO market has been quite active” for a couple of quarters, said an executive at a major Wall Street bank, who asked not to be named.

Still, observers note the comeback is only partial.

“There’s an uptick, but it’s still small compared with the pre-crisis peak,” said Campbell Harvey, a finance professor at Duke University.

CLOs are structured financial products in which financial institutions pool loans of varying risk and market the securities to investors.

The securities can be sliced into tranches of different underlying loan risk levels. The riskiest “junior” or “equity” tranches – which were at the heart of the financial crisis of 2008 – remain popular with speculative funds because they pay higher yields.

“With interest rates still very low and borrowing costs so cheap, some investors are searching for risk,” said Ruben Marciano, a trader at Societe Generale.

Tranches packed with loans of moderate risk are known as “mezzanine” loans, while “senior” tranches are the safest.

Before the financial crisis, many CDO slices that were categorized “senior” and rated highly by credit ratings agencies were actually high-risk and contained many subprime mortgages that ended up in default.

Moreover, because all of the loans packaged in the same derivative products were in the same sector – housing – the instrument itself was vulnerable when the housing market collapsed.

An analyst who specializes in CDOs for a large British bank said the investments are better bets when they contain loans from different sectors.

Buyers of the current batch of CLOs have hired independent specialists to analyze the instruments and no longer rely on credit-rating agencies, said the analyst.

Even as new CDO issues have vanished, Marciano said there remains an active secondary market since the crisis.

“There are investors out there who have made a lot of money from buying low-quality CDOs at very low prices,” Marciano said. – Rappler.com