The problem with CDOs
Recent turmoil has put the focus back on a lack of diversity
Among the noise about downgrades and hedge fund losses, a simple point has been lost about collateralized debt obligations, the product that has been put in the spotlight in the recent credit market turmoil.
They suffer, as they always have done, from a lack of name diversity. Switching from using cash bonds to credit derivatives as the underlying assets has changed many things about the array of CDO products. There are now more asset classes available and they can be traded much more easily. In the case of high-grade and high-yield synthetic CDOs there exist credit derivative indices as hedging instruments, which have, by and large, weathered the recent crisis well and maintained a good degree of liquidity.
The newer, derivative-based structures of the last few years help mitigate the problems that beset the old cash arbitrage CDOs of the late 1990s that went so spectacularly wrong in 2001-2003.
But name concentration still exists, and looks unlikely to change any time soon. Dealers might claim they trade 400 to 600 single names in credit derivatives, but how liquid these are is another matter. Less conflicted observers estimate that only 200-300 names are in any way liquid, which is not much different to the cash bond market.
All these liquid credits have been used in a multiple CDOs, and churned out again and again, just as happened in the cash CDO market. In a hunt for yield in a credit bull market it looks great; everything tightens. But all it takes is one blow-up to spoil the party.
The auto company downgrades, by themselves, should not do much harm. It took the blow up of major bond issuers such as WorldCom to open many investors’ eyes to the problems with cash CDOs. A mere downgrade should not have the same effect.
CDOs are now much more tradable, which means any pain should be much more immediate and also treatable. But, for as long as the structure relies on too few names in too many CDOs, the fear of a market meltdown will stay with us.
China’s bold first step
The long journey to reform its stock markets is finally under way
China’s government at last appears to be taking the issue of reforming its hamstrung stock markets seriously. The recently announced proposals to remove the huge overhang of state-controlled, unlisted shares in mainland listed companies provide a more thoughtful approach to one of the country’s most pressing financial problems than the two earlier attempts, both of which ended in an embarrassing climb down.
The price of course is that the reforms, if they do prove effective, will take many years to implement. They are not without risks either. The decision to leave detailed proposals for transferring the state-owned ‘legal person’ shares to each individual company is a sign of acceptance by the CSRC, China’s securities regulator, that the market usually finds the best solution. That, coupled with the trick of requiring shareholders’ approval of compensation terms, neatly removes the onus of responsibility from the authorities.
What is less clear is whether the CSRC in the long run can avoid the temptation to repeat the mistakes of the past of meddling in what should now be a private sector solution to a private sector problem. The CSRC, it seems, still controls the list of companies that will be eligible to implement so-called ‘full listing’ proposals. Its track record of handling listing quotas suggests it may not be able to keep its hands off.
Still, the proposals, while conservative, are largely workable, and the first four companies look as much like corporate guinea pigs as anything else. The viability of the entire programme rests on the success of these initial companies in devising proposals that are seen to be fair and reasonable and, crucially, implemented in an orderly fashion to minimize disruption to the market. The government has proved in the past to be trigger-sensitive to sharp adverse falls in the market. Any hint that the reforms will seriously affect the market as a whole may kill the programme in its tracks.
A test of government resolve may arrive sooner than many anticipate and from a less obvious source. As more Chinese companies free up controlling interests in their shares, the more appealing assets may attract the attentions of larger international private equity funds, flush with cash and eager to find a way into China’s vast market, or just as feasibly, western multinational corporations hungry to buy China market share. Any such moves could either provide a significant additional impetus to China’s state-owned sector reforms or provide a reason for the authorities to shelve the idea.
The government does seem serious this time, however. Talk in China is that future domestic IPOs will be full listings, removing the build up of additional legal person shares. That is a moot point, however, if there is truth to the unconfirmed reports of an immediate ban on new listings.
What is certain is that China’s long overdue steps towards arm’s length, fully functional stock markets where capital is allocated to the most deserving rather than the best connected, will be both small and tentative. But as the Chinese themselves are fond of saying, even the longest journey starts with a single step. And the new initiative is in itself a major leap for China’s markets.
The power behind the debt markets
It’s time for investors to reduce the influence of rating agencies
If the downgrade of Ford and General Motors to junk at the beginning of last month by Standard & Poor’s and its impact on the debt markets says one thing, it must be that the debate about the power of ratings agencies should be brought to a conclusion. When the entire market can swing on one agency’s take on the strength of the sports utility vehicle market, and one automotive analyst at S&P, Scott Sprinzen, can hold such sway it’s time for investors to change the rules by which they rank securities.
After Moody’s announced it would keep GM at investment grade for the time-being at least, the spotlight fell on Fitch to see whether it would downgrade Ford and GM, thereby permanently shutting them out of the Lehman Brothers Investment Grade index. At the end of May the GM downgrade duly came, prompting an unseemly scramble among funds trying to adjust their positions.
Was it right for a couple of analysts at Fitch to have such a disproportionate influence on the market? Standard & Poor’s has made its judgment at an arbitrary point in time about credits that have been facing the same problem for years and years: that they don’t make any money from selling cars and have huge pension and healthcare burdens. Every investor and banker knows this. Isn’t it about time market players started trusting their own judgment?
In the words of one banker: “I think investors have a bit more of an idea of where GM/Ford should be trading then one rating agency does.”
The truth about stock exchange competition
Can stock exchange competition finally deliver something for clients?
It is hard to reconcile the widespread enthusiasm for exchange competition with comments from fund managers such as: “I’d be delighted if the whole market imploded into just one market place”.
Brokers rather than fund managers tend to be the most enthusiastic cheerleaders of exchange competition. Complex trading environments give brokers more opportunities to earn fees. Fund managers need help negotiating fragmented liquidity pools, and only the global brokers have the budgets to keep up with all the technical investment needed.
When Citigroup wrote to the UK competition commission this May to voice its opposition to a takeover of the London Stock Exchange by European rivals Deutsche Börse or Euronext, it did so on the grounds that it would “reduce competition as regards to where to list new issues or to trade them”.
But it is not easy to see exactly what competition there is that is in danger of being reduced. Decisions about where to list new issues are taken primarily on the basis of where companies’ businesses are based and on where their investors are likely to come from.
In instances where exchanges might actually compete for listings, such as for secondary listings of non-European companies, the main differentiating factors tend to be the receptiveness of investors in an exchange’s home market to such issuers and national regulations. Differences in fees or rules are minor considerations. Exchanges differ in these areas rather than compete.
Competition between exchanges for trading the same securities tends to also be more rigorous in theory than in practice, as the LSE’s failed Dutch trading service illustrates. Dutch brokers used the threat of exchange competition from the LSE to force Euronext to cut its trading fees. That was about all the initiative achieved. Dutch brokers didn’t really want to trade their stocks on another market.
After about a decade of fierce inter-exchange competition in the US, the market has reverted to its two main liquidity pools. Exchange competition is back in the headlines as the New York Stock Exchange and Nasdaq lock horns again after their respective purchases of Archipelago and I-Net. It is about to make a come back in Europe as the securities industry is forced to digest more European regulations in the form of Mifid.
It would be refreshing to see more debate about alternative means towards the ends of lower fees and more innovation, and less fixation on the illusion of competition.
Clearing up conflicts of interest
Pension fund consultants need to be more transparent about their relationships
Life is about to get tougher for pension fund consultants. An examination by the SEC has revealed what many have always suspected: that the managers they put forward to pension fund clients are, more often than not, also their clients.
The SEC report released in the middle of May revealed that more than half of the consultants provided products and services to both pension funds and money managers. And for some of the consulting firms, the compensation received from money managers comprised a significant part of their annual revenue.
The Commission says it was unable to fully analyse whether consultants skewed their recommendations to pension funds to favour certain managers. But, of the six consultants that did provide the information, half had recommended money managers who purchased products and/or services from the consultant more frequently than those money managers that did not.
Some of the leading pension fund consultants have since come out and denied that they would favour managers with whom they do business, but they would say that, wouldn’t they? Whether they are objective or not, only they can know.
It is, therefore, essential that consultants leave it up to each pension fund to decide whether or not their relationship with money managers is a conflict of interest by being transparent. But only one consultant examined actually made client-specific disclosure that it had provided products and services to the same money managers it had recommended. Some provided no disclosure at all, and the majority made generic disclosures such as “the firm also provides [services] to money manager clients”.
While the report does not conclude the consultants are deliberately steering pension fund clients towards revenue-generating managers, the results highlight how immune consultants have perceived themselves to be. With pension funds on the warpath seeking people to blame for their low returns, it’s time for consultants to start taking their own advice and become more transparent.
Pyrrhic victory for structured finance
Will a new approach to analyzing covered bonds benefit issuers as well as investors?
Many analysts at investment banks have expressed their pleasure at Moody’s decision to make Nicholas Lindstrom the public face of its covered bond coverage. The emergence of the likeable Lindstrom, senior credit officer in Moody’s structured finance group, and Juan Pablo Soriano, managing director in the same team, symbolizes the need for structured finance nous in rating covered bonds following the emergence of UK issuers and in anticipation of a European homogeneous issuer base fracturing into a host of different credits.
Their predecessor, Alexandra Sleator, had to defend the notching approach that Moody’s came close to ditching when it revised its covered bond methodology in January and moved towards the more de-linked approach favoured by Standard & Poor’s and Fitch. Having constantly to argue the case for notching was a thankless, and unpopular, task.
The move away from notching and towards a structured finance methodology was inevitable. Investors have been looking for extra value and have tried to find reasons why, say, one Pfandbrief should trade higher than another with the same rating. And the rating agencies understand securitization technology.
Analysts might approve. For covered bond issuers, though, this could be a costly victory. It certainly raises the question of whether they get value for money from a structured finance approach. It will test the assumption that all investors want a more detailed analysis of every single covered bond that they might buy. Some investors don’t have the resources or the inclination, so some covered bonds need to keep their status as a commodity product.
That does not just mean Pfandbriefe. HBOS does not carry the same risk premium as Bradford & Bingley, but it should not necessarily affect how their covered bonds price or trade.
The issuers’ main beef, however, is that the rating agencies can use structured finance analysts as a reason to hike their fees. Dismayed by the agencies’ profit margins – generally reckoned to be between 30% and 50% – issuers are beginning to take concerted action. At a time when underwriting and other costs are under pressure, issuers should keep asking all three of the main rating agencies what they are doing to cut theirs.
