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.