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Very clever, Mr Bond


Friday 5th December 2003

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The reckless greed of New Zealand investors has been commented on often and with some wonderment ­ most recently by Reserve Bank governor Alan Bollard, although he didn't put it quite that way.

You would have to think Joe Blow saver would steer well clear of synthetic collateralised debt obligation (CDO) instruments exposing them to a portfolio of corporate debt through a credit default swap agreement with a global investment bank.

But no. In the last five months, investors have oversubscribed three CDO issues and a number of others are on the drawing board.

It's not that Shoeshine, or any of the wise men who this week laboured heroically to explain these complex beasties to him, has anything against CDOs in themselves.

They're certainly excellent vehicles for banks, which are under pressure worldwide to lift their return on equity. By issuing CDOs they can remove risk from their balance sheets, free up capital, and earn a useful margin.

The question is whether they're appropriate investments for chaps who'd have trouble spelling collateralised and wouldn't know a derivative from a dingo.

Not helping much are the credit rating agencies, who're slapping these things with investment grade ratings without explaining that their ratings are derived in an entirely different manner from the humble bond issued by your friendly local power company.

The brilliant, business-suited elves who dream these things up have produced them in an awesome array of flavours. They can be cash ­ the CDO vehicle actually holds the assets it backs ­ or synthetic, meaning the exposure is achieved by means of a swap.

They can be backed by standalone debt, by a bank's share of a syndicated loan, by swaps or even by emerging market sovereign debt.

And they can be "static," meaning the portfolio won't change over the life of the CDO regardless of changing credit quality or defaults, or have a manager weeding out securities whose credit outlook is deteriorating.

As the static ones are more risky, elsewhere in the world they have until now been held only by sophisticated institutions. But the three issued so far to New Zealand retail investors are all static.

Assuming Shoeshine's advisers have been successful in ramming the gist of CDOs between his clodlike ears, it goes like this.

A "pool" of company bank debt of, say, $100 million from, say, 100 companies is rolled up into a special purpose vehicle, the CDO structure.

The cashflows from the whole pool portfolio are aggregated into a single income stream available to pay interest to CDO holders.

In return, the CDO holders guarantee the debt, meaning if one or more of the pool companies defaults on its debts, it's the holders, not the lending bank, that take the hit.

Within the CDO structure there are several layers or tranches carrying ascending levels of risk, each of which is offered separately to investors.

The equity tranche, usually kept by the sponsoring investment bank, is the lowest-ranking, and stands to get the greatest return.

Each tranche up the structure is then assigned a "protection amount" ­ say, $2 million for tranche 1, $5 million for tranche 2, $10 million for tranche 3, etc.

In essence, the tranche 2 holders have priority over tranche 1 for payments of interest from the pool of income, and for security of their capital.

If one or more pool companies default, in an amount greater than the size of the equity tranche (after any recoveries that might be made), then the equity tranche holders' investment is worthless.

As companies default one after another, the holders of tranche 1, then tranche 2, lose their shirts.

If 10 companies, representing $10 million of pool debt, default, then even tranche 3 is wiped out.

Take the Global Credit Notes CDO marketed recently by Forsyth Barr.

The protection amount for Series 2, which has an interest rate of 8.25%, is 4.5% of the portfolio or $225 million. For Series 1, which pays 7.2%, the amount is $310 million.

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