Of CDO's, LBO's and Stocks

As I was saying yesterday, Collateralized Debt Obligations (CDOs) were constructed from a variety of debt instruments, thus providing unusually cheap financing to less credit-worthy borrowers. For better or worse, they facilitated transactions that otherwise would have been impossible to accomplish. One example is sub-prime mortgages which helped create further vaporous impetus to the presently imploding housing bubble - but it is not the only one.

Another sector that benefited from CDO's is the debt used to finance leveraged and management buy-outs (LBOs and MBOs). Such cheap debt provided private equity funds with tremendous liquidity resources and financial reach. Nine out of the ten largest ever LBO's were made during 2006 (pls. see posting from Feb. 27 below).

The chart, from fixed-income asset manager PIMCO, shows how volume of such transactions soared in just the past four years.

Private equity firms could borrow cheaply because there was high demand for their LBO debt from CDO issuers. Once again we observe the transmutation of CCC risk into AAA through "financial engineering", based on the extrapolated assumption that defaults on risky bonds will remain at historic lows. Defaults on bonds rated below investment grade reached an all-time low of 1.57% during 2006 vs. an average of 4.90%. But, as the chart below shows, even the average is not indicative of true risk because such bond defaults can reach much higher levels during economic slowdowns - as high as 10-11%.

Source: Moody's via ProFund Advisors

I believe that credit risk is currently being re-assessed and marked higher in all sectors, not just real estate and sub-prime mortgages. The easy-money liquidity sources that drove LBO bids up and helped boost equity markets world-wide are going to start dwindling in the immediate future. After all, to a very large extent the ultimate providers of this liquidity were the buyers of CDOs: pension funds that have to answer to political/regulatory overseers and hedge funds that are subject to sudden investor withdrawals.

Prudent-man rules still apply to all investment activities, particularly when it comes to providing pensions for millions of working people. It will be very challenging for a pension fund manager and his investment councelor to coherently and honestly justify investing in financial instruments that ultimately finance highly leveraged, risky takeovers of listed companies at high multiples of book value. Imagine, even, if they have to do so in front of a Congressional sub-committee hell-bent to discover malfeasance and apportion blame - sometimes unjustly.

Hedge funds could face a much quicker and final judgment from their speculator-investors: a simple request for their money back, i.e. liquidations. As risk appetite is reduced everywhere, hedge funds - being the riskiest in the investment spectrum - will likely feel it first. Unless of course they can demonstrate that they are positioned on the opposite side and can benefit from rising risk aversion through short sales, etc. In that case their actions will simply exacerbate the problem for the others - after all, hedge funds are mostly trend followers and amplifiers. For some of them, pushing the "down" button in the elevator comes as naturally as riding it to the penthouse.