Your Question on CDOs and CDSs

Filed under: Letters

Listener Eduardo Bortoni asks two good questions. The first has to do with CDOs:

1) Why is it still difficult to price CDOs? Aren't they supposed to be generating cash every month due to the income streams in the the "things" in them? Shouldn't this provide a clue to it's intrinsic value?

Eduardo is asking about these complicated bond-like things that are at the center of the financial crisis: CDOs. These are called Toxic Assets, or Toxic Waste and are so unloved and unwanted that nobody will buy them even at firesale prices of a dime on the dollar.

Eduardo notes, correctly, that many of these CDOs are paying off money every month. Doesn't anybody want that money? Should they be willing to pay something for them? Then why aren't they moving?

The answer is complex and lies at the heart of this crisis.

1. What you are willing to pay today represents what you think the CDO will return to you over its lifetime, not what it happens to have paid last month. If you have serious doubts that these things will continue to pay off a decent monthly payment, then you won't pay much for them.

2. Even if you would consider buying a CDO, you probably already have more of these than you want. Most of the institutions that might buy a CDO -- banks, insurance companies, pension funds -- already have too many of them. They don't want any more at any price.

3. You can't agree on a price. There are some willing to buy, hedge funds for example, but they will only pay a steeply discounted price. The banks and others that own the CDOs aren't willing to sell at that discount, because they do think that, eventually, the CDOs will return a higher value. The distance can be huge -- a hedge fund might be offering 10 cents on a CDO whose owner won't sell below 60 cents. The distance is too large.

4. They are impossible to precisely price. CDOs are so ridiculously complicated that there really and truly is absolutely no way to figure out what they will pay over time. CDO payments are impacted by interest rates, GDP growth, foreclosures in the US, the cost of risk, all sorts of variables that are unknown. That huge degree of uncertainty is why buyers and sellers can't come closer to an agreement.

2) CDS: Why did institutions just not use existing (and also regulated) methods to hedge against the company defaulting?

1. Many CDS were not designed to hedge against risk but to make huge, leveraged directional bets. Banks and hedge funds and others used them for trading, not for protection.

Adam Davidson

12:54 PM ET | 11-10-2008 | permalink

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