2.12 Assets Influencing Investment Decision-Making
In spite of the in-depth idea of risk and return, risk
management, financial regulations and value creation towards investment
decision-making discussed above, some prominent economists still suggest that
they are some assets within the financial markets that help in influencing
investment decisions-making processes. Some of these include:
2.12.1 Collateralized Debt Obligations (CDOs)
CDOs are investment grade securities which are backed by
bonds, loans as well as other assets. Note that CDOs do not specialise in just
one debt type rather they are more of non-mortgage loans or bonds. With CDOs,
the different debt types are often referred to as `tranches' with each tranche
having different maturities and risks associated with it. Bear in mind that the
higher the risk the higher the CDO to be paid. These CDOs are very unique in
that they represent different types of credit risks and debts. No doubt, they
are being looked at as structured finance vehicles aimed at issuing multiple
classes of liabilities as well as rating debt tranches having different credit
risk/return profiles.
With CDOs, the securities are divided into different classes of
risk because the interest and
the principal payments are being made with
reference to the risk class with the most senior
classes being looked upon as the safest securities. Some
investors warned that CDOs are assumed to be spreading risks through
diversification rather than reducing risks of the underlying assets. As a
result of this, one of the reasons for the outbreak of the present financial
crisis was the failure of the credit rating agencies in adequately accounting
for large risks when they were rating these CDOs.
According to Moody's Investors Service, the growth of the CDO
markets never accelerated until in the early 2000s when these CDOs were
introduced. They got to their peak in the first half of 2007 although it was so
short-lived because statistics show that from the first half of 2007 to the
second half of the same year, the CDO issuance is assumed to have dropped by
50% . This drastical drop was considered to have resulted from liquidity
problems especially as investors disappeared leaving residential
mortgage-backed securities to deteriorate (Steven, 2008). Below is a table
summarising the global CDO market issuance data for the period of 2006-2007.
Table 2: Global CDO Market for 2006-2007
|
Period
|
Total Issuance in millions of USD
|
|
2006-Q1
|
108,012.7
|
|
2006-Q2
|
124,977.9
|
|
2006-Q3
|
138,628.7
|
|
20006-Q4
|
180,090.3
|
|
2007-Q1
|
184,757.4
|
|
2007-Q2
|
179,493.0
|
|
2007-Q3
|
91,529.2
|
|
2007-Q4
|
29,946.7
|
Figure 6: Global CDO Market for 2006-2007
Source: Thomson Financial
Looking at both the table and the graph, it can be observed
that the global CDO issuance was increasing steadily between Q1-06 and Q1-07.
It got to its peak during the first quarter of 2007 but this was so short lived
because by the fourth quarter of the same 2007, the global market has dropped
drastically. Because of what was experienced in the first quarter of 2007,
academicians as well as economists have regarded CDO as one of the most
important new financial innovations of the past decade no doubt it has
registered an increasing number of appeal from many asset managers and
investors. This is so because, the CDOs enabled the originators of the
underlying assets pass on credit risks to other investors and institutions,
thereby making it possible for investors to be forced to understand the
in-depth of how the risk for CDOs is being calculated. As if that is not
enough, when the CDOs is being issued,
the issuer (typically an investment bank), earns a commission
done at the time of the issue as well as a management fee during the life of
the CDO.
Note that for any CDO transaction to be effected some
participants need to be present. These include investors, underwriters
(structurers and arrangers of CDOs- assigning different interest rates to
different securities with more risky classes of securities bearing higher
interest rates so that investors can be attracted to those securities),(Chromow
and Little, 2005), asset managers, trustee and collateral administrators as
well as accountants and attorneys with each having different functions and
interests. Banks were allowed to participate only at the beginning of 1999
following the Gramm-Leach-Bliley Act (also known as the Financial Services
Modernization Act). This is because this Act helped in opening up markets
within the banking industry, securities companies as well as insurance
companies.
According to Steven, 2008, balancing risk perception,
monitoring the performance of underlying assets, getting investors to return to
the market and finding liquidity again are some of the things that need to be
restructured in the CDO for it to survive. The growth of the CDO was as a
result of investors' demand although the issuing of these CDOs were reduced in
2008 because investors had disappeared and liquidity problems began thereby
portraying CDOs as greater risks indicators.
CDOs offer returns that are sometimes 2-3 percentage points
higher than corporate bonds with the same credit rating. Because of this
discrepancy, CDOs have been criticized and looked up to as some sort of complex
instruments which are difficult to value. No doubt some economists refer to
CDOs as financial weapons of mass destruction thereby blaming them for making
the 2007-2009 credit crises more severe than it should have been and led to the
subsequent failure of some big financial institutions such as Lehman
Brothers.
There exists so many different types of CDOs of which some
include: CLOs (collateralized loan obligations)- these are mostly CDOs that are
backed up primarily by leveraged bank loans; SFCDOs (structure finance
CDOs)-CDOs backed by structured products; CBOs (collateralized bond
obligations)-CDOs backed by fixed income securities; CSOs (collateralized
synthetic obligations)-implying CDOs backed by credit derivatives, etc as well
as there are some CDOs backed by commercial real estate assets, corporate
bonds, insurance, etc. With all these different types of CDOs, bear in mind
that as of the year 2007, 47% of these CDOs were backed by structured products,
45% were backed by loans and just less than 10% were backed by fixed income
securities.
CDOs are known to vary in structure as well as the underlying
assets although the basic principle is the same. It is evident that the growth
of the CDOs plus the increasing appetite of the CDOs managers for more debt
securities are having an important impact in the real estate debt markets
(Chromow and Little, 2005). Apportioning different credit rating levels to the
different tranches of CDOs makes things easier to be understood since it will
be easier for institutional investors to make their investment decisions. This
is in the sense that with credit rating agencies rating an asset with AAA
signifies the asset is very safe. Therefore, with investors bearing this in
mind, they will be able to sell the most risky assets to those they know can
withstand high risks while the safest (AAA-rated) assets would be held by the
more risk-averse investors.
This credit rating is done so as to get the exact size of
classes and this is done with the help of credit rating agencies such as
Standard and Poor's and Moody's. These agencies rate the highest/safest class
with AAA although this class has the lowest interest, followed by the AA
assets. Note that the lowest priority classes are either not rated at all or
referred to as the junk class (Chromow and Little, 2005). Because of this
increased demand for AAA assets, the lower quality securities that were issued
against the initial package of mortgages needed to be
repackage with similar securities from other packages thereby
resulting in the creation of new AAA securities referred to as portions of the
CDOs since investors used to rely heavily on these securities while the credit
rating agencies do their valuations.
Contrary to the above, this process does not work well all the
time. Investors have learnt to believe that assets with a triple `A' are always
the safest. Unfortunately, this was not the case all the time. These credit
rating agencies did rate some toxic assets with AAA, which was therefore
misleading. Hence one of the causes of the global financial crises was as a
result of this mistake done by these credit rating agencies. This is because
investors hurried up to these assets thinking they were safe not knowing that
they were toxic assets whose financial values have significantly fallen.
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