CDOs and mortgage debt: The latest market bogeymen?

(August 2007) Collateralized debt obligations comprised of U.S. mortgage backed securities may have exposure to U.S. sub-prime loans. While most Canadian investors likely don’t invest in CDOs, they might have indirect exposure, leaving some to wonder whether mortgage-backed securities are a backdoor for sub-prime troubles to enter Canada.

A CDO can be a very complex debt instrument that is usually comprised of bonds or mortgage debt, which vary in credit ratings and tranches. There’s no definition of what sort of underlying debt obligations make up the CDOs, which in part adds to their complexity.

“The sky is the limit to the creativity of a CDO, as long as there is somebody who wants to buy it,” says James Feehely, senior vice-president of structured finance for Dominion Bond Rating Services.

Up until recently, CDOs comprised of mortgage back securities were quite popular, particularly with institutional investors. During the recent rash of sub-prime problems, however, there has been increased scrutiny of the underlying debt obligations within the CDOs. With mortgage back securities, a mortgage lender will sell a percentage of a mortgage to a third party, so in a way, the lender is hedging its risk.

Critics contend that credit rating agencies were giving AA or AAA ratings to CDOs that had a mixture of debt, but significant exposure to sub-prime mortgage back securities with a much higher rate of default. So large institutional investors were sometimes taking a riskier position in holding sub-prime mortgages, individually considered “junk” debt but when mixed with some higher quality securities, collectively earned a higher credit rating.

Some analysts contend that the CDO market is partly responsible for the sub-prime problem, because lenders were more willing to take on riskier borrowers because they could share or reduce the risk through CDO investors. If you add credit default swaps to the mixture, you have CDOs that could be potentially on the hook for a huge proportion of the mortgage defaults because the CDO investors is actually taking on the role or a credit protection seller, where they’re obligated to provide credit protection in the case of a default.

“Conceptually similar to an insurance company providing you insurance on your house if there is a fire, a credit protection seller will provide the credit protection buyer protection from certain credit events from occurring (such as a particular corporation defaulting on its bond payment),” Feheely explains.

Feheely, whose company does credit ratings on CDOs, notes the rating system is not done haphazardly. Each CDO they rate is given a rating based on a rigorous analysis.

“DBRS is involved in rating CDOs when the credit protection seller desires to access the capital markets to fund its exposure in a CDO,” Feehely says. “This evaluation is distilled into three basic factors: the probability of default; if such defaults occur, the loss severity that is expected to occur; and the correlation assumptions between the reference obligations. For example, if one obligation defaults, will it increase the chance of or cause the default of another reference obligation in the same CDO)?”

Feehely says if DBRS is satisfied with the composition and structure of the CDO, it will permit the capital markets to fund all or a portion of the CDO. So, effectively, if an institutional investor is exposing themselves to risk, they’re quite aware of it.

In fact, institutional investors likely bought sub-prime CDOs firmly with their eyes open. Bob Gorman, senior portfolio manager at TD Financial, says the U.S. CDOs are purchased for their volatility. The CDOs were a way for institutional investors to try to capitalize on the upside potential of sub-prime mortgages while reducing the risk they would be exposed to by holding them individually.

“CDO packages with differing degrees with securities attached to them. They are packaging within a diversified portfolio that will hopefully give you a higher return overall,” he says.

Gorman hopes investors don’t paint CDOs and mortgage back securities with one brush. He notes Canadian mortgage backed securities are one of the safest investments in the Canadian marketplace because their default risk is guaranteed by the government of Canada, through the Canadian Mortgage and Housing Corporation.

“Canadian mortgage backed securities provide regular payments on the 15th of each month and from that standpoint they represent a consistency of income particularly for retirees,” he says. “They are also very secure, that’s important to flesh that out a bit, they are guaranteed by CMHC. They have a triple AAA rating, which is as good as it gets.”

Domestically, the sub-prime default risks are virtually non-existent because almost all of the major lenders require borrowers to take out mortgage insurance. The CMHC says that most of the mortgage backed securities are actually taken out on non-insured mortgages, which means the borrower made a down-payment of more than 20% on their home. So not only is the principal guaranteed in the case of default, the quality of the mortgage loan is fairly high.

And as a fixed-income instrument they offer fundamentally the same protection as a government of Canada bond, but usually with a higher interest yield, Gorman adds.

“The yields are quite good compared with those you might get in competing instruments,” he explains. “I spoke to one of my colleagues who conducted a few trades and he was comparing the yield with Government of Canada 10-year bonds which had a current yield of about 3.6%, against a 10-year mortgage backed security that had yield of about 5.3%. You’re picking up about 60 basis points. That is significant in a low-yield environment. This is the sort of product that has a lot of appeal.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

Mark Noble