Sutherlands Edinburgh

2007-07-04
Recent problems with two of Bear Stearns’ credit hedge funds have highlighted some of the risks associated with CDO investments. After the hedge fund posted poor results, a number of its lenders decided to sell CDO collateral which should have immunized them from any potential capital loss. However, it quickly became clear that the current price they could achieve (market price) was much lower than the valuation (model price) for the CDO collateral. Usually valuation is done using complex financial models with underlying asset return or default correlation as the key parameter. Does this mean that current valuation models are obsolete?
The Financial Times reports Anthony Bolton, a Fidelity Fund Manager saying at Fund Forum 2007 in Monaco, "There are major risks with these CDOs/CLOs... they are basically based on a model, which is based on a set of assumptions... if something goes wrong with the assumptions, it changes the model." Martin Gilbert, Chief Executive of Aberdeen Asset Management, said, "CDOs are built on confidence and once that goes, that is it. They are the equivalent of split-caps for professional investors.” He went on to say, "I think what will happen is that the prime brokers won’t allow valuations based on models. They will require valuations based on the market and that will be a mechanism leading to more reality."
Another major concern is that collateralized debt obligations (CDO) have been used to package debt of various qualities into tranches which appeal to the risk appetites of a broad spectrum of investor classes. Many have suggested that a number of these tranches are too risky for the investors who are purchasing them, for example, "The Poison in Your Pension Fund." (http://www.bloomberg.com/news/marketsmag/pensions.pdf) states, "Banks are selling the riskiest CDO portions, known as toxic waste, to public pension and state trust funds."
What do these recent developments tell us that we did not already know about CDO risks and what has been missing in modelling to date? There are two types of risk at play. The underlying risks associated with cashflows from the structure and its market risk. Current modelling has concentrated on the underlying risks associated with the cashflows from the structures. This has been due to the absence of a liquid market and available pricing which has meant that market participants have been unable to estimate the current level of CDO pricing.
The Sutherlands Edinburgh modelling framework used by the PBCAM for corporate bonds includes an estimation of the current market "risk aversion" as well as a "liquidity premium". This allows valuation to include both the long-run default/cashflow profile of bond structures and the current market's pricing level, eliminating any market related pricing problem.