Tower warns people about CDO investments

Tower is warning investors about the risks associated with CDO-backed fixed interest investments following the Delphi bankruptcy and Refco fraud allegations.

Tuesday, 25 October 2005

Tower New Zealand chief executive Tony Hilydard says these incidents, along with others such as the Parmalat collapse, are a warning to investors. “Structured debt products offered in the local market have been demonstrating the true breadth of their risks with increasing frequency,” he said. "We have seen a series of incidents wherein overseas credit defaults have had or threatened an impact on local investor returns."

Macquarie's Fortress notes have seen their net asset backing fall by around 5c each because of the Refco case, and its Generator bonds issue has been put on credit watch negative by Standard and Poor's following the Delphi collapse.

"These credit events, as the jargon calls them, have come out of left-field for Kiwi investors and in some cases impacted on the value or return of their investments."

"Investors need to be aware of the risks of these complex products, collectively known as collateralised debt obligations (CDOs)," he says.

"CDOs often involve substantial leverage and their underlying collateral pool (what they actually invest in) can comprise almost any source of regular cash flows."

He says he says seen everything int he collateral pool including "expected football stadium receipts, song royalties or aeroplane leases through to high yield bonds, credit default swaps and syndicated senior loans."

"It may not be realised by CDO investors in New Zealand that they are, in some cases, actually insuring a third party’s risk of credit defaults or rating downgrades on foreign corporate bonds, either specifically in the collateral pool or by the fact that their bonds are subordinated in the CDO debt structure."

"Many clients would think of themselves as bond investors in these products rather than as credit insurers for CDOs or as bag-holders in the event of senior loan default, but the latter is really what they are."

Hilyard says some of these investments are "pass-the-parcel structures designed to offload some third party’s risk".

A big issue for many investors and clients is that they don't understand how these complex investments work.

"In a nutshell, structured debt products are a result of financial reengineering, a mathematical restructuring of a series of expected cashflows to create a number of new debt instruments producing a range of theoretical cashflows and of differing credit quality." He says advisers and investors need to be fully conversant with CDOs before committing money to them.

He also says that people rely too much on the credit ratings given to these products.

"A credit rating is not a guarantee of projected return," he says. "Credit ratings can lead too easily to laziness or complacency on the part of advisers who do not properly research or understand structured debt products they recommend and false expectations from their clients."

"Moreover, credit ratings on CDOs are calculated from a different basis than those applied directly to conventional bonds, which is something not often understood by the investing public."

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