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1625848
To: MARC@JANAPARTNERS.COMMARC|I I
Structured Complacency
Credit markets are sanguine. Structured credit is
proliferating. Could the first fact be related to the second?
Yes, we say. There?s no end of explanation for the mysterious
willingness of bond buyers and bank-loan investors to accept persistently
modest returns over riskless government yields. Liquidity has been
superabundant, hedge-fund assets are on the prowl, yield thirst goes
unslaked?all these causes are put forward. We are about to suggest
another explanation for the bewildering complacency of lenders. Spreads
are tight in part because of the growing number of collateralized debt
obligations (CDOs). What these entities share is a strong propensity to
buy and a low propensity to sell. A new fact commands the attention of
lenders and borrowers: Financial engineering is displacing credit
analysis.
Definitions are in order. A CDO is a debt-acquisition enterprise. It
raises money from investors. It acquires assets with the proceeds?bonds,
bank loans, mortgages, asset-backed securitics, etc. It can buy
floating-rate assets or fixed-, senior claims or subordinated. In 2005,
no less than $250 billion of CDOs came into the world, 59% more than in
analysis, we venture the following capsule distinction: financial
engineering is the science of structuring cash flows; credit analysis is
the art of getting paid.
The liabilities side of a CDO balance sheet is what gives the structure
its distinctive investment personality. The liabilities are layered.
Field-strip a typical $100 million CDO and you find, first, a large swath
of ?senior? liabilities, say $70 million worth, rated triple-A; a $20
million ?junior? slice rated single- or double-A; a $3 million mezzanine
piece rated triple-B; and $7 million of unrated equity.
The top-rated assets are not inherently triple-A. Their
strength derives rather from the vulnerability of the assets underneath.
The equity tranche is most exposed; to it goes the first loss. When it
has borne all it can bear (i.e., $7 million), the next loss goes to the
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