Seven years after the global financial crisis, collateralized debt obligations and mortgage backed securities are back and in good health. According to the latest data, sales of both CLOs (CDOs with loan collaterals) and CMBS (Commercial mortgage-backed securities, the pools on which CMOs are based) are expected to exceed pre-2007 levels this year, respectively with $100bn and $106bn of new underwritings (FT). This is particularly striking if we consider that until 2010 markets for most structured products had basically been wiped out. A case in point is that of Mortgage backed securities, new issuances of which slumped from $ 1,200 Billion in 2007 to 200 billion dollars in a year.
As from 2012, super low interest rates in the US have been moving investors’ preferences from bonds towards higher yielding securities; the CLO market also took advantage of a sharp fall in the leveraged loan retail market in April, which made the purchase of new assets for securitization much cheaper. However, the FED has already warned that the parts of the credit market such as leveraged lending might be overheating, as the weakest debtors are likely to default on their loans as soon as interest rates rise in 2015. Though CMBS default rates might be a fraction of the crisis-era figure of 1.97% (2008), they have increased to 0.06% as insolvencies on underlying mortgages emerge.
In short, despite the new wave of enthusiasm about structured products, such instruments and the issues they face are basically the same ones of the last credit boom which eventually led to the 2008 meltdown.
Could these securities play a role in causing another crisis?
In our view, many things have changed since 2008 and it is highly unlikely that CDOs will be used again in the same irresponsible manner.
To begin with, the new 2.0 CLOs and CMBSs are structurally different from their ancestors, as over time underwriting standards have improved and new regulation has been enforced. There are currently stricter rules concerning the underlying collateral to structured products: many of these securities are already Volcker Rule-compliant, I.E. they meet the requirements that will not be effective until 2019.
Regulation helped improve standards, but the real change is that in buyers’ preferences, according to Credit Suisse.
Prior to the crisis, in fact, the safest and lowest defaulting CDOs were the hardest to sell, as investors sought for the highest yields at whatever cost and gobbled up billions of Subprime-backed residential MBS and CLOs based on leveraged loans to poorly rated firms. Unlike in the old days, new buyers (especially hedge funds and European institutions) are now more risk adverse and look for the safest high yield securities.
New instruments are also being built paying more attention to the diversification of risk. Before the crisis CMOs were typically based on residential mortgages on properties in the same geographical areas, thus concentrating risk and making securities vulnerable to market downturns; on the contrary, today most MBS are bundled-up commercial mortgages, which did not suffer as much as their residential counterparts in the 2008 collapse.
In conclusion, given the different underwriting standards, the general regulatory context and a milder risk appetite of investors, we believe fears concerning securitized products might be excessive. This does not mean that these securities will not suffer from interest rates rises, as they probably will (at the moment interest rates, and consequently default rates, are at unsustainably low levels), but their demonization will not help either.
The Financial Crisis Inquiry Commission agrees that structured products are a powerful risk management tool-provided that they are used correctly and within reasonable limits; during the last credit bubble such securities were ill-built, mispriced and over-rated, eventually leading to the downfall we all know too well.
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