More on CDOs and Derivatives

When Scott Patterson wrote about CDOs as though they were derivatives this morning, I slapped him a little: I thought it a silly mistake. But now I see that Tony Jackson is doing exactly the same thing in the FT, and I'm beginning to wonder whether there's something I'm missing. Here's Jackson:

Contrast the Bear Stearns case, which triggered the latest mini-crisis. The other banks that inherited the subprime derivatives in question have held off selling them, precisely because they risk crystallising a much lower market price – which would then apply across the board.

The "subprime derivatives in question" are, of course, CDOs. And most of what goes into CDOs is not subprime derivatives at all, but rather loans or mortgage-backed securities.

Now I do appreciate that some CDOs do play in the CDS market. (All these three-letter acronyms can be confusing: a CDO is a collateralized debt obligation, which basically just means pool of loans. A CDS, on the other hand, is a credit default swap – a derivative contract based on whether or not a certain credit goes into default. I know that they share their first two letters, but the two abbreviations don't have a single word in common.)

But here's the thing: insofar as the problem with CDOs is their subprime exposure, then their CDS exposure is not an issue. The CDS market is much less developed in the world of subprime mortgages than it is in the world of corporate and sovereign credits. CDSs on certain mortgage-backed securities do indeed trade, and they're generally more liquid than the underlying securities. But as I understand it, these particular derivatives are trading vehicles, or dynamic hedges: they're not generally long-term investments which get issued by CDOs and then have to be unexpectedly valued in a liquidation scenario.

If you look at the sheer quantity of subprime-backed bond issuance, it seems clear that there's more than enough actual paper to go around – if CDOs wanted exposure to subprime mortgages, they tended to simply buy those subprime mortgages. By contrast, much of the rise in CDS issuance is a consequence of demand for credit meeting the reality of relatively little new bond issuance. So CDOs start writing credit protection instead – a strategy which replicates the risks of buying bonds, without having to actually source the bonds in question.

As a consequence, there are a lot of CDOs which have a lot of exposure to the CDS market. There are also a lot of CDOs which have a lot of exposure to the subprime market. I just don't think they're the same CDOs.