(This article appears courtesy of International Financial Law Review, sign up for a free trial on their site) In his recent Mansion House speech Mervyn King, the governor of the Bank of England, focused on some of the concerns surrounding investment in CDOs and the structural implications for the financial system of their increasing prevalence. Some of those concerns may be overplayed.
Historically, CDO-squared transactions have come in for the most criticism. These instruments pool together a portfolio of underlying CDO transactions in certain circumstances, magnifying the effects of a default that might be present in more than one of the underlying CDOs. This can create a precipice effect, because a single default can have a catastrophic effect on a CDO-squared transaction, multiplying loss to the structure. There has been criticism of lemming-like behaviour in the investor base where, in a low-spread environment, investors have sought to increase their returns by investing in these riskier portfolios. Concerns over CDO-squared transactions have been exacerbated recently because many deals have an exposure to CDOs of ABS linked to the US sub-prime market. However, most investors in these products are sophisticated, and do not rely simply on ratings, but conduct their own extensive review of the underlying portfolios, drilling down into all the underlying transactions to reach an informed assessment of the risk involved.