Banks announced plans to repackage collateralized debt obligations (CDOs) into new, highly rated securities.
The drop in demand for securitized debt starved markets of an important source of lending.
A securitized debt revival (though uncertain) could help banks and credit markets.
Have you ever turned on the radio and heard a familiar song, only to realize the melody's changed? Remixes can be refreshing improvements on old classics or make a slow jam into a dance tune. Today's structured debt market might be in for a bit of a remix too. Collateralized debt obligations (CDOs) were vilified as tools of financial malfeasance last fall, but they soon could have investors dancing to a brand new beat. Recently, financial firms have been repackaging beleaguered CDOs into new highly rated securities, making these so-called "toxic" assets much more palatable to investors. To some, this might seem akin to putting a new cover on a Rolling Stones album—the same old songs with a shiny new look. But revitalized interest in the market for structured debt could help the economy get its groove back.
Elevated default rates and a grim economic picture caused ratings agencies to downgrade scores of CDOs. Lower ratings reduce the demand for these investments because many of the buyers—including banks, insurance companies, pension funds, etc.—want or have to own debt deemed "investment grade." Anemic demand for already illiquid assets and off-base mark-to-market accounting rules contributed to billions of dollars of asset write-downs on firms' balance sheets. Now, banks are repackaging these distressed assets with features giving the top-tier portions greater protection from defaults, making them more attractive to investors seeking safety. The lower-tier portions will have higher yields to entice hedge funds and other investors willing to accept more risk. Overall, the reconfigured CDOs promise more transparency, at least partially lifting the veil of uncertainty associated with these complex products.
At first blush, this might all seem like more questionable financial engineering emanating from what was once Wall Street. But innovation is often a bumpy ride and capital markets evolve quickly. Signs of life in the structured debt market can have important, positive implications for the economy and stock market.
It's no secret many types of loans are now harder to come by than early Beatles vinyl, but suddenly stingy banks aren't the main reason for reduced lending. Lack of demand for structured debt had an even more deleterious impact. CDOs were an important part of this market prior to the onset of the credit crisis. In 2006, over $520 billion worth of CDOs were created worldwide. By 2008, that amount fell to only about $60 billion. Many dour economists cited the impaired CDO market as a reason the recession has persisted. A nascent revival in what has been the most troubled corner of the structured debt market would positively sign structured debt can once again be an important future source of credit. In fact, these deals already boosted demand and narrowed spreads for commercial mortgage-backed securities.
The repackaging of existing structured debt could also benefit bank balance sheets. As we've asserted many times, banks were forced to write down assets well below their actual values. If banks repackage written-down assets, these assets could effectively be written-up as the new CDO tranches are sold.
Demand for new-and-improved CDOs could bode well for the economy. Considering the large role structured debt played in credit markets prior to last year's panic, remixed CDOs might just have a beat we can dance to.