Capital Markets

The Toxic Avenger

Capital hero or capital punishment? The verdict's still out on collateralized debt obligations.
Tim ReasonJanuary 1, 2002

Things could be worse. Despite a dismal economy, companies with solid credit have had little trouble raising capital. And although borrowing is tougher for companies with a double-B rating or lower, capital markets are more diverse than they were back in July 1991, when default rates caused by the last recession peaked.

“There was no material source of nonbank capital in the loan market then,” notes Dan Gates, senior vice president of Moody’s Investors Service. “This time around, the leveraged loan market looks to be stronger, because you have an additional class of lenders.” Gates is talking about collateralized debt obligations (CDOs), an investment vehicle invented about five years ago that slices up corporate loans or other assets into tranches with varying levels of risk. The investment-grade top tranches, which pay off earlier, have much higher credit ratings than the borrowers themselves, making them attractive to investors. “CDOs are one of the keys to providing capital to noninvestment-grade borrowers,” says Gates.

Of course, some investors must also hold the lower tranches, including the unrated bottom, or “equity,” tranche–often called the “toxic waste.” American Express Financial Advisors, Conseco, and other institutional investors have all been burned recently by toxic waste from CDOs written four to five years ago. “Certainly some investors have already been shying away from CDOs,” admits Jerry Gluck, managing director of Moody’s CDO-rating team. “We have downgraded a lot of them this year.”

Observers also say downgrades of CDOs lag behind downgrades of the underlying corporate debt–another worry for investors. “The good news,” counters Gluck, is that sharp increases in spreads over Treasuries have increased the potential arbitrage for equity holders.

Can investors overcome the toxic fallout? “I think we are still seeing the CDO track record evolve,” says Julie Burke, a managing director of Fitch IBC’s Insurance Group.