CDOs are back! How to spot them in fund holdings?

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nisiprius
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CDOs are back! How to spot them in fund holdings?

Post by nisiprius » Mon Apr 22, 2013 6:36 am

Let me begin by acknowledging this is a hypothetical concern since I (blindly) trust Vanguard's bond funds. The story of Mabel Yu's role in keeping subprime-based securities out of Vanguard's bond funds is good enough to make me feel pretty secure.

Still, it appears that CDOs are back, see story below. Very likely the first ones will be relatively good, but if nothing else, the subprime crisis proved to me that either a) the financial community does NOT know how to assess their risk accurately, or b) this is a (legal) scam of the asymmetric-information variety--the issuer does understand the risk, but hopes that it has been successfully hidden from the "fools in Stuttgart" who buy them.

So, when one is looking through a Morningstar portfolio summary or a list of holdings, what would one look for to figure out whether a fund is dabbling in the kind of investments that blew up so spectacularly before? I'm sure they've figured out new and euphemistic names for them. Just looking for "mortgage backed" isn't good enough because of course there is are perfectly sound mortgage backed securities in the BarCap index, Total Bond, etc. (Larry Swedroe warns against them, but he's made it clear that he's talking about an incremental problem--a small amount of illusory outperformance that may one day suddenly become a small amount of underperformance--not a catastrophe).

I don't worry too much about the supposed "bond bubble" and interest rate risk, but I do worry about "cowboy bond manager risk", and I worry about it more in a competitive environment where bond earnings are low and managers may be tempted to distinguish themselves from the competition. This isn't a vacuous concern; see Schwab Total Bond Market SWLBX, Fidelity Ultrashort FUSFX, The Principal Inflation-Protected PIFSX, Oppenheimer Core OPIGX below. And note that Schwab Total Bond, although it wasn't strictly speaking an index fund, had tracked the BarCap Aggregate index just as closely as Vanguard Total Bond for fourteen years.

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As for CDOs being back: NYT story, Wall St. Redux: Arcane Names Hiding Big Risk (If that link doesn't work, Google search on the title by clicking here and click on the first result.)
The banks that created risky amalgams of mortgages and loans during the boom — the kind that went so wrong during the bust — are busily reviving the same types of investments that many thought were gone for good. Once more, arcane-sounding financial products like collateralized debt obligations are being minted on Wall Street.

The revival partly reflects the same investor optimism that has lifted the stock market to new heights. With the real estate market and the economy improving, another financial crisis seems a distant prospect.... the revival also underscores how these investments, known as structured financial products, have largely escaped new regulations that were supposed to prevent a repeat of the last financial crisis.

“All of this seems like a fairly quick round trip,” said Manus Clancy, a managing director at Trepp, a research firm that focuses on commercial real estate. “You are seeing a fair number of sins being forgiven.”

Banks are turning out some types of structured products as fast or faster than they did before the bottom fell out....

....The structured product that has been the fastest to revive is the one that encountered the least trouble in 2008: collateralized loan obligations. These involve pools of loans given to companies with junk ratings.... banks have been able to loosen underwriting standards on the underlying loans and bonds. This provoked the Federal Reserve to release guidance last month warning that “prudent underwriting practices have deteriorated.”

....last year, revenue from securitizations was up 68 percent, according to the data company Coalition.

“Literally we thought the business was gone,” said Jeanne E. Branthover, a Wall Street recruiter. “The surprise is that this is a skill that banks are looking for again."
Last edited by nisiprius on Mon Apr 22, 2013 6:44 am, edited 2 times in total.
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Re: How to spot flaky stuff in bond fund holdings?

Post by livesoft » Mon Apr 22, 2013 6:41 am

This is especially important for folks who have to use non-Vanguard bond funds in their 401(k) plans.

Back in 2008, I looked at my 401(k) and wanted to exchange into a "safer" bond fund. I chose the one with "government securities" in the name, but did not look inside the fund. It turned out to own a big chunk of Countrywide junk and dropped 10% in the month after I bought it.
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F150HD
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Re: CDOs are back! How to spot them in fund holdings?

Post by F150HD » Mon Apr 02, 2018 10:18 pm

Published 3:44 PM ET Thu, 29 March 2018......Issuance of securities backed by riskier US mortgages roughly doubled in the first quarter from a year earlier, as investors lapped up assets blamed for bringing the global financial system to the brink of collapse a decade ago.

Article: US subprime mortgage bonds back in fashion

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Re: CDOs are back! How to spot them in fund holdings?

Post by Valuethinker » Tue Apr 03, 2018 3:31 am

F150HD wrote:
Mon Apr 02, 2018 10:18 pm
Published 3:44 PM ET Thu, 29 March 2018......Issuance of securities backed by riskier US mortgages roughly doubled in the first quarter from a year earlier, as investors lapped up assets blamed for bringing the global financial system to the brink of collapse a decade ago.

Article: US subprime mortgage bonds back in fashion
Thank you for that.

I noted:

- underwriting standards are still tougher than pre crash- the banks have paid 10s of billions of fines over defrauding investors, so their risk control people will be all over it. Also the banks are required to keep 5% of the mortgages on their balance sheet, when they securitize

- the market is still small (but growing)

I don't think this is (yet) a major risk-- granting that the article has "spin" in it. Probably more worried re subprime car loans etc.

It's almost certain the next financial crisis will not be in the same type of debt or sector of the economy as the last one. My own bet is Canadian and Australian housing- and those are now big enough bubbles to have a noticeable effect on the world financial system, but probably not in and of themselves enough to cause another global financial crisis. But there are always linkages that one misses-- as there were with the US mortgage crisis.

Someone suggested Hong Kong, which has all the symptoms of overvaluation of Vancouver etc., as well as concentrated financial institutions with deposits and assets much larger than GDP-- which was true of Iceland, Ireland & the UK at the time of the last crash. I don't know enough about the HK financial system nor wrt to the PRC itself. My presumption is they would bail out HK at the cost of curtailment of freedoms. But that's a presumption.

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Re: CDOs are back! How to spot them in fund holdings?

Post by Whakamole » Tue Apr 03, 2018 9:41 am

Valuethinker wrote:
Tue Apr 03, 2018 3:31 am
- underwriting standards are still tougher than pre crash- the banks have paid 10s of billions of fines over defrauding investors, so their risk control people will be all over it. Also the banks are required to keep 5% of the mortgages on their balance sheet, when they securitize
I would point to Wells Fargo as an example of a bank whose risk control department seemed to be asleep (willfully or not) at the recent fake account scandal. It didn't take that long for one of the largest banks in America to forget, while not the specific lessons about underwriting standards, at least the lessons about good stewardship and not breaking the law.

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Re: CDOs are back! How to spot them in fund holdings?

Post by Valuethinker » Tue Apr 03, 2018 10:38 am

Whakamole wrote:
Tue Apr 03, 2018 9:41 am
Valuethinker wrote:
Tue Apr 03, 2018 3:31 am
- underwriting standards are still tougher than pre crash- the banks have paid 10s of billions of fines over defrauding investors, so their risk control people will be all over it. Also the banks are required to keep 5% of the mortgages on their balance sheet, when they securitize
I would point to Wells Fargo as an example of a bank whose risk control department seemed to be asleep (willfully or not) at the recent fake account scandal. It didn't take that long for one of the largest banks in America to forget, while not the specific lessons about underwriting standards, at least the lessons about good stewardship and not breaking the law.
That, I think, is a different aspect of risk control?

WF clearly had a culture of targets, and that led to the falsification of those targets.

That's separate from identifying products where there is an incentive to ignore loan risks (on the underwriting side) and also on the reselling/ origination side (that packages up and selling the mortgages as bonds).

Perhaps I don't fully understand how Risk works across departments in a bank.

Nonetheless I am fairly sure, for most US banks, the creation of MBS will be tightly supervised-- because the bank still has "skin in the game" post deal AND because of the costs to the banks in terms of federal fines.

I agree with you (implicitly) that there are still fundamental issues in risk-reward in banking and incentives. Thus, the sector has to be highly regulated wrt capital and liquidity.

I suspect the real risk in the financial system has moved to non bank participants - the so-called Shadow Banking System.

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Re: CDOs are back! How to spot them in fund holdings?

Post by welderwannabe » Tue Apr 03, 2018 11:04 am

There is really nothing wrong with CDOs. Having tranches of various priorities can be a help to investors. The real issue was the underwriting standards and the lack of effective ratings by the ratings agencies.

The real problem was taking a bunch of subprime crap, putting them in a CDO, and then the first 50% of tranches AAA and the second half AA. That is what got everyone in trouble. A CDO doesn't have to be full of sub prime, although I recognize the utility of them is reduced in that case.

I stay away from MBS, and don't like the 'opacity' of CDOs myself, but I feel the construct of a CDO can be a valid investment vehicle as long as an investor can understand everything that is in it and the underlying cash flows work for them.

CDOs of CDOs is another story.
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Re: CDOs are back! How to spot them in fund holdings?

Post by ThrustVectoring » Tue Apr 03, 2018 3:01 pm

IMO the fixed income side of your portfolio is not where you want to take risks. If you need higher returns, you're typically better compensated by increasing equity exposure than by choosing less-safe bonds.

Personally, all my money is in either FDIC insured accounts, bonds issued by the US treasury department, or in the stock market.

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Re: CDOs are back! How to spot them in fund holdings?

Post by tesuzuki2002 » Tue Apr 03, 2018 3:07 pm

Whakamole wrote:
Tue Apr 03, 2018 9:41 am
Valuethinker wrote:
Tue Apr 03, 2018 3:31 am
- underwriting standards are still tougher than pre crash- the banks have paid 10s of billions of fines over defrauding investors, so their risk control people will be all over it. Also the banks are required to keep 5% of the mortgages on their balance sheet, when they securitize
I would point to Wells Fargo as an example of a bank whose risk control department seemed to be asleep (willfully or not) at the recent fake account scandal. It didn't take that long for one of the largest banks in America to forget, while not the specific lessons about underwriting standards, at least the lessons about good stewardship and not breaking the law.

Excellent point! I opened a simple checking account at WF 3 weeks ago... I've gotten 6 account offers in the mail... and I suspect I probably now have 3 accounts I don't yet know about and possibly a new car insurance policy. :oops: :oops:

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Re: CDOs are back! How to spot them in fund holdings?

Post by Whakamole » Tue Apr 03, 2018 3:23 pm

tesuzuki2002 wrote:
Tue Apr 03, 2018 3:07 pm
Whakamole wrote:
Tue Apr 03, 2018 9:41 am
Valuethinker wrote:
Tue Apr 03, 2018 3:31 am
- underwriting standards are still tougher than pre crash- the banks have paid 10s of billions of fines over defrauding investors, so their risk control people will be all over it. Also the banks are required to keep 5% of the mortgages on their balance sheet, when they securitize
I would point to Wells Fargo as an example of a bank whose risk control department seemed to be asleep (willfully or not) at the recent fake account scandal. It didn't take that long for one of the largest banks in America to forget, while not the specific lessons about underwriting standards, at least the lessons about good stewardship and not breaking the law.

Excellent point! I opened a simple checking account at WF 3 weeks ago... I've gotten 6 account offers in the mail... and I suspect I probably now have 3 accounts I don't yet know about and possibly a new car insurance policy. :oops: :oops:
You forgot the new mortgage! :beer

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Re: CDOs are back! How to spot them in fund holdings?

Post by ThrustVectoring » Wed Apr 04, 2018 12:54 pm

taguscove wrote:
Tue Apr 03, 2018 9:50 pm
The markets are efficient. That's the whole point of being on the Bogleheads forums. CDOs are a great way to diversify your beta portfolio.
Not all markets are efficient. They're only as efficient as pricing discrepancies are exploitable. The thickly traded equity markets with tons of public information are highly efficient. Thinly-traded and poorly understood derivative products, though? Much less likely to be efficiently traded.

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