Tuesday, September 25, 2007

CDOs: The Emperor has no underwear on

Marvelous couple of paragraphs in last week's Economist piece on securitization:

Steven Schwarcz, a professor at Duke University and writer on securitisation, has come across contracts which are so convoluted that it would be impractical for investors to try to understand them: they would have to spend more money hiring experts to deconstruct them than they could ever hope to earn in extra returns.

In a recent paper* on credit derivatives, David Skeel and Frank Partnoy concluded that collateralised debt obligations (CDOs), one of the most common derivatives, are too clever by half. The transaction costs are high, the benefits questionable. They conclude that CDOs are being used to transform existing debt instruments that are accurately priced into new ones that are overvalued.

To recap:

1. CDOs are so complicated the cost of understanding them is greater than the benefit (er, what benefit?) and,

2. The purpose of CDOs is to take a bunch of bonds, mix them all up, dress them up in fancy clothes - and charge more for them.

Reminds me of an old joke about lawyers which can easily be refitted for present circumstances: what do you call 10 thousand investment bankers tied to the bottom of the ocean? A good start.

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