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As a Fixed Income Portfolio Manager from 1999-2007 with a $7b fund, I’ve seen some interesting events and innovations. Can you recall the fear of the Y2K Bug which threatened global collapse as the calendar ticked over to 1 January 2000?
Trading opportunities were borne from events like Y2K, as were changes in technology and in some instances, regulation. As Portfolio Managers, we would embrace these, make educated decisions, and aim to create profitable positions for our investors.
I saw The Big Short on the weekend and while it does a good job at explaining some of the concepts around the GFC in simple terms (with the help of Margot Robbie and Selena Gomez), it also got me thinking about how it all played out in Australia. And why the US subprime collapse managed to affect everyone around the world.
Bonds are debt instruments – an IOU from a Government, Bank or Company. An investor gives money for a fixed term, and gets compensation in return, usually in the form of a fixed coupon. This IOU can be traded in the (bond) market, meaning an investor can sell their bond to another investor for cash. The bond market is mostly over-the-counter (OTC), and relies on “market makers” to make a price Bid (to buy) or Offer (to sell). Market makers are usually the investment bank that helped originate* the bond.
The Australian bond market was historically dominated by Federal and State government bonds, and the Banks. Over the years, our ever growing superannuation system and the funds it produced needed to be invested. This proved a lucrative honey pot to global companies looking for funding, as well as to Banks; enabling them to free up their balance sheets via origination.
The Australian market soon had international banks like ABN AMRO, HSBC Midlands, Rabobank and Citigroup funding their domestic operations here, and introducing fund managers to names like Wachovia Bank, Ford Credit, Household Financial, Lehman Brothers and John Deere. Banks with loan exposure to residential mortgages would “package” them up in special purpose vehicles (SPVs), also selling them to investors.
In 2002, Deutsche Bank listed Australia’s first CDO^ on the ASX – the Nexus bond. Nexus promised a yield of 10.25%p.a over a 5 year term, which compared favourably to a cash rate of 4.75%, and 5 year bond trading above 5%. It was marketed and sold as exposure to 40 well known companies like the AAA rated GE, AA rated Telstra, A rated Coca-Cola, & BBB rated DaimlerChrysler. Names any retail investor would know, but possibly not realise that some of them had deteriorating credit ratings. Nexus went on to issue 3 more CDOs into the market over the following years.
Credit ratings are issued by the main ratings agencies – Standard & Poor’s, Moody’s, Fitch, and paid for by the issuer. They’re used to assess the credit worthiness of the issuer, and reflect the ability of the company to meet their financial obligations as they fall due. AAA is considered the highest quality, and anything below BBB- (or Baa3 on the Moody’s scale) would be considered sub investment grade or “junk”.
Fund managers would typically have a “mandate” or set of rules given to them by their investors. Exposure to bonds and associated credit limits were largely driven by credit ratings. With this in mind, if you could “structure” up an investment which could be rated by the Agencies as AAA, you could more easily market it to some fund managers or investors.
In the RBA’s 2005 Financial Stability Review they estimated that 20% of new issuance of CDOs was taken up by large fund managers (mainly high-yield bond funds), 65% middle market investors (like universities, local government and charities), and 15% to retail investors. They even made the comment that the number of large Australian fund managers taking up CDOs “is small” (compared to overseas markets), and that the proportion of retail investors was high.
Did that mean large fund managers could smell rats? In 2007, innovation accelerated further, with investment banks marketing CDO2 (or CDO-Squared). The CDO² were made up of the lower tranches of CDOs, but when combined, the ratings agencies would still rate some of it AAA.
I can recall being in a meeting with Lehman, and asking them to repeat what they had just said. Even with my Masters in Applied Finance I had to think this one through. I was surprised by the innovation, and asked who was buying them. Unfortunately (as the RBA had identified earlier), it was charities, local governments, universities, and retail who payed the price when the CDO2 market collapsed.
I read The Big Short several years ago, and was interested in the insight it gave into how Wall St operated. Most notable for me, was the “bullying” type culture of making products people find hard to understand, yet buy to feel smart.
The bottom line? If you don’t understand it, don’t buy it.
* Origination is a term used to “create a deal”, by sourcing , marketing, and executing or selling it.
^ Collateralised debt obligation
