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Incentives for Reckless Investing? How CDO managers contributed to the 2007-09 financial crisis

Friday, September 6, 2019

Collateralized Debt Obligations

Collateralized debt obligations (CDOs) and other structured products played a significant role in the credit boom of the early 2000s and the ensuing financial crisis of 2007 to 2009. Contributing to the economic disaster were the actions of a number of CDO collateral managers, who packed their products with inferior components: risky portions of private-label residential mortgage-backed securities (RMBS).


Research by Sergey Chernenko, associate professor in Purdue’s Krannert School of Management, shows why these collateral managers were willing to risk their reputations and select low-quality collateral for their CDOs. Investment banks underwriting the low-rated securities offered an incentive that some could not resist: if they selected the securities for their CDOs, they'd be rewarded with more CDO management assignments.


"The collateral managers wanted to attract more business," said Chernenko, who conducted his research while working at Ohio State University. "The way to attract more business is to effectively cater to the investment banks who were underwriting these securities. What I tried to show is evidence that the managers who were more willing to have their CDOs invest in securities that underwriters couldn't sell to anyone else appear to have been subsequently rewarded with more assignments of CDOs to manage."


From 2002 to 2007, about $661 billion worth of non-AAA-rated private-label RMBS worth were issued. During the same period, about $860 billion worth of CDOs were issued, the bulk of which was invested in asset-backed securities (ABS).


In his paper "The Front Men of Wall Street: The Role of CDO Collateral Managers in the CDO Boom and Bust," published in the October 2017 issue of The Journal of Finance, Chernenko studies the identity, incentives and performance of collateral managers of ABS CDOs issued from 2002 to 2007. His paper fills a gap in academic literature by illuminating the role of collateral managers in the financial crisis, while also adding to the growing body of literature on conflicts of interest in the securities market. 


To conduct his research, Chernenko gathered information on 136 collateral managers from a variety of sources, including deal prospectuses, Standard and Poor’s pre-sale and CDO manager focus reports, and the SEC’s Form ADV.


Chernenko finds evidence to support the view, popularized by Michael Lewis in his book The Big Short, that collateral managers acted as front men for the investment banks, engaging in a quid pro quo that impaired their independent judgement in selecting securities for their CDOs.


A number of SEC administrative proceedings and private lawsuits were brought against collateral managers, alleging that they misrepresented who would make collateral selection decisions. Most notable are those involving deals sponsored by Magnetar Capital, a suburban Chicago hedge fund. 


As reported by ProPublica reporters Jesse Eisenger and Jake Bernstein, who won a Pulitzer Prize for their coverage of the CDO industry, Magnetar sponsored tens of billions of dollars of new CDOs and at the same time placed bets, through credit default swaps, that portions of its own deals would fail. To increase the probability that the CDOs would fail and Magnetar would profit handsomely on the short bets, the hedge fund pressured CDO collateral managers to include riskier assets in their CDOs.


The “Magnetar Trade,” as the deals were known, were not illegal, according to Eisenger and Bernstein, but “illustrate the perverse incentives and reckless behavior that characterized the last days of the boom."


Chernenko notes in his paper that not all collateral managers were willing to abdicate their responsibility for selecting collateral. “Many worried about the possibility of negative reputational effects for their non-CDO businesses,” he writes. He cites the example of Ischus Capital Management, which was unwilling to invest in a portfolio of securities suggested by Magnetar, responding in an email that “we will not assemble a portfolio we are not proud of.”


Lending credence to the front man narrative, Chernenko finds that specialized managers in particular were willing to cater to CDO underwriters by investing in low-quality collateral that investment banks were unable to sell to anyone else. 


Diversified managers were less likely to engage in bad deal-making and risk their reputations. They were concerned about harming the franchise value of their other businesses. As a result, they lost market share over time, but the CDOs that they assembled performed better than those of specialized managers. 


Not all diversified managers were able to maintain high standards. Chernenko’s research, while not ruling out alternative explanations, suggests that competition from specialized managers produced a “race to the bottom” that ensnared diversified managers as well, resulting in blemished reputations. Institutional investors punished such managers by withdrawing from mutual funds managed by firms whose reputations had been stained.


Reputational risks are more significant to many collateral managers than financial risk, Chernenko notes, because collateral managers do not necessarily invest in the CDOs that they manage and because a large portion of their management fees comes in the form of upfront and senior fees that do not depend much on the CDO’s performance.


Chernenko’s findings suggest a way for regulators to track potential instability in a market. In actively growing markets, if specialized managers' market share outpaces diversified managers' or if most of the activity is driven by new entrants who don’t have much reputation or franchise value at stake, that could be a sign of trouble ahead.


"It could be just one of a number of different signals that regulators pay attention to," Chernenko said.


By Melvin Durai



Chernenko, S. (2017). The Front Men of Wall Street: The Role of CDO Collateral Managers in the CDO Boom and Bust. Journal of Finance, vol. 72 (5), 1893–1936.