Collateralized Debt Obligations, Bond Obligations and Loan Obligations are entities that collect

capital from investors and lenders with which to construct portfolios of the relevant instruments.

The capital structure of the entity is tiered, so that the providers of capital have varying priorities

in terms of being repaid and participating in losses.

The senior-most lender enjoys security from the entire portfolio, and because his loan is thus

heavily over-secured and highly rated, he demands only a low rate of return. The second-most-

senior loan is a bit less well secured and less highly rated, and thus the rate demanded on his debt

is a bit higher, and so forth. Because the interest rates promised to the senior lenders are below

the average coupon on the portfolio, there should be a lot of cash left over for the junior lenders

and the equity investors – if things go well. But the equity is also in the first-loss position, so it’s

truly a make-it-or-break-it proposition.

Vast sums have been raised for this “silver-bullet” solution to the problems of allocating risk,

leveraging returns and putting money to work. Clearly, the key to seeing all this work out lies in

enough credit expertise being present for risks to be controlled and defaults minimized. But

today the necessary ingredient for the establishment of these structured vehicles isn’t credit

expertise, but the ability to structure the entity so as to win high-enough ratings on the senior

tranches to attract capital and permit a lot of leverage. This distinction is highly significant. In a

clear analogue to real estate appraisers, the people controlling the all-important credit spigot are

the financial structurers assembling the entities and the CDO analysts at the credit rating

agencies.

In a June 2 article entitled “Structured Complacency,” the often-brilliant “Grant’s Interest Rate

Observer” went into great (and, as usual, critical) detail on this phenomenon. As to the

popularity of structured vehicles, it wrote, “Credit markets are sanguine. Structured credit is

proliferating. Could the first fact be related to the second?” And as a key part of this trend,

it says, “Financial engineering is displacing credit analysis.” What’s the difference?

“Financial engineering is the science of structuring cash flows; credit analysis is the art of

getting paid.”

Why the declining interest in credit analysis? Grant’s advances the thesis that it is linked to

disintermediation, in which many lenders no longer hold on to the loans they make, but more

often syndicate or sell them onward to other providers of capital. Holding the keys in this

process are the risk manager who structures the entity based on statistical likelihoods and the

rating agency that applies the stamp of approval for buyers lacking direct knowledge of the

underlying instruments and the ability to understand the structure. Grant’s quotes the IMF’s

2006 Global Financial Stability Report:

Not surprisingly, the development of structured credit markets has coincided with

the increasing involvement of people with advanced financial engineering skills

required to measure and manage these often complex risks. In fact, for many

market participants, the application of such skills may have become more

important than fundamental credit analysis. . . .

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