Subprime mortgage scare spurs even fancier CDOs

By Neil Shah- Analysis

NEW YORK (Reuters) - With the subprime mortgage crisis making investors wary of collateralized debt obligations, or bonds secured by other bonds, Wall Street is cooking up even riskier deals offering bigger returns to lure hedge fund investors.

Managers of collateralized debt obligations, or CDOs, are taking advantage of a recent spike in yields on subprime-related CDOs to churn out these more lucrative deals, called "CDO squareds."

A CDO squared, put simply, is a CDO secured by other CDOs.

CDOs are securities backed by one or more types of debt products such as junk bonds, mortgage-backed securities or credit derivatives, which are insurance contracts that allow investors to bet on the credit-worthiness of a company.

CDO squared issuance has soared about 900 percent this year compared with last year's first quarter, with seven deals worth $4.4 billion, JP Morgan said. Six more are in the pipeline.

"We're expecting to see a lot of CDO squared activity," said Kedran Garrison, vice president at JP Morgan in New York.

But the rise of CDO squareds, which were last popular a few years ago, could make a bad hangover from the subprime crisis worse if borrowers start defaulting in higher numbers.

"You have the potential for a small change in the performance of the underlying (collateral) to completely blow you up," said Mark Adelson, head of structured finance research at Nomura Securities International in New York.

HUGE RETURNS

Cautious buyers like pension funds gobbled up traditional CDOs as interest rates fell because CDOs offered higher yields but still carried strong ratings from credit agencies.

An average CDO might contain 100 bonds divided into different layers based on their exposure to default, with buyers of the lowest pieces getting the highest yield but paying higher-ranking investors if the CDO faced trouble.

Many buyers have been skeptical of CDO squareds, however.

"You have a mortgage inside a (mortgage) bond inside a CDO inside a CDO," a trader at a Wall Street firm said. It's "very complex. So in general investors don't like them.

"But the reason that there are so many coming to market right now is because the equity returns" are huge, he added.

This is how it works: Rising defaults on subprime loans, or loans to risky borrowers, have boosted the "spread," or yield premium, on lower-tier portions of subprime mortgage CDOs.