Getting a handle on CDOs is a complex challenge

Collateralized debt obligations, or CDOs, have been a hot product with many big investors. Yet their complexity has put off even some of the largest institutional investors.

The California Public Employees’ Retirement System, for example, has steered clear of CDOs in recent years, said Curtis Ishi, a senior investment officer at the pension fund.

“We need to understand the management and how they produce returns,” Ishi said. CDOs, he said, require “quite a bit of analysis.”

These typically aren’t investments that mutual funds buy. Los Angeles-based TCW Group, one of the biggest manager of CDOs, says none of its retail mutual funds owns CDOs.

The central idea of a CDO is to take a pool of assets, such as mortgage-backed securities, and carve it into slices that offer varying levels of risk and return.

That involves a lot of financial modeling about how the underlying assets will fare.

The background of people who work on CDOs says something about the complexity of the products: Pete Nolan, who analyzes the portfolios for money manager Smith Breeden Associates in Chapel Hill, N.C., has a Ph.D. in sub-molecular physics.

Because of CDOs’ complexity, analysts say, many institutional investors simply relied on the quality grades that major bond rating firms gave to CDO slices. If a rating firm said a CDO slice was of good quality, that may have been enough justification for an investor to own it.

“They were buying a rating,” said Scott Simon, a mortgage expert and money manager at Pacific Investment Management Co. in Newport Beach.

Now, amid rising mortgage defaults and deepening fear about widespread fraud in loan underwriting during the housing boom, the rating firms are under pressure to review their upbeat CDO grades.

Relatively few of the CDOs sold in recent years have been downgraded.

“No one can say we’re not aware of the risks,” said Kevin Kendra, an analyst at rating firm Derivative Fitch. “It just hasn’t materialized yet” in the structure of CDOs, he said.

Yet many analysts say the market prices of the diciest mortgage bonds, those backed by so-called sub-prime loans, indicate that still-rosy CDO ratings aren’t reflecting reality.

Some mortgage bonds rated BBB, the lowest investment-grade rating, “are going to see real losses of principal soon,” predicted Janet Tavakoli, head of Tavakoli Structured Finance Inc., a consulting firm.

What happens if investors are shocked to see their CDO slices downgraded in quality, and fear worse to come? Because CDOs are private pools, selling out isn’t necessarily a snap.

Investors either could go to Wall Street to try to sell their piece of the pie, or back to the CDO manager. Either way, the risk is that investors would end up selling at fire-sale prices -- and add more fuel to the meltdown already well underway in many mortgage securities.