Hedge funds are bringing back collateralized debt obligations, or CDOs. These are the same financial vehicles that caused the severe financial crisis of 2008.
A CDO is essentially a collection of debt, often home mortgages, and is reliant upon people successfully paying off their debts. When all goes well, it can pay off wonderfully. However, if people go into default, disaster can strike.
CEO of StoneCastle Financial Joshua Siegel says that his group is one of the hedge funds that is reviving CDOs. He insists that this time it will be different.
The CDO created by StoneCastle is backed by subordinated debt that was issued by about 35 local community banks. Some of these banks are so small that they don’t even have credit ratings. StoneCastle selected the banks based on geographical locations that are known for having low rates of default and are therefore viewed as safe for investing.
In a bankruptcy, subordinated debt is paid off last. As a result, buyers of securities backed by subordinated debt are rewarded with yields that are typically higher than that of other borrowings. Greater risk means greater reward.
The deal made by StoneCastle was worth about $250 million. The group received help from Citigroup in completing the deal. The CDO is expected to provide investors with a 5.75% return. The CDO financial vehicle will reportedly receive a rating of A3 from Moody’s Investors Service, six grades below AAA.
Siegel promises that his CDO is a wise investment.
He says, “A CDO is just another word for financing. What matters are what assets are being financed.”
Siegel has tried similar investing methods in the past. In the late 1990s, Siegel created CDOs out of trust-preferred securities of banks. These securities are typically viewed as predecessors to subordinated debt. The process went extremely well until the financial crisis of 2008, when the crash of the housing market made his investment vehicle extremely unpopular.
However, Siegel says that banks have learned from their mistakes, and better regulation makes CDOs a safer bet than they were in the past.
Time will tell if Siegel and StoneCastle can achieve long term success with this strategy, or if history will simply repeat itself.