CDOs (Collateralised Debt Obligations) are being hailed in some quarters as the next split cap catastrophe. As a result of the US sub prime mortgage crisis, some CDOs that are heavily exposed to the US subprime mortgage crisis have fallen dramatically in value and hedge funds that have a big exposure to these CDOs are on the brink of collapse. There are legitimate concerns with some aspects of the CDO market and perhaps the biggest one is that there isn't a hell of a lot of confidence that the ratings agencies are on the ball (see my previous comment). Mervyn King touched on this suject at a recent speech too (as reported by Richard here). However, a lot of fear and confusion about CDOs comes from a lack of understanding of what they actually are.

A CDO is essentially just like an asset backed security (ABS). The assets that form the collateral for ABS deals are usually pools of credit card loans or car loans, but they could theoretically be anything that throws out a cash stream. David Bowie sold the rights to his songs for $55m in 1997 by issuing a Bowie bond, while Calvin Klein once issued a bond linked to future sales of its perfume products.

In a basic CDO, the collateral is a diverse portfolio of corporate bonds, high yield bonds, asset backed securities, mortgage backed securities and/or leveraged loans. The cash flows from this portfolio are then repackaged into different tranches, each with different risk and return characteristics and these tranches are sold to investors. Cash flows are received by the investors in the lowest risk tranche first, while the highest risk tranche receives cash flows last.

The highest rated tranche forms about 70% of the structure of a CDO and carries an AAA rating because it is the first in the queue and there would have to be a huge number of defaults in the underlying portfolio (about 30%) before any of the AAA rated investors start getting hit. Credit ratings of the tranches deteriorate as you go further down the queue, reflecting the fact that there's less of a buffer, and right at the bottom is an unrated 'equity' tranche which is first in the firing line if things go wrong. Investors in the equity tranche stand to make fantastic returns as long as nothing defaults in the underlying portfolio, but as soon as anything does go bust then these investors start getting hit. And that's exactly what's happening now in the US.

Some CDOs have been heavily invested in mortgage backed securities, which themselves were backed by pools of subprime mortgages. These mortgage backed securities may have once been rated BBB, but now that so many US sub prime borrowers are defaulting, the credit ratings of these mortgage backed securities have plummeted. Many investors in CDO equity tranches are hedge funds, who were attracted to the prospect of returns of over 20% per year. Unfortunately, it seems that some investors in CDO equity tranches have also been pension funds, whose gullible trustees clearly didn't have clue what they were getting into and have failed in their fiduciary duty.

Are all CDOs bad? As long as the underlying collateral is of sound quality, then they're not bad at all. So called 'CDO squared' products, which are CDOs invested in other CDOs (this stuff really is a bit like split caps) are potentially poisonous, but they're really not that common. CDOs in which the collateral is leveraged loans (these are Collateralised Loan Obligations, or CLOs) are actually very attractive right now and Richard has bought some for the M&G Optimal Income Fund.

In any area that has seen such phenomenal growth, there are likely to be some cases of abuse of the system, but that doesn't absolve sophisticated investors of not reading the small print, or understanding the investment they are buying. It should also not deflect from how CDOs can offer attractive investment opportunities.

The following question was sent to us from a client last week:

The recent profits warning from Northern Rock has clearly taken the equity market by surprise in the short term, though equally many people will regard it as a victory for common sense that sooner or later they had to pay the price of such an aggressive strategy. But where does this leave sentiment in the mortgage-backed securities market and is it likely to add to difficulties in the already-spooked credit markets? Do you have any exposure to any of the higher-risk UK lenders, and why?

Over the past six months, our team (and myself in particular) have probably thought more about the UK and US housing markets than any other topic, as regular readers of this blog will probably have realised. Will the US sub prime crisis spread to the wider credit market, and if so, when (see Jim's recent comment here)? How strong is the UK housing market and when will it start to slow?

Sentiment in the mortgage-backed securities market has weakened on the back of a sharp housing market slowdown in the US. The roots of this lie in the Federal Reserve's decision to hold interest rates at just 1% in 2003-04 in an effort to encourage consumers to borrow and spend. The Fed's policy initially succeeded, as the US consumer pulled the economy from the brink of recession. The US housing market was a great beneficiary as consumers took advantage of amazingly cheap credit to borrow like crazy, causing US house prices to shoot up. But the supply of new houses exploded as the construction industry adjusted to soaring demand by churning out a load of trailers and condos. So now that US interest rates stand at 5.25% and demand has started to dry up, suddenly the US economy is left with a huge overhang of inventory, and house prices are starting to fall and will continue to do so until the market returns to equilibrium.

The story is not the same in the UK, where there have been few signs of any slowdown in the UK housing market. The reason for this dichotomy lies in the very different dynamics of the US and UK housing markets. In the UK, the supply of land is limited, and a booming economy and low real interest rates simply encourage borrowing, forcing house prices up. Despite recent rate hikes, UK real interest rates are still very low, and the housing market is if anything accelerating. Northern Rock's profit warning was not a function of a worsening UK housing market (there has been virtually no deterioration in asset quality), but was more to do with profit margins getting squeezed from rising competition (in January I discussed the changing dynamics of the UK housing market and its influence on UK interest rates here).

If the housing market meltdown is primarily a US phenomenon, why are we concerned? Just as the FTSE falters when the Dow Jones dips, UK corporate bond spreads will tend to follow the US market, which isn't surprising given that the £1.5 trillion US corporate bond market is 50% bigger than the UK and European markets combined (and many of the issuers in the European markets are US companies).

I have therefore reflected my concerns about the US mortgage market by positioning my portfolios defensively, favouring higher rated corporate bonds. In keeping with this, I have tended to avoid the aggressive and smaller UK mortgage lenders and have no exposure to Northern Rock. Within the M&G Optimal Income Fund, I have gone the next step by buying protection on Wachovia, a bank heavily exposed to the US housing market (for more detail on what I've been up to in the fund and for more detail on my views, see a replay of my recent teleconference here).