Reminiscences of a CDO Trader

Reminiscences of a CDO Trader


I sat down this evening with my trading notebooks.  It was a reminiscence of 11-14 years in the past.  I may produce another chapter of “education of a corporate bond manager” from the books.  But it gave me a flavor of what I learned (rapidly) as a mortgage bond manager 1998-2001.  So let me share a few more bits of what I learned.

1) Avoid esoteric asset classes.  I am truly amazed at how many people believed that securitization created a lot of value, when it was more incremental.  There were many who proclaimed “Buy every new ABS structure,” because it had worked well in the past.

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Sadly, that is a bull market argument, and many would lose a lot of money following that advice.  In 2008, it all came crashing down for unique structures.

2) Avoid volatile asset classes.  Collateralized Debt Obligations are volatile, and not worthy of being investment grade.  That said, when I was younger, I erred with CDOs and we lost money.  Never invest with those whose incentives are different from yours.

3) There was also a period where CDO managers would buy each others BBB tranches — it was a way of lowering capital costs, at least on a GAAP basis.  We did that with NY Life, but never got the benefit, because we never did our CDO.

4) The are many asset sub-classes that have “only been through a bull market cycle.”  That is the nature of new ideas that are introduced to applause.  But those are bull market babies.  Avoid sub-asset classes that have never seen failure.

5) There was the desire that we could originate our own commercial mortgages, with me doing the work of a full mortgage department.  I conveyed to my boss that this was impossible even if I dedicated 100% of my time to the process, and then he would not have me for the reasons he hired me.  This came up many times, and took a long time to die.

6) But at a later date, something better came up, doing credit tenant leases.  They are illiquid, but they have good protection.  The credit tenant guarantees the mortgage.  If there is non-payment, the property is yours.  I can get into securitized lending.  This was a great deal, but my colleagues in the firm overruled me, and foolishly.  Why give up protection, when you can’t get a safe yield at an equivalent spread.

7) I also learned that in the merger in 2001 that little things mattered.  So when they came to meet us in Baltimore in mid-2001, we took them to an Italian Deli that we liked.  They loved it, saying that there was nothing like it in Burlington.

I will continue this in the next part/episode.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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