CDO Squareds: A Cliffhanger

The stock of MBIA (MBI) dropped over 25% last week on disclosure of exposure to $8 billion of CDO squareds. Analysts contended that this was information that management had withheld, while MBI announced that the information had been disclosed on August 2, 2007. But the real question in everyone's mind was, "what's a CDO squared?" and "should I be afraid of these things?"

A CDO-squared is a type of collateralized debt obligation (CDO) where the underlying portfolio includes tranches of other CDOs. The following chart describes these:

Given the double-layer structure, CDOs-squared were perceived as having an added protection against losses, because tranches in underlying CDOs and the CDO-squared are protected by subordination at each level. This week's reaction showed that is no longer the belief.

The CDO squared structure amplifies the characteristics of a CDO. In an earlier post, I detailed how a CDO allows for a reduction of risk while enhancing return as long as there is low correlation of bad events. The CDO squared causes a further reduction of risk while enhancing returns as long as the bad events do not occur in one CDO, but are spread among the CDOs.

Because of this characteristic, CDO squareds are often referred to as being subject to the so-called "cliff" risk, a phenomenon where the tranche gets wiped out quickly once losses reach it. Given today's deteriorating environment, the marketplace clearly regards that risk as possible. Stay tuned.