What's wrong with CDO?
I was reading sixth edition of Security Analysis by Ben Graham and David L Dodd and in 1934 they provided the answer to this question. Here is what they said about investing in Fixed Income Securities:
I. Safety is measured not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations.
II. This ability should be measured under conditions of depression rather than prosperity.
III. Deficient Safety cannot be compensated for by an abnormally high coupon rate.
IV. The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by statue to govern investments of savings banks.
In first point above
The basic difference confronts us at the very beginning. In the past the primary emphasis was laid upon the specific security, i.e., the character and supposed value of the property on which the bonds hold a lien. From our standpoint this consideration is quite secondary; the dominant element must be the strength and soundness of the obligor enterprise. There is here a clearcut distinction between two points of view. On the one hand the bond is regarded as a claim against property; on the other hand, as a claim against a business.
The older view was logical enough in its origin and purpose. It desired to make the bondholder independent of the risks of the business by giving him ample security on hich to levy in the event that the enterprise proved a failure. If the business became unable to pay his claim, he could take over the mortgaged property and pay himself out of that. This arrangement would be excellent if it worked, but in practice it rarely proves to be feasible. For this there are three reasons:
1. The shrinkage of property values when the business fails.
2. The difficulty of asserting the bondholders’ supposed legal rights.
3. The delays and other disadvantages incident to a receivership.
I. Safety is measured not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations.
II. This ability should be measured under conditions of depression rather than prosperity.
III. Deficient Safety cannot be compensated for by an abnormally high coupon rate.
IV. The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by statue to govern investments of savings banks.
In first point above
Safety not measured by lien but by abilty to paythey further explain:
The basic difference confronts us at the very beginning. In the past the primary emphasis was laid upon the specific security, i.e., the character and supposed value of the property on which the bonds hold a lien. From our standpoint this consideration is quite secondary; the dominant element must be the strength and soundness of the obligor enterprise. There is here a clearcut distinction between two points of view. On the one hand the bond is regarded as a claim against property; on the other hand, as a claim against a business.
The older view was logical enough in its origin and purpose. It desired to make the bondholder independent of the risks of the business by giving him ample security on hich to levy in the event that the enterprise proved a failure. If the business became unable to pay his claim, he could take over the mortgaged property and pay himself out of that. This arrangement would be excellent if it worked, but in practice it rarely proves to be feasible. For this there are three reasons:
1. The shrinkage of property values when the business fails.
2. The difficulty of asserting the bondholders’ supposed legal rights.
3. The delays and other disadvantages incident to a receivership.
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