Sie sind auf Seite 1von 25

SIMSR

COLLATERALIZED DEBT
OBLIGATION

Rahul Krishna M
Roll no:159
PGDM-Finance

Under the guidance of


Prof A K Pradhan
SIMSR
Contents
Abstract.................................................................................................................................................3
Introduction...........................................................................................................................................4
Development of CDO’s..........................................................................................................................6
CDO Life cycle........................................................................................................................................6
Types of CDO’s.......................................................................................................................................6
The CDO Market....................................................................................................................................8
The Rise and fall of the CDO..................................................................................................................8
Current Financial crisis.........................................................................................................................13
Mathematical Challenges in Modelling the Mechanism of CDOs........................................................14
Challenge of Rating Structured Finance Assets....................................................................................15
Financial Stability Implications............................................................................................................17
Four good reasons for CDO business...................................................................................................18
Pros and cons of CDO’s........................................................................................................................19
Foreign Market Scenario.....................................................................................................................22
Indian Scenario....................................................................................................................................23
Conclusion...........................................................................................................................................25
References...........................................................................................................................................25

2
Abstract
This paper aims to reveal the mechanism of Collateralized Debt Obligations (CDOs) and how
CDOs extend the current global financial crisis. We first introduce the concept of CDOs and
give a brief account of the development of CDOs. We then explicate the mechanism of CDOs
within a concrete example with mortgage deals and we outline the evolution of the current
financial crisis. Collateralized debt obligations (CDOs) have been responsible for $542 billion
in write-downs at financial institutions since the beginning of the credit crisis. In this paper,
we get into the causes of this adverse performance, looking specifically at asset-backed
CDO’s (ABS CDO’s). Using novel, hand-collected data from 735 ABS CDO’s, I document
several main findings. First, poor CDO performance was primarily a result of the inclusion of
low quality collateral originated in 2006 and 2007 with exposure to the U.S. residential
housing market. Second, CDO underwriters played an important role in determining CDO
performance. Lastly, the failure of the credit ratings agencies to accurately assess the risk of
CDO securities stemmed from an overreliance on computer models with imprecise inputs.
Overall, my findings suggest that the problems in the CDO market were caused by a
combination of poorly constructed CDOs, irresponsible underwriting practices, and flawed
credit rating procedures. This paper explores the market of CDOs and synthetic CDOs and
their use in bank balance sheet management. It discusses about the details regarding the
CDO as an instrument and how it has been performing in the credit market. Here we
consider both the foreign market scenario and the Indian market scenario from which we
will be analysing the advantages and disadvantages of CDO’s as an instrument and the
required changes that need to happen for developing a successful market for the
Collateralised Debt Obligation both in India as well as in abroad. Apart from this we will be
looking upon the learning’s that we get from the failure of the ICCDO and the reasons for its
failure.

3
Introduction
Collateralized Obligations (COs) are promissory notes backed by collaterals or securities. In
the market for COs, the securities can be taken from a very wide spectrum of alternative
financial instruments, such as bonds (Collateralized Bond Obligations, or CBO), loans
(Collateralized Loan Obligations, or CLO), funds (Collateralized Fund Obligations, or CFO),
mortgages (Collateralized Mortgage Obligations, or CMO) and others. And frequently, they
source their collaterals from a combination of two or more of these asset classes.
Collectively, these instruments are popular referred to as CDOs, which are bond-like
instruments whose cash flow structures allocate interest income and principal repayments
from a collateral pool of different debt instruments to a prioritized collection of CDO
securities to their investors. The most popular life of a CDO is five years. However, 7-year,
10-year, and to a less extent 3-year CDOs now trade fairly actively. A CDO can be initiated by
one or more of the followings: banks, non-bank financial institutions, and asset
management companies, which are referred to as the sponsors. The sponsors of a CDO
create a company so-called the Special Purpose Vehicle (SPV). The SPV works as an
independent entity and is usually bankruptcy remote. The sponsors can earn serving fees,
administration fees and hedging fees from the SPV, but otherwise has no claim on the cash
flow of the assets in the SPV. According to how the SPV gains credit risks, CDOs are classified
into two kinds: cashflow CDOs and synthetic CDOs. If the SPV of a CDO owns the underlying
debt obligations (portfolio), that is, the SPV obtains the credit risk exposure by purchasing
debt obligations (e.g. bonds, residential and commercial loans), the CDO is referred to as a
cashflow CDO, which is the basic form in the CDOs market in their formative years. In
contrast, if the SPV of a CDO does not own the debt obligations, instead obtaining the credit
risk exposure by selling CDSs on the debt obligations of reference entities, the CDO is
referred to as a synthetic CDO; the synthetic structure allows bank originators in the CDOs
market to ensure that client relationships are not jeopardized, and avoids the tax-related
disadvantages existing in cashflow CDOs. After acquiring credit risks, SPV sells these credit
risks in tranches to investors who, in return for an agreed payment (usually a periodic fee),
will bear the losses in the portfolio derived from the default of the instruments in the
portfolio. Therefore, the tranches holders have the ultimate credit risk exposure to the
underlying reference portfolio. Tranching, a common characteristic of all securisations, is
the structuring of the product into a number of different classes of notes ranked by the
seniority of investor's claims on the instruments assets and cashflows. The tranches have
different seniorities: senior tranche, the least risky tranche in CDOs with lowest fixed
interest rate, followed by mezzanine tranche, junior mezzanine tranche, and finally the first
loss piece or equity tranche. A CDO makes payments on a sequential basis, depending on
the seniority of tranches within the capital structure of the CDO. The more senior the
tranches investors are in, the less risky the investment and hence the less they will be paid
in interest. The way it works is frequently referred to as a “waterfall” or cascade of cash
flows. In perfect capital markets, CDOs would serve no purpose; the costs of constructing

4
and marketing a CDO would inhibit its creation. In practice, however, CDOs address some
important market imperfections. First, banks and certain other financial institutions have
regulatory capital requirements that make it valuable for them to securitize and sell some
portion of their assets, reducing the amount of (expensive) regulatory capital that they must
hold. Second, individual bonds or loans may be illiquid, leading to a reduction in their
market values. Securitization may improve liquidity, and thereby raise the total valuation to
the issuer of the CDO structure.
In light of these market imperfections, at least two classes of CDOs are popular: the balance-
sheet CDO and the arbitrage CDO. The balance-sheet CDO, typically in the form of a CLO, is
designed to remove loans from the balance sheets of banks, achieving capital relief, and
perhaps also increasing the valuation of the assets through an increase in liquidity. An
arbitrage CDO, often underwritten by an investment bank, is designed to capture some
fraction of the likely difference between the total cost of acquiring collateral assets in the
secondary market and the value received from management fees and the sale of the
associated CDOs structure.
The CDO functions in the following way

Objective of the study:


The purpose of the research would be to find out the reasons for the non-existence of
CDO’s in the Indian Financial Markets. The research analyses the evolution of CDO’s in the
global markets and the reasons for the failure of the instrument describing the various
effects in the economy that resulted in the disaster for the CDO market. It also envisages on
the difficulties that the issuers and the investors have in making decisions for trading with
the CDO instruments.

Scope and Research Methodology:


Since CDO’s are currently non-existent in India, International markets will be studied to find
out more about their relevance, preference and penetration. The focus of this research
would be to identify the factors that prevented CDO’s from entering the Indian markets.
Some of the factors that will be studied are the eligibility criteria put forth by RBI, valuation
of this instrument and calculating the default risk on interest payments.

5
The Research methodology would be to study and analyse the secondary data in the form of
research paper, white paper, thesis and dissertations.

Development of CDO’s
The market for CDO’s began as early as 1980’s. At that time CDO’s were sharing the market
with CMO’s which had a similar functionality as of CDO’s. By the late 1990’s CDO’s were
becoming a strong instrument being traded in the market and the volumes had also
increased by huge numbers. There were many indicators of this development:

1. Issuance volume was rising constantly.


2. Cross-border investment into CDO’s also began to rise.
3. The asset classes that were being used as the collateral had been increasing.
4. Apart from all these there were also some changes in the legislation and regulations
which benefitted CDO’s a lot.

But by the period of 2001 the demand for the credit derivatives had increased a lot which
resulted in some new instruments which were the synthetic products of the CDO’s came
into existence and began to take over the market share of the CDO’s. An example for this
can be given as the CDO’s of CDO’s developed during the year of 2002 where a portfolio of
CDO’s were assembled and sold to the potential buyers. The main reason for the popularity
and the high amounts of trading of CDO’s in the market was the increasingly deteriorating
credit quality.

CDO Life cycle


The lifecycle of CDO typically revolves around three periods:

1. Ramp-up period- Collateral portfolio is decided and formed during this period.
2. Cash-flow period-It covers the major part of the CDO’s life-span. This is the time
when the collateral portfolio is functional in the market, during this period the
manager can actively speculate with it or just leave it to generate cash-flows.
3. Unwind period-This is the period when the investors are repaid with their principal
investment.

Types of CDO’s
The CDO’s can be basically divided into two types:

1. Balance sheet CDO’s


2. Arbitrage CDO’s

Balance sheet CDO’s are those in which the loans of one institution generally banks are
transferred to the other institution. The latter institution that purchases the loans gets a

6
discount on the book value which is the amount that it charges for undertaking the default
risk of those loans. The relative low coupon attached to these assets, results in a smaller
spread cushion than the corresponding arbitrage structure. However, given their relative
superior quality, they require less subordination when used in a CDO deal.

Arbitrage CDOs are those where the originator looks to extract value by repackaging the
collateral into tranches. The main objective for the trading of the Balance sheet CDO’s is for
the institutions to hedge their default risks by transferring it to the other institutes where as
in the case of Arbitrage CDO’s the main criteria is the arbitrage profits that the institutions
receive. Arbitrage CDO’s can again be divided into two types:

1. Arbitrage market value CDOs


Arbitrage market value CDOs, unlike balance sheet CDOs where there is no active trading of
loans in the portfolio; go through a very extensive trading by the collateral manager,
necessary to exploit perceived price appreciations.
This type of CDO relies on the market value of the pool securitised, which is monitored on a
daily basis. Every security traded in capital markets, with estimated price volatility, can be
included in this type of CDO.
In fact, the primary consideration is the price volatility of the underlying collateral.
The important aspect is the collateral manager’s capacity to generate a high total rate of
return. The CDO manager has a great deal of flexibility in terms of the asset included in the
deal. During the revolver period, the collateral manager can increase or decrease the
funding amount that changes the leverage of the structure.

2. Arbitrage cash flow CDOs


By their very nature, collateral assets have been purchased at market price and are
negotiable instruments, therefore most assets are bonds. However syndicated loans, usually
tradable, have been included in past transactions. As arbitrage deals, the collateral assets
can be refinanced more economically by re -tranching the credit risk and funding cost in a
more diversified portfolio. Unlike arbitrage market value CDOs, the collateral assets are not
traded very frequently.
These two types of CDO’s are the most basic type of CDO. These types of CDO’s are also
termed as Cash CDO’s.

Synthetic CDO

A form of collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or
other non-cash assets to gain exposure to a portfolio of fixed income assets. Synthetic CDOs
are typically divided into credit tranches based on the level of credit risk assumed. Initial
investments into the CDO are made by the lower tranches, while the senior tranches may
not have to make an initial investment. 

All tranches will receive periodic payments based on the cash flows from the credit default

7
swaps. If a credit event occurs in the fixed income portfolio, the synthetic CDO and its
investors become responsible for the losses, starting from the lowest rated tranches and
working its way up.

Other types of CDO’s

CDO Squared

It is also known as CDO2 note, is simply a CDO issue using other CDO notes as collateral. The
process is called re-securitisation. In case of default among any of the underlying CDO’s, the
SPV loses its corresponding principal investment and in response passes this loan to its own
investors so that they lose their principal in order of their seniority.

The CDO Market


The market for Collateralized Debt Obligations has grown continuously over the past ten
years, both in absolute and relative market terms. In 2005, it was the second largest credit
derivative market after the credit default swaps.

Although the CDO market began with Cash CDO’s, by now the most commonly traded CDO
type is the synthetic CDO that builds on other credit instruments instead of the direct sale of
the underlying assets. The popularity of the synthetic CDO’s over the cash CDO’s is in part
explained by their feature of allowing the issuer-normally a bank-to maintain the direct
relationship with the client, without having to sell or move the loans off his balance sheet.
Synthetic CDO’s are also attractive for the geographic markets where the originator for legal
reasons is not allowed to make a full transfer or full sale of assets; the synthetic derivative
then provides access to that market’s investor community. From an investment perspective,
the synthetic CDO allows a clearer investment opportunity for the buyer: The synthetic CDO
only brings credit risk, whereas the cash CDO, with its complete transfer of the asset to the
SPV, brings in addition to the credit risk all the normal risks associated with owning an asset,
such interest rate, prepayment and currency risk.

The Rise and fall of the CDO


Every player was benefiting from CDOs and issuance exploded, reaching $50 billion in 2006.
The rating agencies were making record profits as the demand for rated structured products
skyrocketed. Institutional investors loved the high-yielding AAA securities created from ABS
CDOs, CDO underwriters collected fees and achieved regulatory capital relief by off-loading
their assets, and CDO collateral managers earned hefty returns by retaining the equity
tranches, benefiting from the low cost of funding senior tranches. However, by 2003,
several changes in CDOs were working to create the perfect storm that was unleashed upon
financial markets in 2007.

8
First, the collateral composition of CDOs changed as collateral managers looked for ways to
earn higher yields. The managers began investing more heavily in structured finance
securities, most notably subprime RMBS, as opposed to corporate bonds. Furthermore, they
invested in the mezzanine tranches of these securities, moves designed to create higher-
yielding collateral pools. Table documents the evolution of ABS CDO assets from 1999-2007,
illustrating the profound increase in subprime RMBS (HEL) collateral, with 36% of the 2007
CDO collateral comprised of HEL bonds.
Average Principal Allocations by Asset-Class

Source: Lehman Live (2009-CDO meltdown)


(Table summarizes the average collateral composition for of 735 ABS CDO deals originated between
1999-2007)
HEL – home equity loan (includes all RMBS less than prime)
RMBS – residential mortgage-backed securities (by prime borrowers)
CMBS – commercial mortgage backed securities
Other ABS – other asset-backed securities (including auto-loans, credit-cards, etc.)

In response to the explosion in CDO issuance, the increased demand for subprime
mezzanine bonds began to outpace their supply. This surge in demand for subprime
mezzanine bonds helped to push spreads down – so much so that the bond insurers and
real estate investors that had traditionally held this risk were priced out of the market. The
CDO managers that now purchased these mortgage bonds were often less stringent in their
risk analysis than the previous investors and willingly purchased bonds backed by ever-more
exotic mortgage loans. Clearly, the bonds in the CDOs have performed worse, indicating
that there might have been a degree of adverse selection in choosing the subprime bonds
for CDOs.

9
Repackaging of Subprime Bonds into CDOs

(Source: The Story of the CDO Market Meltdown: An Empirical Analysis by Anna Katherine
Barnett-Hart)
In addition to the increased investment in risky mortgage collateral, the next development
was the creation of the notorious “CDO squared,” (and the occasional “CDO cubed”), which
repackaged the hard-to-sell mezzanine CDO tranches to create more AAA bonds for
institutional investors. Lastly, the advent of synthetic CDOs significantly altered the
evolution of the CDO market. Rather than investing in cash bonds, synthetic CDOs were
created from pools of credit-default swap contracts (CDS), essentially insurance contracts
protecting against default of specific asset-backed securities. The use of CDS could give the
same payoff profile as cash bonds, but did not require the upfront funding of buying a cash
bond. Furthermore, using CDS as opposed to cash bonds gave CDO managers the freedom
to securitize any bond without the need to locate, purchase, or own it prior to issuance.
Taken together, these observations indicate that CDOs began to invest in more risky assets
over time, especially in subprime floating rate assets. Essentially, CDOs became a dumping
ground for bonds that could not be sold on their own – bonds now referred to as “toxic
waste.” As former Goldman Sachs CMBS surveillance expert Mike Blum explains: Wall Street
reaped huge profits from “creating filet mignon AAAs out of BB manure.”

10
Collateral Composition Trends in ABS CDOs

(Source: Lehman Live)


The deterioration in CDO collateral quality was matched by a decrease in the credit support
of the rated tranches, leaving investors more exposed to losses on the collateral. The
subordination levels have decreased slightly for all tranches, with the most pronounced
decline in the AAA-rated tranches, which went from an average of 25% subordination in
2002 to less than 15% in 2007. With the issuance of CDOs growing unabated and the quality
of their collateral declining, both the rating agencies and the investment banks failed to
recognize the amount of risk inherent in these products. The below figure shows the
dramatic increase in realized default levels of ABS CDOs, with over 40% of the 2007 CDO
assets in default.
Historical Realized Default Levels

11
(Source: The Story of the CDO Market Meltdown: An Empirical Analysis by Anna Katherine
Barnett-Hart)
Credit ratings have been vital to the development of the CDO market, as investors felt more
confident purchasing the new structures if they were rated according to scales that were
comparable to those for more familiar corporate bonds. Investors came to rely almost
exclusively on ratings to assess CDO investments: in essence substituting a letter grade for
their own due diligence. In addition, credit ratings from agencies deemed to be “nationally
recognized statistical organizations” (NRSRO) were used for regulatory purposes by the SEC.
While there are five credit rating agencies with the NRSRO qualification, only three were
major players in the U.S. structured finance market: Moody’s, Fitch, and Standard and
Poor’s (S&P). While S&P and Moody’s rated almost all CDO deals, Fitch’s market share
declined to less than 10% by 2007. The rating agencies earned high fees from the CDO
underwriters for rating structured finance deals, generating record profits as seen in
Diagram C. Table 3 shows the amount of CDO business each of the CRAs did with the various
CDO originators. Problems with CDO ratings rapidly developed as the rating agencies came
under enormous pressure to quickly crank out CDO ratings and the market exploded faster
than the number or knowledge of analysts. Analysis of CDOs came to rely almost completely
on automated models, with very little human intervention and little incentive to check the
accuracy of the underlying collateral ratings.
The advent of CDOs in the mid-1980s was a watershed event for the evolution of rating
definitions. Until the first CDOs, rating agencies were only producers of ratings; they were
not consumers. With the arrival of CDOs, rating agencies made use of their previous ratings
as ingredients for making new ratings – they had to eat their own cooking. For rating CDOs,
the agencies used ratings as the primary basis for ascribing mathematical properties (e.g.,
default probabilities or expected losses) to bonds.
Not only did the rating agencies fail to examine the accuracy of their own prior collateral
ratings, but in many cases, they also used other agency’s ratings without checking for
accuracy. To correct for any shortcomings in the other agency’s rating methodology, they
created the practice of “notching,” whereby they would simply decrease the rating of any
collateral security that they did not rate by one notch. In other words, if Moody’s rated a
CDO that was composed of collateral rated BB+ by Fitch only, Moody’s would instead use a
rating of BB in their own CDO model because it was not their rating. They never went back
and reanalyzed the other rating agency’s rating, conveniently assuming that decreasing it by
a notch would compensate for any shortcomings in the initial risk analysis.
The inputs and definitions associated with the models were frequently changed, generating
confusion and inconsistencies in the ratings: Fitch’s model showed such unreliable results
using its own correlation matrix that it was dubbed the “Fitch’s Random Ratings Model.”
Furthermore, it became clear that similarly rated bonds from different sectors (i.e. ABS vs.
corporate bonds, RMBS vs. CMBS) had markedly different track records of realized default
probabilities, and the agencies began to adjust their meanings and models haphazardly in
an attempt to correct their previous mistakes.
However, investors thought, and were encouraged to believe, that the ratings of CDOs
corresponded to similar default distributions as individual corporate bonds, thereby further
fueling the asset-backed frenzy. Lastly, as CDO structures became more complex,

12
incorporating features such as super senior tranches, payment-in-kind (PIK) provisions, and
a diversity of trigger events that could change the priority of liability payments, CDO ratings
became even less meaningful. In addition to the problems with the accuracy of the ratings,
there was also the fact that the ratings themselves were not meaningful indicators for
assessing portfolio risk. Furthermore, ratings are a static measure, designed to give a
representation of expected losses at a certain point in time with given assumptions. It is not
possible for a single rating to encompass all the information about the probability
distribution that investors need to assess its risk. Investors often overcame these limitations
by looking at ratings history, filling in their missing information with data about the track
record of defaults for a given rating. Since there was little historical data for CDOs, investors
instead looked at corporate bond performance. However, as noted above, asset-backed
ratings have proven to have very different default distributions than corporate bonds,
leading to false assessments.
The heavy reliance on CDO credit ratings made it more devastating when problems with the
models and processes used to rate structured finance securities became apparent. The Bank
for International Settlements commissioned a report summarizing the difficulties in rating
subprime RMBS. They found that the credit rating agencies underestimated the severity of
the housing market downturn, which in turn caused a sharp increase in both the correlation
among subprime mezzanine tranche defaults and their overall level of realized defaults,
while decreasing the amount recovered in the event of a default (i.e. loss given default). In
addition, the ratings of subprime RMBS relied on historical data confined to a relatively
benign economic environment, with very little data on periods of significant declines in
house prices.

Current Financial crisis


The main reason for the current financial crisis is the US subprime mortgage financial crisis.
The crisis happened because of the excess boom in the US housing market which raised the
supply levels in the market to level far greater than the demand levels in the market. This
resulted in the suppliers bearing huge amounts of losses due to which they began to default
the borrowings from the different banks and financial institutions. Initially the institutions
that got affected because of this default were the banks and institutions that used to
provide credit for home construction. But as we now that it’s rarely possible that one sector
is getting affected and the other sectors function in the normal way. In this case the money
rose for the home construction purpose was not only raised through banks but also a
number of reputed institutions issued bonds in order to raise capital. As a result the liquidity
in the market came down by a huge level and also the risk aversion of the lenders had
increased which resulted in a higher interest even for non-housing borrowings and also the
availability came down making it difficult for the other sectors to satisfy their capital
requirements. Also ‘Securitisation’ became an important factor for giving loans and this
resulted in the development of the Asset Backed Securities (ABS).

13
In early 2007, when defaults were rising in the mortgage market, New York's Wall Street
began to feel the first tremors in the CDOs world. Hedge fund managers, commercial and
investment banks, and pension funds, all of which had been big buyers of CDOs, found
themselves landed in trouble, as many CDOs included derivatives that were built upon
mortgages—including risky, subprime mortgages. More importantly, the mathematical
models that were supposed to protect investors against risk weren’t working. The
complicating matter was that there was no market on which to sell the CDOs. CDOs are not
traded on exchanges and even not really structured to be traded at all. If one had a CDO in
his/her portfolio, then there was not much he/she could do to unload it. The CDO managers
were in a similar bind. As fear began to spread, the market for CDOs' underlying assets also
began to disappear. Suddenly it was impossible to dump the swaps, subprime-mortgage
derivatives, and other securities held by the CDOs.

Mathematical Challenges in Modelling the Mechanism of CDOs


The basis of a CDO was not a mortgage, a bond or even a derivative, but the metrics and
algorithms of quant and traders. The credit for the success of CDO’s during the period of
2001 can be mainly given to the invention of the Gaussian Copula. With this formula pricing
of the CDO had become very easy but only after a period of time that it was realised that
there were some flaws while pricing the CDO using these formulas. The main criteria for
financial institutions to trade instruments are the availability of a model to price those
instruments, in the absence of which the institutions will try to not include these
instruments in their profile. Many of the investors had felt that investing in CDO’s reduced
their risk as CDO had included a large number of individual bonds that underlie a particular
deal, but only later it was found that all these bonds were highly correlated and the amount
of risk wasn’t coming down as the amount of diversification due to the CDO’s was very less.

Pricing a CDO is mainly to find the appropriate spread for each tranche (level) and its
difficulty lies in how to estimate the default correlation in formulating models that fit
market data. With the empirical evidence of the existence of mean reversion phenomena in
efficient credit risk markets, mean-reverting type stochastic differential equations are
considered. In addition, the CDOs market has seen the phenomenon of heavy tail
dependence in a portfolio, which draws the attention to use modelling with heavy tail
phenomenon as a feature. Besides, the efficiency in calibrating pricing models to market
prices should be paid much attention. A well calibrated and easily implemented model is the
right goal.

The market standard model is the so-called one factor Gaussian copula model. The
assumptions of the one factor Gaussian copula model about the characteristics of the
underlying portfolio simplify the analytical derivation of CDOs premiums but are not very
realistic. Thereafter more and more extensions have been proposed to pricing CDOs:
homogeneous infinite portfolio is extended to homogeneous finite portfolio, and then to

14
heterogeneous finite portfolio which represents the most real case; multifactor models are
considered other than one factor model; Gaussian copula is replaced by alternative
probability distribution functions; the assumptions of constant default probability, constant
default correlation and deterministic loss given default are relaxed and stochastic ones are
proposed which incorporate dynamics into pricing models.

Challenge of Rating Structured Finance Assets


Credit ratings are designed to measure the ability of issuers or entities to meet their future
financial commitments, such as principal or interest payments. Depending on the agency
issuing the rating and the type of entity whose creditworthiness is being assessed, the rating
is either based on the anticipated likelihood of observing a default, or on the basis of the
expected economic loss – the product of the likelihood of observing a default and the
severity of the loss conditional on default. As such, a credit rating can intuitively be thought
of as a measure of a security’s expected cash flow. In the context of corporate bonds,
securities rated BBB- or higher have come to be known as investment grade and are thought
to represent low to moderate levels of default risk, while those rated BB+ and below are
referred to as speculative grade and are already in default or closer to it.
These estimates are derived from a study of historical data and are used in Fitch’s model for
rating collateralized debt obligations (Derivative Fitch, 2006). It is noteworthy that within
the investment grade range, there are ten distinct rating categories (from AAA to BBB-) even
though the annualized default rate only varies between 0.02 and 0.75 percent. Given the
narrow range of the historical default rates, distinguishing between the ratings assigned to
investment grade securities requires a striking degree of precision in estimating a security’s
default likelihood. By contrast, the ten rating categories within the speculative grade range
(from BB+ to C) have default rates ranging from 1.07 to 29.96 percent.
In the single-name rating business, where the credit rating agencies had developed their
expertise, securities were assessed independent of one another, allowing rating agencies to
remain agnostic about the extent to which defaults might be correlated. But, to assign
ratings to structured finance securities, the rating agencies were forced to address the
bigger challenge of characterizing the entire joint distribution of payoffs for the underlying
collateral pool. The riskiness of collateralized debt obligation tranches is sensitive to the
extent of commonality in default among the underlying assets, since CDOs rely on the
power of diversification to achieve credit enhancement.
The structure of collateralized debt obligations magnifies the effect of imprecise estimates
of default likelihoods, amounts recovered in the event of default, default correlation, as well
as, model errors due to the potential misspecification of default dependencies. These
problems are accentuated further through the sequential application of capital structures to
manufacture collateralized debt obligations of CDO tranches, commonly known as CDO-
squared (CDO2). With multiple rounds of structuring, even minute errors at the level of the
underlying securities, which would be insufficient to alter the security’s rating, can
dramatically, alter the ratings of the structured finance securities.

15
A large fraction of collateralized debt obligations issued over the course of the last decade
had subprime residential mortgage-backed securities as their underlying assets.
Importantly, many of these residential mortgage-backed securities are themselves tranches
from an original securitization of a large pool of mortgages, such that CDOs of mortgage-
backed securities are effectively CDO2s. Moreover, since substantial lending to subprime
borrowers is a recent phenomenon, historical data on defaults and delinquencies of this
sector of the mortgage market is scarce. The possibility for errors in the assessment of the
default correlations, the default probabilities, and the ensuing recovery rates for these
securities was significant. Such errors, when magnified by the process of re-securitization,
help explain the devastating losses some of these securities have experienced recently.
When credit rating agencies started rating both structured finance and single-name
securities on the same scale, it may well have lured investors seeking safe investments into
the structured finance market, even though they did not fully appreciate the nature of the
underlying economic risks. In the logic of the capital asset pricing model, securities that are
correlated with the market as a whole should offer higher expected returns to investors,
and hence have higher yields, than securities with the same expected payoffs (or credit
ratings) whose fortunes are less correlated with the market as a whole. However, credit
ratings, by design, only provide an assessment of the risks of the security’s expected payoff,
with no information regarding whether the security is particularly likely to default at the
same time that there is a large decline in the stock market or that the economy is in a
recession. Because credit ratings only reflect expected payoffs, securities with a given credit
rating can, in theory, command a wide range of yield spreads – that is, yield in excess of the
yield on a U.S. Treasury security of the same duration – depending on their exposure to
systematic risks. For example, consider a security whose default likelihood is constant and
independent of the economic state, such that its payoff is unrelated to whether the
economy is in a recession or boom, whether interest rates are rising or falling, or the
behaviour of any other set of economic indicators. An example of this type of a security is a
traditional catastrophe bond. Catastrophe bonds are typically issued by insurers, and deliver
their promised payoff unless there is a natural disaster, such as a hurricane or earthquake,
in which case the bond default. Under the working assumption that a single natural disaster
cannot have a material impact on the world economy, a traditional catastrophe bond will
earn a yield spread consistent with compensation for expected losses. Investors are willing
to pay a relatively high price for catastrophe bonds because their risks are uncorrelated with
other economic indicators and therefore can be eliminated through diversification.
At the other end of the range, the maximum yield spread for a security of a given rating is
attained by a security whose defaults are confined to the worst possible economic states. If
we assume that the stock market provides an ordering of economic states – that is, if the
Standard and Poor’s 500 index is at 800, the economy is in worse condition than if that
same index is at 900 – then the security with maximal exposure to systematic risk is a digital
call option on the stock market. A digital call option pays $1 if the market is above a pre-
determined level (called a “strike price”) at maturity and $0 otherwise. Because this security

16
“defaults” and fails to pay only when the market is below the strike price, it represents the
security with the greatest possible exposure to systematic risk. By selecting the appropriate
strike price, the probability that the call fails to make its promised payment can be tuned to
match any desired credit rating. However, because a digital call option concentrates default
in the worst economic states, investors will insist on receiving a high return as
compensation for bearing the systematic risk, and require the option to deliver the largest
yield spread of all securities with that credit rating. The process of pooling and tranching
effectively creates securities whose payoff profiles resemble those of a digital call option on
the market index. Intuitively, pooling allows for broad diversification of idiosyncratic default
risks, such that – in the limit of a large diversified underlying portfolio – losses are driven
entirely by the systematic risk exposure. As a result, tranches written against highly
diversified collateral pools have payoffs essentially identical to a derivative security written
against a broad economic index. In effect, structured finance has enabled investors to write
insurance against large declines in the aggregate economy. Investors in senior tranches of
collateralized debt obligations bear enormous systematic risk, as they are increasingly likely
to experience significant losses as the overall economy or market goes down. Such a risk
profile should be expected to earn a higher rate of return than those available from single-
name bonds, whose defaults are affected by firm-specific bad luck. If investors in senior
claims of collateralized debt obligations do not fully appreciate the nature of the insurance
they are writing, they are likely to be earning a yield that appears attractive relative to that
of securities with similar credit ratings (that is, securities with a similar likelihood of default),
but well below the return they could have earned from simply writing such insurance
directly—say, by making the appropriate investment in options on the broader stock market
index. Coval, Jurek, and Stafford (2008) provide evidence for this conjecture, showing that
senior tranches in collateralized debt obligations do not offer their investors nearly large
enough of a yield spread to compensate them for the actual systematic risks that they bear.
The fact that corporate bonds and structured finance securities carry risks that can, both in
principle and in fact, be so different from a pricing standpoint, casts significant doubt on
whether corporate bonds and structured finance securities can really be considered
comparable, regardless of what the credit rating agencies may choose to do.

Financial Stability Implications


The BIS reports that the market-making activities associated with CRT are concentrated with
a limited number of dealer/broker firms. In addition, hedge funds are major investors in the
equity tranches of CDOs and particularly active in correlation-related trading.
At the company level, high transaction costs of these CRT structures, and the mispricing of
credit they generate: “…either CDO’s are evidence of a substantial and pervasive market
imperfection [in the fixed income market], or they are being used to create one. The second
possibility seems more likely.”
Among their reform suggestions:

17
- Stricter disclosure requirements (register credit derivatives transactions, centralized
pricing service; disclose the effect of credit derivatives transactions on companies’ risk
exposure)
- Competition in credit ratings industry
- There may be room for non-bank financial institutions to narrowly specialize on the
monitoring and credit risk assessment roles that traditionally have played by banks
(Annex: Key Facts and Numbers on Structured Credit and Credit Derivatives13)
The volume of outstanding credit derivatives has grown from less than $1 trillion in 2001 to
$26 trillion in 2006 according to Isda. See table below.
The volume of outstanding cash CDOs stands at $986 billion at the start of 2007, according
to Creditflux Data+
The volume of synthetic CDO tranches traded in the past three years is $739 billion,
according to Creditflux Data+
The most important users of credit derivatives have historically been banks (see chart
below). But anecdotal evidence suggests that hedge funds, insurance companies, mutual
funds, pension funds and other buy-side firms are the fastest growing sectors of the market.

Four good reasons for CDO business


Besides the four motivations summarized in the sequel, tax and legal arbitrage play an important
role in CDO structuring.

1. Spread arbitrage opportunities: On the asset side premiums are collected on a single-
name base, whereas premium/interest payments to the super senior swap counterparty and
the note holders refer to a diversified pool (CDS agreements are made with different
institutions)

Total spread collected on single credit risky instruments at the asset side of the transaction
exceeds the total ‘diversified’ spread to be paid to investors on the trenched liability side of
the structure.

2. Regulatory capital relief: ‘D’ in ‘CDO’ becomes an ‘L’ standing for ‘loan’.

The only regulatory capital requirement the originator has to fulfil regarding the securitized
loan pool is holding capital for retained pieces.

A full calculation of costs compared to the decline of regulatory capital costs is required to
judge about the economics of such transactions.

3. Funding: Involves a true sale ‘off balance sheet’ of the underlying reference assets to an
SPV which then issues notes in order to refinance/fund the assets purchased from the
originating bank.

The advantage of refinancing by means of securitizations is that resulting funding costs are
mainly related to the credit quality of the transferred assets and not so much to the rating of
the originator.

18
4. Economic risk transfer: Such a transaction divides the loss distribution in two segments
First loss refers to losses carried by the originator (e.g., by retaining the equity piece).The
excess loss of the first loss piece, taken by the CDO investors.

Pros and cons of CDO’s


CDO-squared have the similar advantages and disadvantages to CDOs. However, due to the
unique structure of CDO-squared there are still some differences between CDO and CDO-
squared. We will illustrate advantages and disadvantages of CDO-squared from the aspects
of both originator and investors.

Advantage to Originator

1. Risk transference to increase the ratio of capital to risky assets and ROE
The main purpose of the securitization is to make the debt off-balance sheet. There are
some limits about capital of the banks and some financial institution, for example, the
capital adequacy ratio. Therefore, the originator can change the risky assets into cash which
is considered less risky, or transfer these risky assets to other insurance company and other
institution to sustain. That would increase the ratio of capital to risky assets and largely
reduce the requirement of the risky assets reservation of the banks and financial institution.
Furthermore, it would increase the ROE. There is one important thing is that the CDO-
squared just can transfer parts of risk and not similar to CDO which can totally transfer all of
it. Hence, the issuer has to sustain this part of credit risk.

2. Reducing capital cost


The reference obligors are packed and strengthen their credit level. It always can make CDO
squared have higher credit rating than the originator; therefore, SPV can reduce its funding
cost. In addition, SPV fund through CDO-squared can reduced the capital requirement,
reservation requirement; moreover, SPV can get cash which is considered risk less through
this process. Moreover, it would reduce the capital cost.

3. Improving the liquidity of assets and efficiency of the use of working capital
The individual bond or loan which the banks hold may be illiquid in the market and the price
may be underestimated. However, these assets can be more liquid through packing into
small unit of CDO-squared. In addition, CDO-squared can transfer mid-term or long-term
loan or asset into high liquid short-term asset and largely improve the efficiency of working
capital.

4. Provide another way to fund


The enterprises which have high quality asset may be not easy to fund money when their
credit ratings are not good enough. CDO-squared provide another choice for financial
institution to fund, and expand to the global capital market.

19
5. Receive fixed and periodic service revenue
The originator plays the role of servicer and receives the cash flow of origination for SPV.
The originator can earn the fixed and periodic service revenue from issuing the CDO-
squared through SPV.

Advantage to Investor

1. Having one more choice of investment instrument and can diversify unsystematic risk
Through securitized, the SPV can repack reference CDOs into securities with different
maturity, interest rate, and risk. It makes investors have much more choices, and investors
can choose products based on their needs and their risk preferences. Therefore, CDO-
squared can diversity unsystematic risk and even have higher degree of diversity achieved
than CDO, because CDO-squared have several underlying CDOs which already have many
CDSs in it.

2. Higher safe and liquidity instrument


There are many criterions by government in issuing the CDO or CDO-squared, and these
securities have to strength their credit and supervised by credit rating institutions.
Therefore, the investors of CDOs or CDO-squared have less default risk and more liquidity.

3. Earn higher spreads


The CDO-squared is double-lay structure; therefore, it provides investors more choice of
investing in credit and earns higher spreads.

4. Reduce the adverse selection problem


There is a lot of unpublicized information about the credit risk issue of junk bonds or the
loans of the banks. Thus, on average, investors willing to offer lower price than it should be
under they have symmetric information. In this case, the SPV have the adverse selection
problem.

As we know, when the adverse selection problem occurs, it would make the price of
commodity lower and the price difference is called Lemon’s premium. This kind of problem
cannot totally avoid by securitized, but this problem would be released. When the SPV issue
CDOs to make the price higher and the adverse selection problem will concentrate in equity
tranche and not affect other tranches. Hence, if the issuer can keep the equity tranche by
itself and just sell other tranches, the other tranches can get more funds.

20
Disadvantage to Originator

1. The net benefit of securitization may be negative


The securitization involves many professional institutions, i.e. SPV, the credit rating
company, and the counterparty of credit default swap. Therefore, it will be more
transparent through the market operation. However, the relative fee may be higher than
the benefit which it brings.

2. High quality of long-term loan would be hard to acquire


When the originator securitizes the high quality loan, it may be not to get such good assets
again. The originator may lose the stable interest.

Disadvantage to Investor

1. The more complicated the commodity, the more difficult to valuate


Although the CDO-squared can achieve the higher spread, it also reflects the complicated
and the unique of this derivative. Therefore, CDO-squared is more difficult to valuate than
CDOs or CDS.

2. Undertake higher credit risk


CDO-squared can achieve the higher spread, but also bring more risk than CDO. This is due
to the slight change of underlying reference credits would lead to big change of value of
CDO-squared, even bigger than value of CDO.

3. Maybe have moral crisis problem


The SPV can transfer the credit risk into the insurance company and the investors through
securitization. It may make the originator lend money without careful survey the credit of
borrower. Or, the originator would take the poor quality loans to securitize and keep the
higher quality loans. It would let investors face the moral crisis problem.

21
Foreign Market Scenario:

Global CDO Issuance Volume


Year USD billion
2004 157.4
2005 251.3
2006 520.6
2007 481.6
2008 61.9
2009 4.2
Data Ref: Collateralized debt obligation-Wikipedia

There were several reasons for the fall in the volumes of issuance of CDO’s after 2006 due
to several reasons. Some of them are

1. Housing Effect: Residential mortgage collateral has performed poorly, caused by a


combination of declining underwriting standards by mortgage originators and the
collapse in home values.
2. Vintage Effect: Collateral from 2006 and 2007 vintages showed worse performance
and even there was a decline in underwriting standards during this period.
3. Complexity Effect: Increasing complexity in CDO assets also made people shift
towards other instruments.
4. Underwriter Effect: CDO performance varied based on the underwriting bank as it
plays the main role in developing and marketing the CDO through which it earns its
service fee. Amount of due diligence conducted by the underwriter had a great
influence on the performance of the CDO transaction.
5. Size Effect: Performance of an underwriter’s CDOs varies according to the size of their
CDO business, with overly-aggressive or very inexperienced banks issuing worse
CDOs, as measured by their ex-post defaults and rating downgrades. Certain banks
might have been better CDO underwriters for unknown reasons; it is possible that the
variation in underwriting standards is a function of the size of the bank’s CDO
business.
6. Originator Effect: Performance of a CDO depends on the specific entities that
originated its collateral assets. Lending standards of the originating entity will affect
the ultimate performance of the CDO assets.
7. Recycled Ratings Effect: The rating agencies relied almost exclusively on the prior
ratings of the underlying collateral, without making sufficient distinctions for different
asset types.
8. Peer Pressure Effect: CRAs were worried about ratings shopping, causing more liberal
ratings when they knew another agency was also rating the deal, in fear that they
would lose business if their rating were less desirable than their competitors.

22
Indian Scenario
The activity in the ABS market is picking up in India; the number of investors for securitized
paper is very limited. In the absence of a Securitization Act, there are taxation and legal
uncertainties with the securitization vehicle. In India, transfer of secured assets as required
for securitization, can attract a stamp duty as high as 10% in some states precluding
transaction possibilities. With favourable legislation and taxation regime, the ABS market in
India can hope to see a lot of activity in future.
Though securitisation has been in place in India over last 6 years or so, there has been no
CDO/ CLOICICI Ltd. during 2002 announced the launch of India's first multi-tranched
Collateralised Debt Obligation named Indian Corporate Collateralised Debt Obligation Fund.
The ICCDO did not perform well when compared to the other instruments in the ABS and
also the eligibility criteria that had to be met in order to issue CDO’s in the market were very
difficult to implement.
A major concern for investors is the valuation of this instrument. The confusion probably
cropped up due to the fact that the instrument is to be traded like another bond; however
the valuation was to be done as per any other mutual fund unit. Its NAV was to be declared
every week as is mandatory under SEBI rules.
Bank valuation is done on category wise basis, depending on which category the investment
falls under viz. ‘Available for Trading’, ‘Available for Sale’ and ‘Held to Maturity’. For
‘Available for Trading’ category, the valuation is done on a daily/ weekly basis, as and when
the NAV is published. In ‘Available for Sale’ category, the valuation is done on a quarterly /
half yearly / annual basis and for ‘Held to Maturity’ category, no valuation is required. For
valuation, the price considered is either the NAV or the repurchase price, whichever is
lower.
Though securitisation has been in place in India over last 10 years or so, there has been no
CDO/ CLO. There have been several loan sales by financial institutions. ICICI’s CDO is the first
CDO/ CLO in India. Called Indian Corporation Collateralised Debt Obligation Fund. It is a
balance sheet CDO, consisting of a pool of bonds, PTCs held by ICICI. Capital relief could not
be the purpose: if capital regulations as in BIS are applied, the deal will lead to capital
erosion. In terms of the distribution schedule, it is essentially a pass through structure -
reinvestments only if bondholders opt for growth plan.
Mutual fund is certainly the most efficient possible SPV for a CDO:
• Avoids any withholding tax by obligor
• No tax on the vehicle
• Distributions suffer 10% dividends tax
• No tax on the unit holders
But it creates an enormous tax haven in the system. Taxable incomes become tax free
(other than dividends tax): the originating institution paying tax before, now earns tax free
income. Nothing stops the originator from repackaging his own portfolio into units through
the mutual fund and holds them tax free. The interest on debt paid by the obligors gives
them 38% tax relief, distribution of the same taxable only 10% - a 28% tax shelter

23
Not merely bonds, even loans have been indirectly made tax free: existing loans first
securitised. PTCs thereafter re-securitised because mutual funds cannot buy loans, but can
buy PTCs.

There are a number of factors that need to be taken care before introducing CDO into the
Indian market:
ELIGIBILITY CRITERIA FOR INVESTORS
Co-Operative Banks and Regional Rural Banks
Co-operative Banks are not allowed to invest in Mutual Funds except for schemes floated by
UTI. This regulation did not allow them to invest in the ICCDO. Even RRBs are not allowed to
invest in mutual funds. Co-operative banks cannot invest in corporate paper. RRBs are
allowed to invest in corporate paper with a cap of 5% of their incremental deposits.

Mutual Funds
Mutual Funds preferred to stay away from the issue. The main reason has been the issuance
of the securities in the form of Mutual Fund units. MFs cannot invest more than 5% of their
Net Asset Value in other mutual funds. If a Mutual Fund invests in another MF unit they also
lose out on AMC fees. If Mutual Funds had come in as investors into this issue, it would have
been a positive boost for secondary market liquidity of this instrument, as they (MFs) are
the most active traders.

VALUATION OF THE PAPER IN THE BOOKS OF INVESTORS


A major concern for investors is the valuation of this instrument. The confusion probably
cropped up due to the fact that the instrument is to be traded like a other bond, however
the valuation was to be done as per any other mutual fund unit. Its NAV was to be declared
every week as is mandatory under SEBI rules.
Bank valuation is done on category wise basis, depending on which category the investment
falls under viz. ‘Available For Trading’, ‘Available For Sale’ and ‘Held To Maturity’. For
‘Available For Trading’ category, the valuation is done on a daily/ weekly basis, as and when
the NAV is published. In ‘Available For Sale’ category, the valuation is done on a quarterly /
half yearly / annual basis and for ‘Held To Maturity’ category, no valuation is required. For
valuation, the price considered is either the NAV or the repurchase price, whichever is
lower.

CONCERN ABOUT THE UNDERLYING POOL OF ASSETS


The inclusion of certain assets, which has defaulted on interest payments to institutions, has
made investors skeptical about the motive behind this securitisation transaction. Investors
wrongly felt that ICICI is trying to take out bad assets out of its books. The best way to allay
these fears is if the Originator continues to hold some assets of the same Obligors, after
securitising a part. If to say that nearly all the assets continue to remain on ICICI’s books.

24
However, it should be well emphasized to the investors that since it is very unlikely that all
assets would default at the same time, the cushion in terms of cash reserve and tranching is
sufficient to protect investors from any yield loss to certain extent.

Conclusion
CDO market arose from a combination of poorly constructed CDOs, irresponsible
underwriting practices, and flawed credit rating procedures. One of the main factors
associated with the underperformance of CDOs was the inclusion of low quality collateral
originated in 2006 and 2007 that was exposed to the residential housing market. The
majority of CDOs issued after 2005 contained remarkably high levels of this collateral,
allowing the decline in housing prices to cause a rapid deterioration in the financial health
of CDOs. Second, the CDO underwriters played an important role in determining CDO
performance, even after controlling for the asset and liability characteristics of their CDOs.
The unobserved causes for this underwriter effect might be the ability, diligence, or
philosophy of the underwriting bank. Lastly, the credit ratings of CDOs failed in their stated
purpose, namely to provide a reflection of the CDO’s ability to make timely payments of
principal and interest. This failure arose from a combination of over-automation and heavy
reliance on inputs whose accuracy was not easily judged. While the collateralized debt
obligation will not be the cause of another financial maelstrom, it is likely that the same
combination of market imperfections, misaligned incentives, and human excesses that
spawned this financial monster will not disappear.

References
1. Collateralised Debt Obligations-Domenico Picone

2. On the Mechanism of CDOs behind the Current Financial Crisis and Mathematical
Modeling with Lévy Distributions- Hongwen Du, Jianglun Wu, Wei Yang

3. Credit Derivatives-George Chacko, Anders Sjoman, Deto Motohashi, Vincent Dessain

4. The Story of the CDO Market Meltdown: An Empirical Analysis by Anna Katherine
Barnett-Hart.

5. The Economics of Structured Finance by Joshua D. Coval, Jakub Jurek,Erik Stafford.

6. Securitization in India – Opportunities & Obstacles by V.Sridhar.

7. CDO Modelling: Techniques, Examples and Applications by Christian Bluhm

8. Collateralised Loan Obligations – A Primer –Andreas A.Jobst

25

Das könnte Ihnen auch gefallen