Rahul Krishna M Roll no:159 PGDM-Finance

Under the guidance of Prof A K Pradhan SIMSR

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


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 . 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. It discusses about the details regarding the CDO as an instrument and how it has been performing in the credit market. my findings suggest that the problems in the CDO market were caused by a combination of poorly constructed CDOs. Collateralized debt obligations (CDOs) have been responsible for $542 billion in write-downs at financial institutions since the beginning of the credit crisis. we get into the causes of this adverse performance. and flawed credit rating procedures. irresponsible underwriting practices. We first introduce the concept of CDOs and give a brief account of the development of CDOs. I document several main findings. looking specifically at asset -backed CDO s (ABS CDO s). poor CDO performance was primarily a result of the inclusion of low quality collateral originated in 2006 and 2007 with exposure to the U. Using novel. 3 . residential housing market. hand -collected data from 735 ABS CDO s. We then explicate the mechanism of CDOs within a concrete example with mortgage deals and we outline the evolution of the current financial crisis. This paper explores the market of CDOs and synthetic CDOs and their use in bank balance sheet management.Abstract This paper aims to reveal the mechanism of Collateralized Debt Obligations (CDOs) and how CDOs extend the current global financial crisis.S. In this paper. Lastly. Second. First. 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. CDO underwriters played an important role in determining CDO performance. Overall.

that is. bonds. The sponsors of a CDO create a company so-called the Special Purpose Vehicle (SPV).g. According to how the SPV gains credit risks. The more senior the tranches investors are in. And frequently. The way it works is frequently referred to as a waterfall or cascade of cash flows. a common characteristic of all securisations. and to a less extent 3-year CDOs now trade fairly actively. followed by mezzanine tranche. In practice. The tranches have different seniorities: senior tranche. the synthetic structure allows bank originators in the CDOs market to ensure that client relationships are not jeopardized. which are bond-like instruments whose cash flow structures allocate interest income and principal repayments from a collateral pool of different debt instrumen ts to a prioritized collection of CDO securities to their investors. the least risky tranche in CDOs with lowest fixed interest rate. the costs of constructing and marketing a CDO would inhibit its creation. which are referred to as the sponsors. CDOs are classified into two kinds: cashflow CDOs and synthetic CDOs. The most popular life of a CDO is five years. the less risky the investment and hence the less they will be paid in interest. CDOs address some 4 . funds (Collateralized Fund Obligations. or CMO) and others. depending on the seniority of tranches within the capital structure of the CDO. A CDO makes payments on a sequential basis. the CDO is referred to as a cashflow CDO. and finally the first loss piece or equity tranche. the CDO is referred to as a synthetic CDO. or CFO). instead obtaining the credit risk exposure by selling CDSs on the debt obligations of reference ent ities. If the SPV of a CDO owns the underlying debt obligations (portfolio). SPV sells these credit risks in tranches to investors who. loans (Collateralized Loan Obligations. The SPV works as an independent entity and is usually bankruptcy remote. in return for an agreed payment (usually a periodic fee). CDOs would serve no purpose. administration fees and hedging fees from the SPV. Therefore. or CLO). junior mezzanine tranche. if the SPV of a CDO does not own the debt obligations. these instruments are popular referred to as CDOs. the SPV obtains the credit risk exposure by purchasing debt obligations (e. such as bonds (Collateralized Bond Obligations. In perfect capital markets. or CBO). In the market for COs. will bear the losses in the portfolio derived from the default of the instruments in the portfolio. residential and commercial loans). 10-year. A CDO can be initiated by one or more of the followings: banks. The sponsors can earn serving fees. the securities can be taken from a very wide spectrum of alternative financial instruments. which is the basic form in the CDOs market in their formative years. and asset management companies. they source their collaterals from a combination of two or more of these asset classes. Tranching. but otherwise has no claim on the cash flow of the assets in the SPV.Introduction Collateralized Obligations (COs) are promissory notes backed by collaterals or securities. the tranches holders have the ultimate credit risk exposure to the underlying reference portfolio. However. After acquiring credit risks. and avoids the tax-related disadvantages existing in cashflow CDOs. non-bank financial institutions. In contrast. 7-year. however. Collectively. 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. mortgages (Collateralized Mortgage Obligations.

and thereby raise the total valuation to the issuer of the CDO stru cture. and perhaps also increasing the valuation of the assets through an increase in liquidity. First. leading to a reduction in their market values. preference and penetration. achie ving capital relief. 5 . is designed to remove loans from the balance sheets of banks. The Research methodology would be to study and analyse the secondary data i n the form of research paper. valuation of this instrument and calculating the default risk on interest payments. In light of these market imperfections. 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. 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. individual bonds or loans may be illiquid. reducing the amount of (expensive) regulatory capital that they must hold. The balance-sheet CDO. 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. Some of the factors that will be studied are the eligibility criteria put forth by RBI. often underwritten by an investment bank. Securitization may improve liquidity. 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. typically in the form of a CLO. An arbitrage CDO. thesis and dissertations. Scope and Research Methodology: Since CDO s are currently non-existent in India. white paper. Second.important market imperfections. at least two classes of CDOs are popular: the balancesheet CDO and the arbitrage CDO. It also envisages on the difficulties that the issuers and the investors have in making decisions for trading with the CDO instruments. The focus of this research would be to identify the factors that prevented CDO s from entering the Indian markets. International markets will be studied to find out more about their relevance.

This is the time when the collateral portfolio is functional in the market. 2. CDO Life cycle The lifecycle of CDO typically revolves around three periods: 1. Ramp-up period. The main reason for the popularity and the high amounts of trading of CDO s in the market was the increasingly deteriorating credit quality. Balance sheet CDO s 2.Development of CDO s The market for CDO s began as early as 1980 s. 3. But by the period of 2001 the demand for the credit deriv atives 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. Issuance volume was rising constantly. 3. 4. The relative low coupon attached to these assets. results in a smaller 6 . The asset classes that were being used as the collateral had been increasing. during this period the manager can actively speculate with it or just leave it to generate cash-flows. At that time CDO s were sharing the market with CMO s which had a similar functionality as of CDO s. Arbitrage CDO s Balance sheet CDO s are those in which the loans of one institution generally banks are transferred to the other institution. Apart from all these there were also some changes in the legislation and regulations which benefitted CDO s a lot. Unwind period-This is the period when the investors are repaid with their principal investment. The latter institution that purchases the loans gets a discount on the book value which is the amount that it charges for undertaking the default risk of those loans. Cash-flow period-It covers the major part of the CDO s life -span. There were many indicators of this development: 1. An example for this can be given as the CDO s of CDO s developed duri ng the year of 2002 where a portfolio of CDO s were assembled and sold to the potential buyers.Collateral portfolio is decided and formed during this period. Cross-border investment into CDO s also began to rise. 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. Types of CDO s The CDO s can be basically divided into two types: 1. 2.

have been included in past transactions. 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. the primary consideration is the price volatility of the underlying collateral. The main objective for the trading of the Balance shee t 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. This type of CDO relies on the market value of the pool securitised. Unlike arbitrage market value CDOs. These types of CDO s are also termed as Cash CDO s. All tranches will receive periodic payments based on the cash flows from the credit default swaps. Arbitrage cash flow CDOs By their very nature. The CDO manager has a great deal of flexibility in terms of the asset included in the deal. given th eir relative superior quality. 2. Every security traded in capital markets. Arbitrage CDO s can again be divided into two types: 1. therefore most assets are bonds. the collateral manager can increase or decrease the funding amount that changes the leverage of the structure. 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. Arbitrage CDOs are those where the originator looks to extract value by repackaging the collateral into tranches. Arbitrage market value CDOs Arbitrage market value CDOs. These two types of CDO s are the most basic type of CDO. In fact. However syndicated loans. Initial investments into the CDO are made by the lower tranches. the collateral assets are not traded very frequently.spread cushion than the corresponding arbitrage structure. The important aspect is the collateral manager s capacity to generate a high total rate of return. Synthetic CDOs are typically divided into credit tranches based on the level of cre dit risk assumed. they require less subordination when used in a CDO deal. while the senior tranches may not have to make an initial investment. usually tradable. However. If a credit event occurs in the fixed income portfolio. with estimated price volatility. go through a very extensive trading by the collateral manager. can be included in this type of CDO. collateral assets have been purchased at market price and are negotiable instruments. necessary to exploit perceived price appreciations. which is monitored on a daily basis. During the revolver period. the synthetic CDO and its 7 . unlike balance sheet CDOs where there is no active trading of loans in the portfolio.

it was the second largest credit derivative market after the credit default swaps. In 2005. several changes in CDOs were working to create the perfect storm that was unleashed upon financial markets in 2007. 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. is simply a CDO issue using other CDO notes as collateral. The Rise and fall of the CDO Every player was benefiting from CDOs and issuance exploded. prepayment and currency risk. starting from the lowest rated tranches and working its way up. whereas the cash CDO. 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. benefiting from the low cost of funding senior tranches. The process is called re-securitisation. with its complete transfer of the asset to the SPV. without having to sell or move the loans off his balance sheet. Other types of CDO s CDO Squared It is also known as CDO2 note. Institutional investors loved the high-yielding AAA securities created from ABS CDOs. In case of default among any of the underlying CDO s. both in absolute and relative market terms. From an investment perspective. the synthetic CDO allows a clearer investment opportunity for the buyer: The synthetic CDO only brings credit risk. 8 . the synthetic derivative then provides access to that market s investor community.investors become responsible for the losses. Although the CDO market began with Cash CDO s. by 2003. 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. such interest rate. reaching $50 billion in 2006. and CDO collateral managers earned hefty returns by retaining the equity tranches. The CDO Market The market for Collateralized Debt Obligations has grown continuously over the past ten years. 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. However. The rating agencies were making record profits as the demand for rated structured products skyrocketed. brings in addition to the credit risk all t he normal risks associated with owning an asset. CDO underwriters collected fees and achieved regulatory capital relief by off-loading their assets.

Furthermore. as opposed to corporate b onds. Table documents the evolution of ABS CDO assets from 1999-2007. 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. 9 . the collateral composition of CDOs changed as collateral managers looked for ways to earn higher yields. they invested in the mezzanine tranches of these securities. The managers began investing more heavily in structured finance securities. 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. most notably subprime RMBS. with 36% of the 2007 CDO collateral comprised of HEL bonds.First. credit-cards. moves designed to create higheryielding collateral pools. 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.) In response to the explosion in CDO issuance. etc. 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 insu rers and real estate investors that had traditionally held this risk were priced out of the market. illustrating the profound increase in subprime RMBS ( HEL) collateral.

using CDS as opposed to cash bonds gave CDO managers the freedom to securitize any bond without the need to locate. or own it prior to issuance. Taken together. Rather than investing in cash bonds. purchase. 10 . CDOs became a dumping ground for bonds that could not be sold on their own bonds now referred to as toxic waste. especially in subprime floating rate assets. the advent of synthetic CDOs significantly altered the evolution of the CDO market. The use of CDS could give the same payoff profile as cash bonds. essentially insurance contracts protecting against default of specific asset-backed securities.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. (and the occasio nal CDO cubed ). synthetic CDOs were created from pools of credit-default swap contracts (CDS). these observations indicate that CDOs began to invest in more risky assets over time. Essentially. As former Goldman Sachs CMBS surveillance expert Mike Blum explains: Wall Street reaped huge profits from creating filet mignon AAAs out of BB manure. which repackaged the hard-to-sell mezzanine CDO tranches to create more AAA bonds for institutional investors. Lastly. the next development was the creation of the notorious CDO squared. but did n ot require the upfront funding of buying a cash bond. Furthermore.

with the most pronounced decline in the AAA -rated tranches.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. With the issuance of CDOs growing unabated and the quality of their collateral declining. Historical Realized Default Levels (Source: The Story of the CDO Market Meltdown: An Empirical Analysis by Anna Katherine Barnett-Hart) 11 . The below figure shows the dramatic increase in realized default levels of ABS CDOs. with over 40% of the 2007 CDO assets in default. The subordination levels have decreased slightly for all tranches. which went from an average of 25% subordination in 2002 to less than 15% in 2007. leaving investors more exposed to losses on the collateral. both the rating agencies and the investment banks failed to recognize the amount of risk inherent in these products.

as CDO structures became more complex. To correct for any shortcomings in the other agency s rating methodology. Fitch. but in many cases. if Moody s rated a CDO that was composed of collateral rated BB+ by Fitch only. 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. Not only did the rating agencies fail to examine the accuracy of their own prior collateral ratings. The inputs and definitions associated with the models were frequently changed. it became clear that similarly rated bonds from different sectors (i. RMBS vs. CMBS) had markedly different track records of realized default probabilities.g. With the arrival of CDOs. However. and Standard and Poor s (S&P). Problems with CDO ratings rapidly developed as the rating agencies came under enormous pressure to quick ly crank out CDO ratings and the market exploded faster than the number or knowledge of analysts. For rating CDOs. In other words. they created the practice of notching. 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. Lastly. While there are five credit rating agencies with the NRSRO qualification. ABS vs. structured finan ce market: Moody s. conveniently assuming that decreasing it by a notch would compensate for any shortcomings in the initial risk analysis. While S&P and Moody s rated almost all CDO deals. The advent of CDOs in the mid-1980s was a watershed event for the evolution of rating definitions. Moody s would instead use a rating of BB in their own CDO model because it was not their rating. credit ratings from ag encies deemed to be nationally recognized statistical organizations (NRSRO) were used for regulatory purposes by the SEC.e. and the agencies began to adjust their meanings and models haphazardly in an attempt to correct their previous mistakes. rating agencies made use of their previous ratings as ingredients for making new ratings they had to eat their own cooking. The rating agencies earned high fees from the CDO underwriters for rating structured finance deals.. they also used other agency s ratings without checking for accuracy. only three were major players in the U. the agencies used ratings as the primary basis for ascribing mathematical properties (e.Credit ratings have been vital to the development of the CDO market. Table 3 shows the amount of CDO business each of the CRAs did with the various CDO originators. that the ratings of CDOs corresponded to similar default distributions as individual corporate bonds. they were not consumers. Investors came to rely almost exclusively on ratings to assess CDO investments: in essence substituting a letter grade for their own due diligence.S. Furthermore. with very little human intervention and little incentive to check the accuracy of the underlying collateral ratings. In addition. whereby they would simply decrease the rating of any collateral security that they did not rate by one notch. They never went back and reanalyzed the other rating agency s rating. default probabilities or expe cted losses) to bonds. corporate bonds. thereby further fueling the asset-backed frenzy. payment-in-kind (PIK) provisions. and were encouraged to believe. Until the first CDOs. incorporating features such as super senior tranches. generating record profits as seen in Diagram C. Fitch s market share declined to less than 10% by 2007. Analysis of CDOs came to rely almost completely on automated models. and 12 . rating agencies were only producers of ratings. investors thought.

there was also the fact that the ratings themselves were not meaningful indicators for assessing portfolio risk. Hedge fund managers. 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 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. 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. Since there was little historical data for CDOs. In addition to the problems with the accuracy of the ratings.e. as noted above. loss given default). which in turn caused a sharp increase in both the correlation among subprime mezzanine tranche defaults and their overall level of realized defaults. Current Financial crisis The main reason for the current financial crisis is the US subprime mortgage financial crisis. filling in their missing information with data about the track record of defaults for a given rating. In addition. designed to give a representation of expected losses at a certain point in time with given assumptions. investors instead looked at corporate bond performance. while decreasing the amount recovered in the event of a default (i. with very little data on periods of significant declines in house prices. 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. The Bank for International Settlements commissioned a report summarizing the difficulties in rating subprime RMBS.a diversity of trigger events that could change the priority of liability payments. when defaults were rising in the mortgage market. They found that the credit rating agencies underestimated the severity of the housing market downturn. asset -backed ratings have proven to have very different default distributions than corporate bonds. CDO ratings became even less meaningful. Investors often overcame these limitations by looking at ratings history. But as we now that it s rarely possible that one sector is getting affected and the other sectors function in the n ormal 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. Furthermore. the ratings of subprime RMBS relied on historical data confined to a relatively benign economic environment. ratings are a static measure. commercial and 13 . Initially t he institutions that got affected because of this default were the banks and institutions that used to provide credit for home construction. Also Securitisa tion became an important factor for giving loans and this resulted in the development of the Asset Backed Securities (ABS). It is not possible for a single rating to encompass all the information about the probab ility distribution that investors need to assess its risk. leading to false assessments. New York's Wall Street began to feel the first tremors in the CDOs world. In early 2007. However.

More importantly. and pension funds. then there was not much he/she could do to unload it. a bond or even a derivative. but the metrics and algorithms of quant and traders. which draws the attention to use modelling with heavy tail phenomenon as a feature. found themselves landed in trouble. subprime mortgages. 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. the market for CDOs' underlying assets also began to disappear. Gaussian copula is replaced by alternative 14 . If one had a CDO in his/her portfolio. 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. The CDO managers were in a similar bind. the mathematical models that were supposed to protect investors against risk weren t working. in the absence of which the institutions will t ry to not include these instruments in their profile. Besides. the CDOs market has seen the phenomenon of heavy tail dependence in a portfolio. With this formula pricing of the CDO had become very easy but only after a period of time that it w as realised that there were some flaws while pricing the CDO using these formulas. A well calibrated and easily implemented model is the right goal. Pricing a CDO is mainly to find the appropriate spread for each tranche (level) and its difficulty lies in how to es timate the default correlation in formulating models that fit market data. and other securities held by the CDOs. the efficiency in calibrating pricing models to market prices should be p aid much attention. multifactor models are considered other than one factor model. subprime -mortgage derivatives. The main criteria for financial institutions to trade instruments are the availability of a model to price those instruments. The credit for the success of CDO s during the period of 2001 can be mainly given to the invention of the Gaussian Copula. all of which had been big buyers of CDOs.investment banks. With the empirical evidence of the existence of mean reversion phenomena in efficient credit risk markets. as many CDOs included derivatives that were built upon mortgages including risky. Mathematical Challenges in Modelling the Mechanism of CDOs The basis of a CDO was not a mortgage. In addition. Thereafter more and more extensions have been proposed to pricing CDOs: homogeneous infinite portfolio is extended to homogeneous finite portfolio. but only later it was found that all the se 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. CDOs are not traded on exchanges and even not really struc tured to be traded at all. Sudden ly it was impossible to dump the swaps. The market standard model is the so-called one factor Gaussian copula model. As fear began to spread. and then t o heterogeneous finite portfolio which represents the most real case. mean-reverting type stochastic differential equations are considered. The complicating matter was that there was no market on which to sell the CDOs.

constant default correlation and deterministic loss given default are relaxed and stochastic ones are proposed which incorporate dynamics into pricing models. amounts recovered in the event of default. the ten rating categories within the speculative grade range (from BB+ to C) have default rates ranging from 1. The riskiness of collateralized debt obligation tranches is sensitive to the extent of commonality in default among the underlying assets. which would be insufficient to alter the security s rating. 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. securities rated BBB. where the credit rating agencies had developed their expertise. since CDOs rely on the power of diversification to achieve credit enhancement. With multiple rounds of structuring. can dramatically. even minute errors at the level of the underlying securities. 15 . 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. alter the ratings of the structured finance securities. The structure of collateralized debt oblig ations magnifies the effect of imprecise estimates of default likelihoods. Given the narrow range of the historical default rates. commonly known as CDOsquared (CDO2). to assign ratings to structured finance securities. It is notewo rthy that within the investment grade range.02 and 0. These estimates are derived from a study of historical data and are used in Fitch s model for rating collateralized debt obligations (Derivative Fitch. model errors due to the potential misspecification of default dependencies. such as principal or interest payments. securities were assessed independent of one another.96 percent. the rating agencies were forced to address the bigger challenge of characterizing the entire joint distribution of payoffs for the underlying collateral pool. as well as. distinguishi ng between the ratings assigned to investment grade securities requires a striking degree of precision in estimating a security s default likelihood.or higher have come to be known as investment grade and are thought to represent low to moderate levels of default risk. As such. In the single-name rating business. the assumptions of constant default probabil ity. default correlation. while those rated BB+ and below are referred to as speculative grade and are already in default or closer to it. Depending on the agency issuing the rating and the type of entity whose creditworthiness is being assessed. 2006). the rating is either based on the anticipated likelihood of observing a default. By contrast.probability distribution functions. But. Challenge of Rating Structured Finance Assets Credit ratings are designed to measure the ability of issuers or entities to meet their future financial commitments. These problems are accentuated further through the sequential application of capital structures to manufacture collateralized debt obligations of CDO tranches. a credit rating can intuitively be thought of as a measure of a security s expected cash flow.75 percent. there are ten distinct rating categories (from AAA to BBB -) even though the annualized default rate only varies between 0. In the context of corporate bonds. allowing rating agencies to remain agnostic about the extent to which defaults might be correlated.07 to 29.

in theory. If we assume that the stock market provides an ordering of economic states that is. However. it may well have lured investors seeking safe investments into the structured finance market. securities that are correlated with the market as a whole should offer higher expected returns to investors. only provide an assessment of the risks of the security s expected payoff. 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. Under the work ing assumption that a single natural disaster cannot have a material impact on the world economy. in which case the bond default. For example. At the other end of the range. such that CDOs of mortgagebacked securities are effectively CDO2s. credit ratings. and the ensuing recovery rates for these securities was significant. when magnified by the process of re -securitization. By selecting the appropriate 16 . a traditional catastrophe bond will earn a yield spread consistent with compensation for expected losses. and deliver their promised payoff unless there is a natural disaster.Importantly. since substantial lending to subprime borrowers is a recent phenomenon. the default probabilities. such that its payoff is unrelated to whether the economy is in a recession or boom. consider a security whose default likelihood is constant and independent of the economic state. 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. Catastrophe bonds are typically issued by insurers. Because credit ratings only reflect expected payoffs. it represents the security with the greatest possible exposure to systematic risk. Moreover. command a wide range of yield spreads that is. historical data on defaults and delinquencies of this sector of the mortgage market is scarce. securities with a given credit rating can. the economy is in worse condition than if that s ame index is at 900 then the security with maximal exposure to systematic risk is a digital call option on the stock market. 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 this security defaults and fails to pay only when the market is below the strike price. Treasury security of the same duration depending on their exposure to systematic risks. A digital call option pays $1 if the market is above a pre determined level (called a strike price ) at maturity and $0 otherwis e. yield in excess of the yield on a U. by design. or the behaviour of any other set of economic indicators. many of these residential mortgage-backed securities are themselves tranches from an original securitization of a large pool of mortgages. help explain the devastating losses some of these securities have experienced recently. even though they did not fully appreciate the nature of the underlying economic risks. Such errors. When credit rating agencies started rating both structured finance and single -name securities on the same scale. An example of this type of a security is a traditional catastrophe bond. In the logic of the capital asset pricing model.S. whether interest rates are rising or falling. such as a hurricane or earthquake. The possibility for errors in the assessment of the default correlations. 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 the Standard and Poor s 500 index is at 800.

Coval. In addition. because a digital call option concentrates default in the worst economic states.Stricter disclosure requirements (register credit derivatives transactions. by making the appropriate investment in options on the broader stock market index. disclose the effect of credit derivatives transactions on companies risk exposure) 17 . and the mispricing of credit they generate: either CDO s are evidence of a substantial and pervasive market imperfection [in the fixed income market].strike price. Financial Stability Implications The BIS reports that the market-making activities associated with CRT are concentrated with a limited number of dealer/broker firms. investors will insist on receiving a high return as compensation for bearing the systematic risk. whose defaults are affected by firm-specific bad luck. be so different from a pricing standpoint. or they are being used to create one. Among their reform suggestions: . centralized pricing service. As a result. regardless of what the credit rating agencies may choose to do. In effect. However. securities with a similar likelihood of default). The second possibility seems more likely. the probability that the call fails to make its promised payment can be tuned to match any desired credit rating. pooling allows for broad diversification of idiosyncratic default risks. high transaction costs of these CRT structures. casts significant doubt on whether corporate bonds and structured finance securities can really be considered comparable. Jurek. The process of pooling and tranching effectively creates securities whose payoff profiles resemble those of a digital call option on the market index. 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. both in principle and in fact. they are likely to be earning a yield that appears attractive relative to that of securities with similar credit ratings (that is. hedge funds are major investors in the equity tranches of CDOs and particularly active in correlation -related trading. At the company level. tranches written against highly diversified collateral pools have payoffs essentially identical to a derivative security written against a broad economic index. 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. If investors in senior claims of collateralized debt obligations do not fully appreciate the nature of the insurance they are writing. but well below the return they could have earned from simply writing such insurance directly say. Such a risk profile should be expect ed to earn a higher rate of return than those available from singlename bonds. and Stafford (2008) provide evidence for this conjecture. Intuitively. The fact that corporate bonds and structured finance securities carry risks that can. and require the option to deliver the largest yield spread of all securities with that credit rating. such that in the limit of a large diversified underlying portfolio losses are driven entirely by the systematic risk exposure. as they are increasingly likely to experience significant losses as the overall economy or market goes down.

Four good reasons for CDO business Besides the four motivations summarized in the sequel. insurance companies.Competition in credit ratings industry . 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. Spread arbitrage opportunities : On the asset side premiums are collected on a singlename base. 1. 3. 2. The only regulatory capital requirement the originator has to fulfil regarding the securitized loan pool is holding capital for retained pieces. according to Creditflux Data+ The most important users of credit derivatives have historically been banks ( see chart below). The volume of outstanding cash CDOs stands at $ 986 billion at the start of 2007.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. 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.. tax and legal arbitrage play an important role in CDO structuring. See table below. Regulatory capital relief : D in CDO becomes an L standing for loan . 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. But anecdotal evidence suggests that hedge funds. pension funds and other buy -side firms are the fastest growing sectors of the market. according to Creditflux Data+ The volume of synthetic CDO tranches traded in the past three years is $739 billion. mutual funds. 18 . A full calculation of costs compared to the decline of regulatory capital costs is required to judge about the economics of such transactions.

SPV can get cash which is considered risk less through this process. Hence. Advantage to Originator 1. the originator can change the risky assets into cash which is considered less risky. it would increase the ROE. the issuer has to sustain this part of credit risk. SPV fund through CDO -squared can reduced the capital requirement.4. In addition. 4. Moreover.The excess loss of the first loss piece. or transfer these risky assets to other insurance company and other institution to sustain. Furthermore. the capital adequacy ratio. 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. it would reduce the capital cost. reservation requirement. Economic risk transfer: Such a transaction divides the loss distribution in two segments First loss refers to losses carried by the originator (e. 3. 19 . due to the unique structure of CDO-squared there are still some differences between CDO and CDO squared. by retaining the equity piece). 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. CDO-squared provide another choice for financial institution to fund. Therefore. Reducing capital cost The reference obligors are packed and strengthen their credit level. 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.. taken by the CDO investors.g. SPV can reduce its funding cost. moreover. 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. for example. There are some limits about capital of the banks and some financial institution. 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. It always can make CDO squared have higher credit rating than the originator. We will illustrate advantages and disadvantages of CDO-squared from the aspects of both originator and investors. However. therefore. 2. and expand to the global capital market. 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. Pros and cons of CDO s CDO-squared have the similar advantages and disadvantages to CDOs. However. In addition. these assets can be more liquid through packing into small unit of CDO-squared.

The originator can earn the fixed and periodic service revenue from issuing the CDO squared through SPV. but this problem would be released. when the adverse selection problem occurs. and these securities have to strength their credit and supervised by credit rating institutions. In this case. and risk. the SPV can repack reference CDOs into securities with different maturity. interest rate. Therefore. Having one more choice of investment instrument and can diversify unsystematic risk Through securitized. because CDO-squared have several underlying CDOs which already have many CDSs in it. the investors of CDOs or CDO-squared have less default risk and more liquidity. it would make the pric e of commodity lower and the price difference is called Lemon s premium. Advantage to Investor 1.5. Receive fixed and periodic service revenue The originator plays the role of servicer and receives the cash flow of origination for SPV. 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. on average. 4. Higher safe and liquidity instrument There are many criterions by government in issuing the CD O or CDO-squared. As we know. if the issuer can keep the equity tranche by itself and just sell other tranches. Therefore. This kind of problem cannot totally avoid by securitized. therefore. Earn higher spreads The CDO-squared is double-lay structure. 20 . CDO squared can diversity unsystematic risk and even have higher degree of diversity achieved than CDO. Hence. the other tranches can get more funds. It makes investors have much more choices. 2. Thus. it provides investors more choice of investing in credit and earns higher spreads. investors willing to offer lower price than it should be under they have symmetric information. When the SPV issue CDOs to make the price higher and the adverse selection problem will c oncentrate in equity tranche and not affect other tranches. the SPV have the adverse selection problem. and investors can choose products based on their needs and their risk preferences. 3.

Therefore. This is due to the slight change of underlying reference credits would lead to big change of value of CDO-squared. the relative fee may be higher than the benefit which it brings. the originator would take the poor quality loans to securitize and keep the higher quality loans. it also reflects the complicated and the unique of this derivative. SPV. Maybe have moral crisis problem The SPV can transfer the credit risk into the insurance company and the investors through securitization. Or. 21 . Therefore. the credit rating company. It would let investors face the moral crisis problem.e. However. CDO -squared is more difficult to valuate than CDOs or CDS. the more difficult to valuate Although the CDO-squared can achieve the higher spread. and the counterparty of credit default swap. but also bring more risk than CDO. Disadvantage to Investor 1. The originator may lose the stable interest. 2. even bigger than value of CDO. it may be not to get such good assets again. Undertake higher credit risk CDO-squared can achieve the higher spread.Disadvantage to Originator 1. i. The net benefit of securitization may be negative The securitization involves many professional institutions. it will be more transparent through the market operation. High quality of long-term loan would be hard to acquire When the originator securitizes the high quality loan. It may make the originator lend money without careful survey the credit of borrower. The more complicated the commodity. 3. 2.

22 .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. Originator Effect: Performance of a CDO depends on the specific entities that originated its collateral assets. without making sufficient distinctions for different asset types. Housing Effect: Residential mortgage collateral has performed poorly. Lending standards of the originating entity will affect the ultimate performance of the CDO assets. 5. it is possible that the variation in underwriting standards is a function of the size of the bank s CDO business. Vintage Effect: Collateral from 2006 and 2007 vintages showed worse performance and even there was a decline in underwriting standards during this period. 7. Size Effect: Performance of an underwriter s CDOs varies according to the size of their CDO business.4 2005 251. Recycled Ratings Effect: The rating agencies relied almost exclusively on the prior ratings of the underlying collateral. Some of them are 1.6 2008 61. as measured by their ex-post defaults and rating downgrades. Peer Pressure Effect: CRAs were worried about ratings shopping.Foreign Market Scenario : Global CDO Issuance Volume Year USD billion 2004 157. in fear that they would lose business if their rating were less desirable than their competitor s. with overly-aggressive or very inexperienced banks issuing worse CDOs. Complexity Effect: Increasing complexity in CDO assets also made people shift towards other instruments. 4. 2.6 2007 481. 8. causing more liberal ratings when they knew another agency was also rating the deal. caused by a combination of declining underwriting standards by mortgage originators and the collapse in home values. Amount of due diligence conducted by the underwriter had a great influence on the performance of the CDO transaction.9 2009 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. Certain banks might have been better CDO underwriters for unknown reasons. 3. 6.3 2006 520.

consisting of a pool of bonds. the price considered is either the NAV or the repurchase price. ICICI s CDO is the first CDO/ CLO in India. distribution of the same taxable only 10% . A major concern for investors is the valuation of this instrument. PTCs held by ICICI.a 28% tax shelter 23 . 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. In the absence of a Securitization Act. can attract a stamp duty as high as 10% in some states precluding transaction possibilities. Called Indian Corporation Collateralised Debt Obligation Fund. The confusion probably cropped up due to the fact that the instrument is to be traded like an other bond. Available for Sale and Held to Maturity . There have been several loan sales by financial institutions. there are taxation and legal uncertainties with the securitization vehicle. For Available for Trading category.Indian Scenario The activity in the ABS market is picking up in India. the number of investors for securitized paper is very limited. as and when the NAV is published. Its NAV was to be declar ed every week as is mandatory under SEBI rules. during 2002 announced the launch of India's first multi -tranched Collateralised Debt Obligation named Indian Corporate Collateralised Debt Obligation Fund. For valuation. Bank valuation is done on category wise basis. there has been no CDO/ CLO. Taxable incomes become tax free (other than dividends tax) : the originating institution paying tax before. Though securitisation has been in place in India over last 6 years or so. In terms of the distribution schedule. whichever is lower. With favourable legislation and taxation regime. Nothing stops the originator from repackaging his own portfolio into units through the mutual fund and holds them tax free . In India. now earns tax free income. It is a balance sheet CDO. Available for Trading . the deal will lead to capital erosion. Though securitisation has been in place in India over last 10 years or so. there has been no CDO/ CLOICICI Ltd. The interest on debt paid by the obligors gives them 38% tax relief. no valuation is required. depending on which category the investment falls under viz. transfer of secured assets as required for securitization. the valuation is done on a quarterly / half yearly / annual basis and for Held to Maturity category. the ABS market in India can hope to see a lot o f activity in future. Mutual fund is certainly the most efficient possible SPV f or 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 . the valuation is done on a daily/ weekly basis. In Available for Sale category. however the valuation was to be done as per any other mutual fund unit. it is essentially a pass through structure reinvestments only if bondholders opt for growth plan. Capital relief could not be the purpose: if capital regulations as in BIS are applied.

Co -operative banks cannot invest in corporate paper. Mutual Funds Mutual Funds preferred to stay away from the issue. whichever is lower. depending on which category the investment falls under viz. If to say that nearly all the assets continue to remain on ICICI s books. after securitising a part. The main reason has been the issuance of the securities in the form of Mutual Fund units. it would have been a positive boost for secondary market liquidity of this instrument. 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. the valuation is done on a quarterly / half yearly / annual basis and for Held To Maturity category. as and when the NAV is published. CONCERN ABOUT THE UNDERLYING POOL OF ASSETS The inclusion of certain assets. Investors wrongly felt that ICICI is trying to take out bad assets out of its books. PTCs thereafter re-securitised because mutual funds cannot buy loans. For valuation. Its NAV was to be declared every week as is mandatory under SEBI rules. For Available For Trading category. no valuation is required. The confusion probably cropped up due to the fact that the instrument is to be traded like a other bond. Even RRBs are not allowed to invest in mutual funds.Not merely bonds. The best way to allay these fears is if the Originator continues to hold some assets of the same Obligors. has made investors skeptical about the motive behind this securitisation transaction. Available For Sale and Held To Maturity . even loans have been indirectly made tax free: existing loans first securitised. however the valuation was to be done as per any other mutual fund unit. If a Mutual Fund invests in another MF unit they also lose out on AMC fees. which has defaulted on interest payments to institutions. but can buy PTCs. as they (MFs) are the most active traders. MFs cannot invest more than 5% of their Net Asset Value in other mutual funds. the valuation is done on a daily/ weekly basis. VALUATION OF THE PAPER IN THE BOOKS OF INVESTORS A major concern for investors is the valuation of this instrument. This regulation did not allow them to invest in the ICCDO. Available For Trading . the price considered is either the NAV or the repurchase price. RRBs are allowed to invest in corporate paper with a cap of 5% of their incremental deposits. In Available For Sale category. If Mutual Funds had come in as investors into this issue. 24 . Bank valuation is done on category wise basis.

The Story of the CDO Market Meltdown: An Empirical Analysis by Anna Katherine Barnett-Hart. Securitization in India Opportunities & Obstacles by V. Examples and Applications by Christian Bluhm 8. even after controlling for the asset and liability characteristics of their CDOs. Coval. Jakub Jurek.Erik Stafford. On the Mechanism of CDOs behind the Current Financial Crisis and Mathematical Modeling with Lévy Distributions. it should be well emphasized to the investors that since it is very unlikely that all assets would default at the same time. References 1. 6. misaligned incentives. and flawed credit rating procedures. Vincent Dessain 4.However. 5. or philosophy of the underwriting bank. Second. The unobserved causes for this underwriter effect might be the ability. it is likely that the same combination of market imperfections. Lastly. irresponsible underwriting practices. 7. Jianglun Wu. While the collateralized debt obligation will not be the cause of another financial maelstrom. allowing the decline in housing prices to cause a rapid deterioration in the financial health of CDOs. diligence. 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. Collateralised Debt Obligations -Domenico Picone 2. the CDO underwriters played an impo rtant role in determining CDO performance. This failure arose from a combination of over -automation and heavy reliance on inputs whose ac curacy was not easily judged. the cushion in terms of cash reserve and tranching is sufficient to protect investors from any yield loss to certain extent. Collateralised Loan Obligations A Primer Andreas A. Conclusion CDO market arose from a combination of poorly constructed CDOs. Deto Motohashi. The majority of CDOs issued after 2005 contained remarkably high levels of this collateral. 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 residentia l housing market. CDO Modelling: Techniques. Anders Sjoman.Sridhar. The Economics of Structured Finance by Joshua D.Hongwen Du. Credit Derivatives-George Chacko. Wei Yang 3. and human excesses that spawned this financial monster will not disappear.Jobst 25 .

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