Bespoke portfolio (CDO)

A bespoke portfolio is a table of reference securities. A bespoke portfolio may serve as the reference
portfolio for a synthetic CDO arranged by an investment bank and selected by a particular investor[1] or for
that investor by an investment manager.

Overview
The list of reference securities making up a portfolio is one of the primary drivers of the investment
outcome of a synthetic CDO.[2] Because the portfolio is not that of a corporate credit index like the CDX
or iTraxx, the mean default probabilities of the reference securities, their distribution of default probabilities,
their default correlations and the recovery amounts upon default can vary greatly.

In principle, the investor chooses the reference securities and decides on the "attachment" and
"detachment" points[3] (that is, the amount of losses that occur before the investor suffers its first dollar of
loss; and the upper limit beyond which the investor suffers no further losses). In reality, the arranger
demands a good deal of input into the selection of the reference portfolio. Most arrangers manage their risks
by buying and selling protection on single-name CDS or on the CDX indexes and therefore they usually
avoid taking positions in CDS that cannot readily be traded.[2]

Bespoke portfolios can have very different default correlation

characteristics from credit indices with similar distributions of
riskiness. Bespoke portfolios almost invariably have numbers of
reference securities similar to those of the major credit indices – 100
to 125 reference securities – but bespoke portfolios can include
reference securities that have highly correlated default probabilities,
either because they are issued by different subsidiaries of the same
parent company, because they include closely related but separate
Probability Distribution around mean
companies, or because the bespoke portfolios include much higher
default probability of 10%, N=100,
concentrations in single industries than occurs in credit indices.[4] rho of 0% and 10%. Created using
Determining the fair default correlations for a bespoke portfolio can Gaussian Copula model and 5,000
be very difficult. The chart on the right shows that differences in simulations
correlation can greatly change the probability distribution of
defaults and thus change the fair value of any given CDO tranche
linked to a particular portfolio.

Initially, bespoke portfolios referenced in most synthetic CDOs were static, meaning that the list of
reference securities would change only because of default, because of a succession event, or because of the
disappearance of a reference security or its issuer. From 2004 onwards, managed transactions were also
issued. Managed bespoke portfolios are those where a third party investment manager is appointed to select
the bespoke portfolio but also to buy and sell the underlying reference securities to exploit trading
opportunities or avoid credit losses.[2]
A synthetic CDO can be structured as a swap between an investor and an arranger, in which case the
investor does not need to fund the purchase of the synthetic CDO notes. The majority of bespoke portfolio
linked CDOs, however, are embedded into credit-linked notes that are purchased by the investor.[2]

Market size
The overall volume of CDOs on bespoke portfolios rose rapidly in the early 2000s. In 1999, synthetic
CDO issuance in total was less than $10 billion. 2005 issuance of bespoke portfolio tranches was cited by
Rajan, McDermott and Roy as $294 billion.[5]

CDO tranches linked to bespoke portfolios continued to trade after the financial crisis of 2007–08 but in
considerably reduced amounts.[6]

Cited advantages
As mentioned above, the key advantage to investors was that it allowed them to specify the reference
securities in the bespoke portfolio as well as the tranche's attachment and detachment points and other
characteristics. A report from the Banque de France stated that: "this avoids some of the dangers of
traditional CDO structures, such as the risks of moral hazard or adverse selection in the choice of the names
in the portfolio ...".[7]

Also, arrangers like CDOs on bespoke portfolios because they are relatively easy to set up.[7] Traditional
CDOs take three to six months to arrange and typically cost $2 to $4 million in legal, rating and marketing
costs, whereas single tranches on bespoke portfolios can be arranged in four to six weeks and upfront costs
are typically less than $500,000.

Criticisms
Because CDOs linked to bespoke portfolios are, by their nature, only held by one or a very small number
of investors, there is no liquid market where they can be bought, sold or valued. Therefore, these CDOs are
valued using mathematical models that performed poorly both before and during the financial crisis.[8][9]
Subsequently banking industry regulators have pointed out concerns applicable to CDO tranches on
bespoke portfolios that exceed even the regulators' concerns about index-based tranches (which are referred
to as "standardized products" in regulatory literature). The Basel Committee on Banking Supervision's
Regulatory Consistency Assessment Programme tested banks' internal models to identify the factors
"contribut[ing] to the observed variability in trading book RWAs". "Bespoke products" were found to
"exhibit much larger variability than standardised products" with respect to value at risk dispersion.[10]

A key reason for this was the correlation characteristics of bespoke portfolios, which by their nature were
unique to the specific portfolio and inherently unobservable in the markets. Brigo, Pallavicini and Torresetti
summed up the problem in their 2010 book as follows: "Bespoke corporate pools have no data from which
to infer default "correlation" and dubious mapping methods are used."[11]

One result of this was that hedge funds specializing in credit correlation were able to arbitrage tranches
among dealers, buying protection from one dealer and almost immediately selling it at a profit to another
dealer.[12] The hedge funds would do this by specifying their own bespoke portfolio and asking 5 to 10
dealers to quote bids and offers on tranches on the portfolio, usually allowing the dealers only a few hours
to quote. Often both dealers would report a first-day profit on the trade.
Part of the problem lies in calibrating tranches on a bespoke portfolio to observable data generated from
credit index tranche prices. Matching a bespoke portfolio to a credit index can be extremely subjective.
Rajan, McDermott and Roy discussed the problem and its possible solution: "... we have no insight into the
value of a tranche that spans, for example, part of two index attachment points ... by being able to relate
[correlation] skews across a range of portfolios through their risk characteristics and maturities, one can
price and hedge customized tranches of bespoke portfolios."[13] However, it is extremely difficult to obtain
certainty as to the correlation skew appropriate to a given bespoke portfolio.

The aforementioned 2005 Banque de France report pointed out that CDO tranche issuance referencing
bespoke portfolios "may have a major impact on credit spreads due to their leverage".[7] Because CDO
tranches on bespoke portfolios could have very narrow spreads between their attachment and detachment
points – far less than the 3% to 5% thickness on index tranche products – they could be far more leveraged,
meaning that a small movement in credit default swap spreads could cause a very large change in the value
of CDO tranches linked to bespoke portfolios. This in turn meant that changes in observed correlations on
index tranches caused very large scale buying of CDS protection by swaps dealers during the financial
crisis, increasing instability and illiquidity.

See also
Single-tranche CDO

References
1. Structured Credit Insights: Instruments, Valuation and Strategies. Morgan Stanley, April
2006, Second Edition
2. Structured Products and Related Credit Derivatives - A Comprehensive Guide for Investors.
pp254-255. Lancaster Schultz Fabozzi. John Wiley & Sons, Inc. - Chichester, 2008
3. Merrill Lynch Credit Derivatives Handbook 2006 - Volume 2, page 4. Merrill Lynch, 14
February 2006
4. Merrill Lynch Credit Derivatives Handbook 2006 - Volume 2, page 14. Merrill Lynch, 14
February 2006
5. The Structured Credit Handbook. Arvind Rajan, Glen McDermott, Ratul Roy. John Wiley &
Sons Inc. - Chichester, 2007. p. 6 [1] (https://books.google.com/books?id=jGPUDnhJ92wC&
q=editions:McfIOPAptDkC)
6. "Crossing Barriers". European Credit Views, 9 June 2010. Credit Suisse.
7. The CDO market; Functioning and implications in terms of financial stability (http://www.ban
que-france.fr/fileadmin/user_upload/banque_de_france/publications/Revue_de_la_stabilite
_financiere/etud1_0605.pdf). Oliver Cousseran and Imene Rahmouni. Banque de France
Financial Stability Review, No. 6. June 2005 p. 48
8. Slices of Risk: How a Formula Ignited Market That Burned Some Big Investors. Mark
Whitehouse. Wall Street Journal. Sept. 12, 2005.[2] (https://www.wsj.com/news/articles/SB1
12649094075137685)
9. Pricing and Hedging Synthetic CDO Tranche Spread Risks. Michael Sherris and Jie Ding.
UNSW Australian School of Business Research Paper No. 2009ACTL04. March 16, 2009
[3] (https://ssrn.com/abstract=1361342)
10. Regulatory Consistency Assessment Programme (RCAP) – Second report on risk-weighted
assets for market risk in the trading book. Basel Committee on Banking Supervision.
December 2013 [4] (http://www.bis.org/publ/bcbs267.htm)
11. Credit Models and the Crisis: A journey into CDOs, Copulas, Correlations and Dynamic
Models. Damiano Brigo, Andrea Pallavicini, Roberto Torresetti. John Wiley & Sons, Inc. -
Chichester, 2010. Preface p. iii
12. Feldstein Who Speared Whale Ready to Unwind Derivatives. Anthony Effinger and Mary
Childs. Bloomberg. Jan 8, 2013. [5] (https://www.bloomberg.com/news/2013-01-09/feldstein-
who-speared-whale-ready-to-unwind-derivatives.html)
13. The Structured Credit Handbook. Arvind Rajan, Glen McDermott, Ratul Roy. John Wiley &
Sons Inc.- Chichester, 2007. p. 213 [6] (https://books.google.com/books?id=jGPUDnhJ92wC
&q=editions:McfIOPAptDkC)

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