Default sharing between banks
and markets: the contribution of
collateralised loan obligations
Franke and Krahnen
Discussant Patricia Jackson
22 October 2004 1
iM147813v1
Considers an important issue
• The effect of securitisation of assets on the
risk profile of banks
• Focuses on collateralised debt obligations
(CDOs) which have seen substantial growth
over past 5years
• New issuance probably running at around
$100bn per annum world wide
22 October 2004 2
iM147813v1
Simple CDO structure
•Asset pool can be static or managed
CDO tranches
Coupons and
Assets principal Senior notes
Issuing bank Mezzanine notes
SPV
(sponsor)
Cash Funds Equity
•Tranched to target investors with different risk appetites
22 October 2004 3
iM147813v1
Paper covers a number of important
questions
• What factors influence the size of the first
loss portion
• The effect of securitisation on the loss
distribution of the bank
• How the market views securitisations, using
event studies
22 October 2004 4
iM147813v1
Moral hazard and first loss portion
• Asymmetry of information/moral hazard
• flp = f (weighted average default probability
(wadp) and Moody’s diversity score (ds))
• Moody’s list 30 industrial sectors and allocates a
weight which reflects concentration of assets in
particular industries
• Find flp is a function of PD and is larger the less
diversified the pool in terms of industrial sectors –
although latter is weakly significant.
• Consistent with first loss covering EL and taking
some of industry idiosyncratic risk
22 October 2004 5
iM147813v1
Effect on the bank’s risk profile
• Authors consider overall effect of CDOs on loss
distribution for bank, with various reinvestment strategies
for the funds
• Generate loss distributions for securitisation from quality
distribution of underlying loans and transition matrices
• Find a large part of the loss distribution remains with the
bank.
• In terms of overall loss distribution for the bank –mean
and standard deviation increase
• But the skewness and Kurtosis of the total portfolio are
reduced
22 October 2004 6
iM147813v1
Authors raise the question of effect
on systematic risk for the
intermediaries
• Argue that banks’ unexpected loss increases
• But need to take into account fact that
likelihood of extreme events affecting the
bank is less – much of the extreme risk has
been moved to bond holders
• Perhaps need to focus on a VaR measure
22 October 2004 7
iM147813v1
Core assumption in the study is the
reinvestment
•Assumes banks are increasing leverage
Makes new Makes new Makes new
loans loans loans
Passes Passes Passes
extreme extreme extreme
risk to market risk to market risk to market
Retains Retains Retains
remainder remainder remainder
22 October 2004 8
iM147813v1
But need to consider regulation
and market discipline
• Banks have to deduct first loss from
regulatory capital
• Under Basel II this structure would lead to
quite a high capital charge – so capital
would be retained against securitisation as
well as new loans
• Economic capital will depend on market
discipline - rating agencies, counterparties
22 October 2004 9
iM147813v1
Event study
• 77 securitisation issues from 27 European
banks
• look at abnormal returns from day -20 to
+20 around the announcement
• average cumulative abnormal return is
very small and statistically insignificant
• repeated securitisations increase the bank’s
beta slightly
22 October 2004 10
iM147813v1
Hypothesis
• Bank systematic risk is increased by
retention of equity /first loss piece
• So securitisation and extension of more
loans should increase a bank’s beta
• Not clear why this is the case – higher
tranches are taking the extreme risk.
• Bank may well be reducing exposure to
systematic risk
22 October 2004 11
iM147813v1
Small securitisations relative to
capital may have little effect on
market perceptions
• How a large securitisation will be received
depends on many factors
• Review of loan book by outsiders to value
tranches may be seen as positive
• Also depends on what is happening to
perceived risk relative to economic capital
22 October 2004 12
iM147813v1