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					Financial Risk Management of
    Insurance Enterprises
   Collateralized Debt Obligations
               (CDOs)
                  Overview
•   Introduction
•   History
•   Fundamentals
•   Attributes
•   Parties
•   Credit Ratings
•   Synthetic CDOs
•   Valuation models
•   Current events
           Introduction of CDOs
•   Asset-backed security
•   Structured credit product
•   Portfolio of fixed-income assets
•   Tranches
                       History
• First CDOs, 1987
    – High yield bond portfolios
• Next CDOs, 1989
    – Mortgage Backed Securities
    – John Meriwether, Salomon Brothers
       • Liar’s Poker
       • Long Term Capital Management
•   Credit Risk Transfer (CRT) vehicles
•   Loans
•   Securitization
•   CDOs Growth
•   Synthetic CDOs
Fundamental Concepts behind CDOs
• Corporate entity raises capital
• Invests in financial assets
• Distributes cash flows
      Four Key Attributes of CDOs
•   Assets
•   Liabilities
•   Purposes
•   Credit Structure
                    Assets
•   Corporate bonds
•   Residential Mortgage-Backed Securities
•   Commercial Mortgage-Backed Securities
•   Asset-backed Securities
                  Liabilities
•   Senior debt
•   Junior debt
•   Subordinated debt
•   Equity
                    Purposes
• Balance sheet
  – Shrink balance sheet
  – Reduce required regulatory capital
  – Lower funding costs
• Arbitrage
  – Asset manager increases fund size and fees
• Origination
  – Issuing securities to CDO as CDO issues liabilities
                    Structure
• Market value CDOs
  – Enhance returns through trading
  – Credit quality derives from the ability to liquidate
    assets and repay debt tranches
• Cash flow CDOs
  – Cash flows from assets pays the interest and
    principal of tranches
             Cash Flow CDOs
• Distribution of cash
  flows: waterfall

• Coverage test
  – Overcollateralization
  – Interest coverage
Structural Matrix
                     Parties
•   Asset managers
•   Asset sellers
•   Investment bankers and structurers
•   Monoline bond insurers and financial
    guarantors
               Credit Ratings
• Collateral diversification
• Likelihood of default
• Recovery rates
             Synthetic CDOs
• Does not own assets on which it bears the
  credit risk
• Sells protection via Credit Default Swaps
• Buys protection via tranches issued
             Valuation models
• Gaussian copula model
  – Default correlation
• Dynamic model
  – Hazard rates with deterministic drift with periodic
    impulses
             CDOs on CDOs
• CDOs based on a tranche from a CDO
• Example:
  – CDO^2 based on a tranche (e.g. BBB) of a CDO
  – CDO^n based on a tranche of a CDO^(n-1)
• It gets very complicated very quickly
                  Current events
•   Subprime mortgage crisis
•   Counterparty credit risk
•   Liquidity issues
•   Prices drops
    – ABX index
• Rating agencies are blamed for inaccurate
  credit ratings
     Concerns with CRT vehicles
• ‘Clean’ risk transfer
• Risk of failure of market participants to
  understand associated risk
• Potentially high concentration of risk
• Adverse selection

				
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posted:7/28/2012
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