CDOs (Collateralized Debt Obligation) Definition
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CDOs allowed banks to repackage credit card debt into securities they sold to investors.&
Photo: Nick Wright/Getty Images
July 07, 2016.
Definition: CDOs, or Collateralized Debt Obligations, are financial tools that
use to repackage individual loans into a product sold to investors on the secondary market. These packages consist of auto loans, , mortgages or corporate debt. They are called collateralized because the promised repayments of the loans are the collateral that gives the CDOs value.CDOs are a particular kind of .
Like its name implies, a derivative is any financial product that derives its value from another underlying asset. Derivatives, such as , , and , have long been used in the stock and
markets.CDOs are called
if the package consists of corporate debt.
The are called
if the loans are mortgages. If the mortgages are made to those with a less than prime credit history, they are called .Banks sold CDOs to investors for three reasons:The funds they received gave them more cash to make new loans.It moved the loan's risk of default from the bank to the investors.CDOs gave banks new and more profitable products to sell. That boosted share prices and managers' bonuses.AdvantagesAt first, CDOs were a welcome financial innovation. They provided more
in the economy. By allowing banks and corporations to sell off their debt, CDOs freed up more
to invest or loan. The creation of CDOs is one reason why the U.S.
economy was robust until 2007.The invention of CDOs also helped create new jobs. Unlike a mortgage on a house, a CDO is not a product that you can touch or see to ascertain its value. Instead, the value of a CDO was based on a computer model. Thousands of college and higher-level graduates went to work in
banks as "quant jocks." Their job was to write computer programs that would model the value of the bundle of loans that made up a CDO.
Thousands of salespeople were also hired to find investors for these new products.As competition for new and improved CDOs grew, these quant jocks made more complicated computer models. They broke the loans down into "," which are simply bundles of loan components with similar interest rates.Here's how that works.
offered "teaser" low-interest rates for the first three to five years. Higher rates kicked in after that. Borrowers took the loans, knowing they could only afford to pay the low rates. They expected to sell the house before the higher rates were triggered.The quant jocks designed CDO tranches to take advantage of these different rates. One tranche held only the low-interest portion of mortgages. Another tranche offered just the part with the higher rates. That way, conservative investors could take the low-risk, low-interest tranche, while aggressive investors could take the higher-risk, higher-interest tranche. All went well as long as housing prices and the economy continued to grow.DisadvantagesUnfortunately, the extra liquidity created an
in housing, credit cards, and auto debt. Housing prices skyrocketed beyond their actual value. People bought homes simply to sell them. The easy availability of debt meant people used their credit cards too much. That drove .The banks that sold the CDOs didn't worry about people defaulting on their debt. The loans were owned by other investors. That made them less disciplined in adhering to strict lending standards. They made loans to borrowers who weren't credit-worthy. That ensured disaster.What made things even worse was that CDOs became too complicated. The buyers didn't know the value of what they were buying. They relied on their trust of the bank selling the CDO. They didn't do enough research to be sure the package was worth the price. The research wouldn't have done much good because even the banks didn't know. The computer models based the CDOs' value on the assumption that housing prices would continue to go up. If they fell, the computers couldn't price the product.How CDOs Caused the Financial CrisisThis opaqueness and the complexity of CDOs created a market panic in 2007. Banks realized they couldn't price the product or the assets they were still holding. Overnight, the market for CDOs disappeared. Banks refused to lend each other money because they didn't want more CDOs on their balance sheet in return. It was like a financial game of musical chairs when the music stopped. This panic caused the .The first CDOs to go south were the mortgage-backed . When housing prices started to drop in 2006, the mortgages of homes bought in 2005 were soon upside-down. That created the . But the
assured investors it was confined to housing. In fact, some welcomed it and said that housing had been in a bubble and needed to cool down.What they didn't realize was how derivatives multiplied the effect of any bubble -- and any subsequent downturn. Not only banks were left holding the bag, but also , , and corporations. It was until the Fed and the Treasury started buying these CDOs that a semblance of functioning returned to the .
CDOs (Collateralized Debt Obligations)Collateralized Debt Obligations: Structures and Analysis, 2nd Edition (Wiley Finance) (Frank J. Fabozzi)
12-22-2011
Since first edition's publication, the CDO market has seen tremendous growth. As of 2005, $1.1 trillion of CDOs were outstanding -- making them the fastest-growing investment vehicle of the last decade. To help you keep up with this expanding market and its various instruments, Douglas Lucas, Laurie Goodman, and Frank Fabozzi have collaborated to bring you this fully revised and up-to-date new edition of Collateralized Debt Obligations. Written in a clear and accessible style, this valuable resource provides critical information regarding the evolving nature of the CDO market. You'll find in-depth insights gleaned from years of investment and credit experience as well as the examination of a wide range of issues, including cash CDOs, loans and CLOs, structured finance CDOs and collateral review, emerging market and market value CDOs, and synthetic CDOs. Use this book as your guide and take advantage of this dynamic market and its products.
by Douglas J. Lucas, price $80
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Recent Info Bin:
Now Looking:Collateralized debt obligations: A double edged
sword of the U.S. ???nancial system
Obligaciones de deuda colateralizadas: Una espada de dos ???los
del sistema ???nanciero de Estados Unidos
Alakh Niranjan Singh
and AKM Rezaul Hossain
Recibido: 06/03/09,
Revisado: 09/03/09,
Aceptado: 20/03/09
C&digo JEL: G01, G02, K02
, XXXIV, 27 (enero-junio, 2009), pp. 37-56
Thunderbird School of Global Management, .
** Division of Bussiness, Mount Saint Mary College, Newburgh, New York, hossain@msmc.edu.
Tis paper points out a design faw in Collateralized Debt Obligation or CDO, one oF
the heavily traded ???nancial instruments by investment banks. Te paper suggests that
???nancial design oF CDO was not incentive compatible among the players involved in the
production, marketing and investing in this instrument. In a CDO, the underlying debt
holders (borrowers) have the incentive to deFault and mortgage service providers (lenders)
have the incentive to go For Foreclosure because the mortgage insurance providers end
up paying For the loss. Te biggest losers in this transaction are the mortgage protection
sellers like the AIG (American International Group) or the Lehman Brothers and CDO
equity holders.
: &inancial crisis, ???nancial instruments, investment banks.
Este trabajo se&ala una Falla de dise&o de las Obligaciones de Deuda Colateralizadas o
ODC, uno de los instrumentos ???nancieros m&s altamente comercializados por los bancos
de inversi&n. El trabajo sugiere que el dise&o ???nanciero del ODC no era compatible desde
el punto de vista de los incentivos entre los participantes en la producci&n, comercializaci&n
e inversi&n en este instrumento. En un ODC, los deudores tienen el incentivo de no pagar
la deuda y los acreedores tienen el incentivo para liquidar el contrato ya que los proveedores
del seguro sobre hipotecas terminan pagando la misma. Los grandes perdedores en este
tipo de transacciones son los protectores de las hipotecas (proveedores de seguros sobre
hipotecas) como AIG (American Internacional Group) o la ???rma Lehman Brothers y
???nalmente los tenedores de ODCs.
Palabras clave
: Crisis ???nancieras, instrumentos ???nancieros, bancos de inversi&n.
, XXXIV, 27 (enero-junio, 2009)
Alakh Niranjan Singh and AKM Rezaul Hossain
Introduction
Recent ???nancial markets meltdown triggered by mortgage market
collapse has brought about a seismic shift in the U.S. ???nancial
landscape. Some argue that creation and bursting of housing bubble
through subprime mortgages is the cause of this crisis (Whalen, 2008;
Mowat, 2008). Others argue that subprime market crisis just started the
process, but the true cause of this crisis lies in large scale deregulation
and lack of oversight of the ???nancial markets in recent years (Mah-
Hui Lim 2008). Tis paper adds to this discussion by pointing out
a design Faw in Collateralized Debt Obligation or CDO, one of the
heavily traded ???nancial instruments by investment banks. Tis paper
suggests that ???nancial design of CDO was not incentive compatible
among the players involved in the production, marketing and investing
in this instrument. Tis created a moral hazard for certain players in the
markets. Due to this design Faw, a trigger event like subprime mortgage
default or foreclosure made the system unstable and shifted almost all
risks associated with this derivative security upon one player in the
CDO markets. Tis instability quickly spread and became one of the
major causes for the breakdown of US ???nancial markets.
Tis paper presents this moral hazard and its consequences in
CDO markets in three sections. Section I provides a brief history and
growth of CDO. Section II discusses basic principles and structures
in CDO market. Section III analyses divergent incentives among the
players involved in the market and points out the inherent moral hazard.
Section IV concludes the paper.
Section I: Brief history and growth of CDO market
Securitization developed in the 1980s is one of the ways to transfer credit
Te ???rst CDO
issued in 1987 by Drexel Burnham Lambert Inc.
is an application of securitization. A typical CDO issues debt and equity
and uses the money it raises to invest in a portfolio of ???xed-income
assets, such as corporate debt obligations or structured debt obligations.
, XXXIV, 27 (enero-junio, 2009)
Collateralized debt obligations.
.., pp. 37-56
It distributes the cash fows From its asset portFolio to the holders oF its
various liabilities according to the relative seniority oF those liabilities. A
decade later with the development oF credit derivatives market,
emerged as the Fastest growing segment oF the asset-backed synthetic
securities market o???ering returns higher than comparable corporate
bonds with the same credit rating. A growing number oF asset managers
and investors are major participants in the CDO market including
commercial banks
investment banks
pension Fund managers
companies and
mutual Fund companies.
In 2000, David Li utilized a copula Function approach to
estimate deFault correlation within a pool oF bonds. His computerized
???nancial model estimated the likelihood that a given set oF corporations
would deFault on their bond debt (Li, 2000). Tis provided a widely
accepted model For pricing CDOs and Facilitated dramatic growth
oF the credit-derivatives markets including CDOs. According to the
Securities Industry and &inancial Markets Association (SI&MA, 2008),
aggregate global CDO issuance totaled US$ 157 billion in 2004, US$
272 billion in 2005, US$ 552 billion in 2006 and US$ 503 billion
in 2007. According to Celent research and ???nancial consulting ???rm
(Celent, 2005) the CDO market has experienced an average annual
growth rate oF 150% since 1998. Celent had estimated that the overall
CDO market represented over US$1.5 trillion and by the end oF 2006
would grow close to US$2 trillion, 40% oF the size oF the $4.9 trillion
bond market.
Tese estimates clearly indicate that the CDO markets had
expanded rapidly during the last ???ve years until 2007. According to
Nathan Lewis the market size For Credit DeFault Swaps (CDS
to grow rapidly From 2003, and by December 2007 it was approximately
to a total notional amount oF about $45 trillion, ten times as large as it
had been Four years previously (Lewis, 2007). However, beginning 2008
CDO market share and value su???ered steady decline. A large part oF
this decline is attributable to loss oF value in CDS. In his latest data oF
March 2009, the Deutsche Bank managing director Athanassos Diplas
reports that including loss From deFault and termination oF contracts in
2008 the estimated market value oF CDS had reduced to $30 trillion.
, XXXIV, 27 (enero-junio, 2009)
Alakh Niranjan Singh and AKM Rezaul Hossain
Te year 2009 indicates similar decline because of transformation of the
CDS industry.
Section II: Basic principles, construction and structure of CDO
Collateralized Debt Obligation (CDO) refers to a broad set of ???nancial
instruments that may include several di???erent types of products. A
typical CDO security can be backed by a diversi???ed pool of one or
more of the following debt obligations including High-yield Corporate
bonds, Structured Financial Products (Mortgage backed & Asset
backed Securities), Emerging market Bonds, Bank Loans or Special
Situation Loans and Distress Debts. Investopedia de???nes CDO as an
investment-grade security backed by a pool of bonds, loans and other
assets (CDO, 2008). CDOs do not specialize in one type of debt but
are often non-mortgage loans or bonds. CDOs are unique in that they
represent di???erent types of debt and credit risk. In the case of CDOs,
these di???erent types of debt are often referred to as &tranches& or &slices&.
Each tranche or a bond class has a di???erent maturity and risk associated
with it. Te higher the risk, the more the CDO pays.
When the underlying pool of debt obligations are bond instruments
such as high yield corporate bonds,
structured ???nancial products, and
emerging market bonds, a CDO is referred to as Collateralized Bond
Obligation (CBO, 2009). A part of the underlying bonds within a
CBO can b the CBO can still be an investment
grade security. Because CBO pools bonds of di???erent credit quality
and their payo??? are negatively correlated by design, it o???ers enough
diversi???cation to be &investment grade. When the underlying pool
of debt obligations are bank loans as opposed to a bonds, a CDO is
referred to as Collateralized Loan Obligation (CLO). Another version
of a CDO is a Collateralized Mortgage Obligation (CMO) which is a
type of mortgage-backed security that creates separate pools of pass-
through securities for di???erent classes of bonds, called tranches, with
, XXXIV, 27 (enero-junio, 2009)
Collateralized debt obligations.
.., pp. 37-56
varying maturities, risk characteristics and coupon rates. Tranches make
CDOs more marketable because they are designed to suit the needs of
the investors.
CDOs vary in structure and underlying assets, but the basic
principle is the same. A CDO investor takes a position in an entity
that has de???ned risk and reward, not directly in the underlying assets.
&erefore, the investment is dependent on the quality of the metrics
and assumptions used for de???ning the risk and reward of the tranches.
Essentially the creator of a CDO is a corporate entity constructed to
hold assets as collateral and to sell packages of cash Fows to investors.
&e construction of a typical CDO can be described in three steps as
A special purpose vehicle (SPV) acquires a portfolio of ???xed income
assets. Some of the common assets include mortgage-backed securities,
commercial real estate debt, and high-yield corporate loans. Typically,
an investment bank often is the issuer of the CDO through SPV. &e
issuer earns a commission at the time of issue and earns management
fees during the life of the CDO.
&e SPV issues di???erent classes of bonds depending upon the need of
the prospective buyers and equity. &e proceeds are used to purchase the
portfolio of credits. &e bonds and equity are entitled to the cash Fows
from the portfolio of credits, in accordance with the Priority of Payments
set forth in the transaction documents. &e senior notes are paid from
the cash Fows before the junior notes and equity notes. In this way, losses
are ???rst borne by the equity notes, next by the junior notes, and ???nally
by the senior notes. Hence, the senior notes, junior notes, and equity
notes o???er distinctly di???erent combinations of risk and return, while
each reference the same portfolio of debt securities. Here is an example
, XXXIV, 27 (enero-junio, 2009)
Alakh Niranjan Singh and AKM Rezaul Hossain
how a very simple CDO works. Suppose the investors in a CDO are
divided up only into three bond classes (tranches) and equity. Tey are
called either class A, B or C investors in which class A is the senior most
class. Each class di???ers in the order it receives principal payments, but
receives interest payments as long as it is not completely paid o???. Class A
investors are paid out principle ???rst with prepayments and repayments
until they are paid o???. Ten class B investors are paid o???, followed by
class C investors and the remaining goes to equity holders. In a situation
like this, class A investors bear most of the prepayment risk, while class
C investors bear the least.
An investment in a CDO is therefore an investment in the cash Fows
of the assets rather than a direct investment in the underlying collateral.
However if there is default, the loss of an investor&s principal is applied
in reverse order of seniority.
Te senior tranche is protected by the
subordinated tranches an thus, it is the most highly
rated tranche (&ranche A in our example). Te equity tranche
vulnerable, and has to o???er higher rewards to compensate for the higher
risk. In our example the default risk is born the most by the equity
holder class, and then by class C investors followed by class B and class
A investors. It is possible that class B and class A investors may not have
to bear any default risk at all depending upon when the default took
place or by how much.
Structures of CDOs
Te CDO family consists of cash CDOs and synthetic CDOs. Tey
can be categorized in several ways. Te primary classi???cations are based
on: (a) source of funds, (b) motivation (c) proportion of funding and
(d) Hybrid.
, XXXIV, 27 (enero-junio, 2009)
Collateralized debt obligations.
.., pp. 37-56
Source of funds: Cash ???ow CDO and market value CDO
Cash fow CDOs pay interest and principal to tranche holders using the
cash fows produced by the CDO&s assets (CFA Institute, 2008). Te
cash CDO is backed by pool o& debt instruments which are purchased
using proceeds &rom equity and sale o& tranches. Cash CDOs involve
a port&olio o& cash assets, such as loans, corporate bonds, asset-backed
securities or mortgage-backed securities. Ownership o& the assets is
trans&erred to the SPV issuing the CDO&s tranches. Te risk o& loss
on the assets is divided among tranches in reverse order o& seniority.
Cash fow CDOs &ocus primarily on managing the credit quality o& the
underlying port&olio. Te motivation behind the cash CDO is either
balance sheet driven or arbitrage driven.
Market value CDOs attempt to enhance investor returns through
&requent trading and pro???table sale o& collateral assets. Te CDO
asset manager seeks to realize capital gains on the assets in the CDO&s
port&olio. Tere is greater &ocus on the changes in market value o& the
CDO&s assets. Market value CDOs are longer-established, but less
common than cash fow CDOs.
Motivation: Arbitrage and balance sheet
Arbitrage transactions (cash fow and market value) attempt to capture
&or equity investors the spread between the relatively high yielding assets
and the lower yielding liabilities represented by the rated bonds. In other
words, the motivation o& the sponsor is to capture a spread between the
return that is possible to realize on the collateral backing the CDO and
the cost o& borrowing &unds to purchase the collateral. Tis cost would
be the interest rate paid on the obligations issued. Te return is the yield
o???ered on the debt obligations in the underlying pool and the payments
made to the various tranches in the structure. Tese are the largest parts
o& cash CDO sector.
Balance sheet transactions, by contrast, are primarily motivated
by the issuing institutions& desire to remove loans and other assets &rom
their balance sheets, to reduce their regulatory capital requirements
, XXXIV, 27 (enero-junio, 2009)
Alakh Niranjan Singh and AKM Rezaul Hossain
and improve their return on risk capital. Sponsors of balance sheet
transactions are typically ???nancial institutions such as banks seeking to
reduce their capital requirements by removing loans due to their higher
risk based capital requirements.
Proportion of funding: Cash CDO and synthetic CDO
Synthetic CDOs, also known as collateralized synthetic obligations
(CSOs), do not own cash assets like bonds or loans. In synthetic CDO
the investor has the economic exposure (risk and rewards) to a pool
of debt instruments but this exposure is realized via a credit derivative
instrument rather than the purchase of the cash market instrument
(CFA Institute 2008). Tus the CDO debt holders do not legally own
the underlying pool of asset on which they have risk exposure and that
is why they are called synthetic. Te underlying asset can be a bond
market index such as high-yield bond index or a mortgage index or
even a portfolio of corporate loans owned by a bank. Te reference asset
serves as the basis for a contingent payment and is realized through
a credit derivative instrument called Credit Default Swap (CDS). As
the name suggests this credit derivative instrument, is used to protect
against credit risk or default.
Te credit default swap is conceptually similar to an insurance
policy though many people argue it is not insurance. Whatever may be
the debate, the mechanism works like this. Tere is a &Protection Buyer&
who purchases protection against credit risk on the reference asset. In
a synthetic CDO, the insurance (protection against default) buyer
is the asset manager who pays a periodic fee and receives, in return,
payment from the protection seller in the event of default a???ecting any
asset included in the reference asset. Te protection seller is the SPV on
behalf of junior note or equity holders (CFA Institute, 2008).
A part of the US mortgage ???nance can be thought of an example
of this mechanism. In a typical mortgage loan, a prospective homeowner
borrows money from a bank to purchase a house. Te house serves as
collateral for the mortgage. Te lender requires borrowers to purchase
, XXXIV, 27 (enero-junio, 2009)
Collateralized debt obligations.
.., pp. 37-56
homeowners& insurance to protect the lender from losses associated with
???re, Food or other accidents. In addition to protection against natural
disasters whenever a loan amount exceeds more than 80% of the home
value, the lender also requires borrowers to purchase private mortgage
insurance (PMI) against losses associated with default that may occur
when a borrower becomes unable to make mortgage payments due to
unemployment, divorce or death. In case of default, the lender possesses
the right to foreclose on the property and sell the house to recoup
investment. At the time of sale, if the value of the house is less than
the outstanding balance on the mortgage, the seller of PMI pays the
di???erence to the bank.
Tis PMI is comparable to a credit default swap whose seller is the
SPV that was created to sell this PMI and the buyer of that credit default
swap is the bank who passes on the cost of PMI to the home borrower in
terms of higher mortgages. In this case, the SPV does not own the loan
(which is owned by the bank), but is exposed to the credit risk of that
loan. &or that exposure, the SPV is receiving the monthly payment from
the bank equal to the amount of PMI. Te bank bene???ts by reduced
risk on that loan and can remove that loan from its balance sheet and
thus reducing its regulatory capital requirement against that loan. &rom
where does the SPV get money to meet that loss amount from default?
&or that it issues CDO tranches to investors.
Similar to cash CDO, the risk of losses on the CDO&s portfolio is
divided into tranches. Losses will ???rst a???ect the equity tranche, next the
mezzanine tranches, and ???nally the senior tranche. Each tranche receives
a periodic payment (the swap premium), with the junior tranches
receiving higher premiums. A synthetic CDO tranche may be either
funded or unfunded. Under the swap agreements, the CDO would have
to pay up to a certain amount of money in the event of a credit event
on the reference obligations in the CDO&s reference portfolio. Some of
this credit exposure is funded at the time of investment by the investors
in funded tranches. ²ypically, the junior tranches that face the greatest
risk of experiencing a loss have to fund at closing. Until a credit event
occurs, the proceeds provided by the funded tranches are often invested
, XXXIV, 27 (enero-junio, 2009)
Alakh Niranjan Singh and AKM Rezaul Hossain
in high-quality, liquid assets or placed in a Guaranteed Investment
Contract (GIC) account that o???ers a return that is a few basis points
London Interbank Offered Rate
Te return from these investments plus the premium from the
swap counter party provide the cash Fow stream to pay interest to the
funded tranches. Te Buyer purchases a credit default swap at time
and makes regular premium payments at times
the associated credit instrument su???ers no credit event, then the buyer
continues paying premiums at
and so on until the end of the
contract at time
. However, if the associated credit instrument su???ered
a credit event at
, then the protection seller pays the buyer for the loss,
and the buyer would cease paying premiums.
Let us consider another example where an investor buys a CDS
from ABC Bank where the reference entity is XYZ Corp. Te investor
will make regular payments to ABC Bank, and if XYZ Corp defaults on
its debt (i.e., misses a coupon payment or does not repay it), the investor
will receive a one-o??? payment from ABC Bank and the CDS contract
is terminated. If the investor actually owns XYZ Corp debt, the CDS
can be thought of as hedging. But investors can also buy CDS contracts
referencing XYZ Corp debt, without actually owning any XYZ Corp
debt. Tis may be done for speculative purposes, to bet against the
solvency of XYZ Corp in a gamble to make money if it fails, or to
hedge investments in other companies whose fortunes are expected to
be similar to those of XYZ.
If the reference entity (XYZ Corp) defaults, one of two forms of
settlement can take place &physical settlement and cash settlement. In a
physical settlement, the investor delivers a defaulted asset to ABC Bank
for a payment of the par value. In case of a cash settlement, the ABC
Bank pays the investor the di???erence between the par value and the
market price of a speci???ed debt obligation (even if XYZ Corp defaults,
there is usually some
, not all your money would be lost.)
When a credit event occurs and a payout to the swap counter
party is required, the required payment is made from the GIC or reserve
account that holds the liquid investments. In contrast, senior tranches
, XXXIV, 27 (enero-junio, 2009)
Collateralized debt obligations.
.., pp. 37-56
are usually unfunded since the risk of loss is much lower. Unlike cash
CDO, investors in a senior tranche receive periodic payments but do
not place any capital in the CDO when entering into the investment.
Instead, the investors retain continuing funding exposure and may have
to make a payment to the CDO in the event the portfolio&s losses reach
the senior tranche. Funded synthetic issuance exceeded $80 billion in
2006. From an issuance perspective, synthetic CDOs take less time to
create. Cash assets do not have to be purchased and managed, and the
CDO&s tranches can be precisely structured.
Te new issue pipeline for CDOs backed by asset-backed and
mortgage-backed securities slowed signi???cantly in the second-half
of 2007 and the ???rst quarter of 2008 due to weakness in subprime
collateral, the resulting re-evaluation by the market of pricing of CDOs
backed by mortgage bonds, and a general downturn in the global
credit markets. According to Security Industry and Financial Markets
Association (SIFMA, 2008), global CDO issuance in the fourth quarter
of 2007 was US$ 47.5 billion, a nearly 74 percent decline from the US$
180 billion issued in the fourth quarter of 2006. First quarter 2008
issuance of US$ 11.7 billion was nearly 94 percent lower than the US$
186 billion issued in the ???rst quarter of 2007. Moreover, virtually all
???rst quarter 2008 CDO issuance was in the form of collateralized loan
obligations backed by middle-market or leveraged bank loans, not by
home mortgage ABS (Aubin, 2008).
Hybrid CDOs
Hybrid CDOs are intermediate instruments between cash CDOs and
synthetic CDOs. Te portfolio of a hybrid CDO includes both cash
assets as well as swaps that give the CDO credit exposure to additional
assets. A portion of the proceeds from the funded tranches is invested
in cash assets and the remainder is held in reserve to cover payments
that may be required under the credit default swaps. Te CDO receives
payments from three sources: the return from the cash assets, the GIC
or reserve account investments, and the CDS premiums.
, XXXIV, 27 (enero-junio, 2009)
Alakh Niranjan Singh and AKM Rezaul Hossain
Section III: Divergent incentives among players in the CDO
market and inherent moral hazard
Investors& incentive
Investors have di???erent motivations for purchasing CDO securities
depending on which tranche they select. At the more senior levels
of debt, investors are able to obtain better yields than those that are
available on more traditional securities of a similar rating. In some cases,
investors utilize leverage and hope to pro???t from the excess of the spread
o???ered by the senior tranche and their cost of borrowing. Tis is because
senior tranches pay a spread above LIBOR despite their AAA-ratings.
Investors also bene???t from the diversi???cation of the CDO portfolio,
the expertise of the asset manager, and the credit support built into the
transaction. Investors include banks and insurance companies as well as
investment funds.
leveraged,
non-recourse
investment in the underlying diversi???ed collateral portfolio. Mezzanine
notes and equity notes o???er yields that are not available in most other
???xed income securities. Investors include hedge funds, banks, and
wealthy individuals.
Underwriters& incentive
Te underwriter, typically an investment bank, acts to structure and
arrange the CDO. Working with the asset management ???rm that selects
the CDO&s portfolio, the underwriter structures debt and equity tranches.
Tis includes selecting the debt-to-equity ratio, sizing each tranche,
establishing coverage and collateral quality tests, and working with the
credit rating agencies to gain the desired ratings for each debt tranche.
Te key economic consideration for an underwriter that is
considering bringing a new deal to market is whether the transaction can
o???er a su???cient return to the equity note holders. Such a determination
requires estimating the after-default net of management fees return
o???ered by the portfolio of debt securities and comparing it to the cost of
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.., pp. 37-56
funding the CDO&s rated notes. Te excess spread must be large enough
to o???er the potential of attractive returns to the equity holders.
Te underwriters place the tranches with investors. Te priority
in placement is ???nding investors for the risky equity tranche and junior
debt tranches of the CDO. It is common for the asset manager to retain
a piece of the equity tranche. In addition, the underwriters are generally
expected to provide some type of secondary market liquidity for the
CDO, especially its more senior tranches.
According to Tomson Financial (Tomson Financial, 2009),
the top underwriters before September 2008 were Bear Stearns, Merrill
Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America
Securities. CDOs are more pro???table for underwriters than conventional
bond underwriting due to the complexity involved. Te underwriter is
paid a fee when the CDO is issued.
Asset managers& incentive
Te asset manager plays a key role in each CDO transaction, even
after the CDO is issued. An experienced manager is critical in both the
construction and maintenance of the CDO&s portfolio. Te manager
can maintain the credit quality of a CDO&s portfolio through trades as
well as maximize recovery rates when defaults on the underlying assets
Te asset manager&s role begins before the CDO is issued. Months
before a CDO is issued, a bank will usually provide ???nancing to enable
the manager to purchase some of the collateral assets that may be used
in the forthcoming CDO in a process called warehousing. Even by
the issuance date, the asset manager often will not have completed the
construction of the CDO&s portfolio. A &ramp-up& period following
issuance during which the remaining assets are purchased can extend
for several months after the CDO is issued. For this reason, some senior
CDO notes are structured as delayed drawdown notes, allowing the
asset manager to drawdown cash from investors as collateral purchases
are made. A transaction is fully ramped when its initial portfolio of
credits has been selected by the asset manager.
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Alakh Niranjan Singh and AKM Rezaul Hossain
However, the asset manager&s role continues even after the ramp-up
period ends, albeit in a less active role. During the CDO&s &reinvestment
period&, which usually extends several years past the issuance date of the
CDO, the asset manager is authorized to reinvest principal proceeds
by purchasing additional debt securities. Within the con???nes of the
trading restrictions speci???ed in the CDO&s transaction documents, the
asset manager can also make trades to maintain the credit quality of the
CDO&s portfolio. Te manager also has a role in the redemption of a
CDO&s notes by auction call.
Te manager&s prominent role throughout the life of a CDO
underscores the importance of the manager and his or her sta???. Asset
Managers make money by virtue of the senior fee (which is paid before
any of the CDO investors are paid) and subordinated fee as well as
any equity investment the manager has in the CDO, making CDOs a
lucrative business for asset managers.
Incentive structure in synthetic CDOs
Te synthetic CDO can be of two kinds: synthetic balance sheet CDO
and synthetic arbitrage CDO. In the synthetic balance sheet CDO
a credit default swap is embedded within a CDO structure. A bank
can shed the credit risk of a portfolio of bank loans without having to
notify any borrowers that they are selling the loans to another party,
a requirement in some countries (CFA Institute, 2008). No consent
is needed from borrowers to transfer the credit risk of the loans, as is
e???ectively done in credit default swaps. Tis is the reason the synthetic
balance sheet CDOs were initially set up to accommodate European
bank balance sheet deals.
Creating CDOs from other CDOs creates enormous problems
for accounting. Tis is because CDO allows large ???nancial institutions
to move debt o??? their books by pooling their debt with other ???nancial
institutions and then bringing these debts back on to their books calling
it a Synthetic CDO asset. Tis has the potential for ???nancial institutions
to hide their losses and in&ate their earnings.
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Collateralized debt obligations.
.., pp. 37-56
Te synthetic arbitrage CDO has several economic advantages
over cash CDO. First it is not necessary to obtain funding for the senior
section, thus making it easier to do a CDO transaction. Second the
ramp up period is shorter than for a cash CDO structure since only the
high quality assets need to be assembled, not all of the assets contained
in the reference asset. Finally there are opportunities in the market to
be able to e???ectively acquire the assets included in the reference asset
via a credit default swap at a cheaper cost than buying the asset directly.
Because of these reasons the issuance of synthetic CDOs has increased
dramatically and faster than Cash CDO since 2001.
Incentive incompatibility and moral hazard in CDO market
Any insurance or similar kind of protection brings forth the problem of
moral hazard for di???erent stake holders i.e. the insured people behave
di???erently than non-insured people. Let&s take the example of US prime
mortgage crisis and how credit default swaps helped explode that crisis.
Te parties involved in such synthetic CDO were:
. the ???nal borrowers
who took loans from ???nancial institutions and purchased the houses,
. the lenders
the banks or ???nancial institutions who ensured that
borrowers meet the underwriting standards of Fannie Mae, Ginni Mae or
Freddie Mac so that they could sell these loans to those institutions, and
. the protection sellers. If the borrowers purchased protection
from protection sellers, the credit rating of borrower was enhanced for
that loan and the borrower became eligible for 100% loan of property
value at concessional interest rates. Tis 100% loan amount also included
the closing costs (around 3%) on purchase of residential houses apart
from the actual cost of houses that went to the seller. Tus the loan
amount was already 3% more than the market value of the house.
Te borrower ended up borrowing without any down payment
up to the limit set by underwriters in the hope that he/she would own
the house with no money in pocket and live comfortably by paying the
mortgage which was almost equal to rent if tax bene???ts were taken into
account. Te appreciation of the house would be the additional bonus for
the borrower. Tus the borrower had the moral hazard of borrowing up
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Alakh Niranjan Singh and AKM Rezaul Hossain
to the maximum available even though it was not possible to serve that
loan in the long run. Te lender did not care much for the risk of default
by the borrower because the borrower had agreed to purchase private
mortgage insurance (PMI, the credit default swap) which guaranteed
the lender to compensate for the loss in case of default by the borrower
and lender going for foreclosure. In fact it was the lender who managed
from whom to buy PMI. Te protection seller did not care much for the
default issue because it was housing loan and hoped that there would
not be many foreclosures because Americans would like to save their
homes from foreclosures. Also even if the foreclosures happened, there
will not be any big losses because at least the value of the property would
go up with the passage of time and could be easily sold. Te house prices
kept on rising because of easy loans, second mortgages and the provision
of 100% loans covering closing costs or in extreme cases even more
than 100% loans, all of which made new borrowers and homeowners
overnight. Tese borrowers did not even need to have any savings from
before. All they needed was a fair credit score, a job to show two pay
stubs or a Master degree. Often the price of the house was decided by
the available loan amount as the negotiations could change prices by as
much as 20% of the initially o???ered home sale price.
Tus everybody had the vested interest of taking excessive risks
which helped CDOs to bubble out. Te borrowers got the house
practically at no cost because the mortgage was equivalent to rent, the
lenders issued the secured loans, and the credit default sellers got regular
premiums with little perceived risk. Te bubble burst when the credit
crisis initiated and the system of 100% or more than 100% of home
value loans were stopped. Te re???nancing became more di???cult. Te
prices of houses began to fall because there were no new 100% loans to
purchase the new houses. Tis gave incentive to the borrowers to default
and go for foreclosures so that they could live in their houses without
paying any rent for a year or so. In USA it takes on an average more than
a year for a lender to get legal title to evict a borrower. Te lenders had/
have the moral hazard of going for foreclosure because they had/have
forced the borrower to buy protection for them and the protection seller
was/is obligated to compensate for the loss. Soon the assets of protection
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Collateralized debt obligations.
.., pp. 37-56
sellers began to vanish quickly. For example AIG (a protection seller)
alone lost $61.7 billion during just last three months of the year 2008
(BBC News, March2, 2009). Lehman Brothers got bankrupt.
Above discussion suggests that borrowers with falling home
prices had/have the incentive (moral hazard) to default because the
protection sellers would pay for the loss of foreclosures to the lenders
hence save the borrowers from prosecution by lenders. Te lenders had/
have the incentive to go for foreclosures because any loss on account
of foreclosures would be compensated by the protection sellers. Moral
hazard occurs because the essential feature of all credit default swaps
(CDO) is that they transfer wealth from one ???nancial institution to
another in a zero sum game. Te loss of protection sellers is the gain to
protection buyers and vice versa. Te only losers from moral hazard in
this mortgage crisis after it started are the protection sellers like the AIG
(American International Group) or the Lehman Brothers. Earlier they
were enjoying the free lunch in terms of PMI paid by the borrowers.
Since the protection sellers are the only su???erers of moral hazard in the
current game which got triggered by foreclosures, they need to ???nd the
solution which would change the incentives of the game so that they
do not remain the only losers and the problem of moral hazard of other
parties is removed. In our view, the solution is to prevent foreclosures by
providing emergency credit to defaulting home owners.
Since the cause of the current ???nancial crisis in USA started with
restricted credit to potential home buyers and existing home owners, it
eventually resulted in falling home prices and foreclosures. Tis spiral
caused and further got fuelled by recession resulting in further restrictions
on credit. Te issue of spiraling credit crisis gave birth to moral hazard
to those home owners and ???nancial institutions which were likely to
bene???t from this crisis. Initially with reduced availability of ???nance,
the borrowers did not have the ability to meet their debt obligations by
re???nancing new loans at lower rates than initial ones when the credit
standard tightened because of few defaults. Tis tightening of credit
adversely a???ected other borrowers& ability also to keep servicing their
mortgages. Once borrowers defaulted, their credit score went down which
further reduced their available credit forcing them to default further on
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Alakh Niranjan Singh and AKM Rezaul Hossain
their mortgages. Along with this, the lenders had the incentive to go for
foreclosures at the slightest evidence of default rather than renegotiate
with the defaulters because credit default swaps which the lenders had
made borrowers to purchase for them before sanctioning loans, enabled
the lenders to get compensated for their losses by the protection sellers.
Conclusion
We therefore conclude that if the protection sellers somehow stop default
of mortgage at the ???rst instance, the problem would not start or be
solved in time if already started. Tis is possible if the protection sellers
closely monitor defaulting borrowers and start giving them emergency
loans at the same or even higher interest rates if they fall behind in their
mortgage payments. Te dollar amount of these loans would be anyway
less than the dollar amount of loss that happens to the protection sellers
on foreclosures because foreclosed homes would be sold at whatever
price would be available in a falling housing market and the di???erential
loss would be recovered by the lenders from the protection sellers. Once
the borrowers& ???nancial situations improve, the protection sellers would
start recovering the loans. Also these loans would be recoverable assets
for the protection sellers while payment for default swaps would be the
non-recoverable losses. Hence the value of stocks of these protection
sellers may not go down if emergency loans are provided to defaulting
home owners and thus ???nancial crisis get averted. Te borrowers too
would love this availability of loans during the period of ???
because it would save their credit history and the potential ???nancial
distress occurring from bad credit scores because of mortgage defaults.
Since loans have positive present values borrowers initially want to save
their credit history. But once their credit history gets spoiled and they
are no longer able to take new loans or re???nance existing loans at lower
interest rates, they get the moral hazard of bene???tting by not paying
existing loans. On account of these reasons we believe this solution would
save the entire USA from ???nancial crisis as it will not let mortgage crisis
to start or to expand to other sectors if it somehow started. Tis would
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Collateralized debt obligations.
.., pp. 37-56
also prevent home prices from falling because of excessive foreclosures
and help alleviate the recessionary pressure. Ultimately the credit crisis
would stabilize, the housing prices would stabilize and the moral hazard
issue too would be solved. Te moral hazard is currently high because it
is happening on a large scale.
Credit risk is the risk that a debt instrument will decline in value as a
result of borrower&s inability (real or perceived) to satisfy the contractual
terms of its borrowing arrangement. In the case of corporate debt
obligations, credit risk may include default risk, credit spread, and rating
downgrade.
For more details see CDO (2008).
Credit derivatives are intended to make bond markets more liquid and
e???cient by allowing risk to be transferred to those most willing to bear
Synthetic CDO uses CDS as a reference asset. For basic structure and
operation of CDS see CFA Institute (2008) and CDS (2009).
Also know as junk bond. A typical junk bond is a low credit quality
security with rating below BB.
Losses applied to from the highest credit risk tranches to the lowest.
Also known as the ???rst-loss tranche or toxic waste!
London Interbank O???ered Rate LIBOR is an interest rate at which banks
can borrow funds from other banks in the London interbank market.
Te LIBOR is ???xed on a daily basis by the British Bankers& Association.
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Alakh Niranjan Singh and AKM Rezaul Hossain
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