Coval Flashcards
(10 cards)
Collateralized Debt Obligation (CDO) + Tranches
- Firm transfer the assets that it wants to remove from its balance sheet to a special purpose vehicle (SPV) (e.g. mortgage)
- SPV then issues securities to investors, backed by the cash flows of the assets
ABS often consists of several tranches
* ABS can be manufactured in a way that each tranche achieves a specific credit rating
* Can achieve a AAA rating even if the entire asset pool consists of lower rated assets
* Rating may be inappropriate if the underlying assets are highly correlated
* Junior tranch (higher return) absorbs losses first, usually rated lower than senior tranch
Mezzanine Tranch / CDO^2
What is it?
- Middle tranch is referred as mezzanine tranch - often hard to sell
- Mezzanine tranches from several different CDO can be packaged together to form a CDO^2
- The senior tranch of this CDO^2 usually gets a AAA rating - ONLY appropriate if the different transches are independent
Expected Payoff vs. Correlation
Junior, Mezzanine, Senior
Mezzanine - expected payoff will decrease if correlation increases
* More likely to have 2+ bonds to default
Junior - expected payoff increases if correlation increases
* Example - p(default) = 0.1 (on 1 bond)
* Junior tranche defaulting = 1 - 0.9 * 0.9 = 0.19 (independent)
* If bonds are 100% correllated, p(default) is now 0.1
Senior - expected payoff reduces slightly
Expected Payoff vs. Default Probability
Junior, Mezzanine, Senior
- All 3 decrease
- Junior decreases faster, than mezzanine, than senior
- Senior tranche never hits 0 - assuming there is a bond recovery rate paid (when default) to the senior tranche
CDO^2
* All 3 decrease to 0
* Junior decreases faster, than mezzanine, than senior
Systematic Risk vs Non-Systematic Risk
Non-systematic risk can be diversified away
Systematic risk cannot be diversified away
Senior tranches are affected only if all bonds default - so they definitely prefer non-systematic risk (can diversify away), but are prone to systematic risk
If an investment has more systematic risk, then investors would need a higher expected return
Rating Process
Single-Name Business vs. Structured Finance Securities
Single name business - no need to account for correlation as these securities are assessed independently
Structured finance securities (ABS, CDOs) - need to address level of correlation
* rating of the securities is highly sensitive to the estimates of the correlation coefficient
Issues of the Rating Process
- Rating agencies may not have understood the impact of errors in the correlation assumptions on the default probabiltiies
- Many agencies incorrectly assumed that housing prices would always appreciate
- Conflict of interest existed - the issuer was paying the credit agency for the credit rating
- Investors didn’t independently assess the level the risk and relied too much on the rating
Why has the quality of subprime borrows deteriorated?
In the last decade, increase in subprime mortgages
- Ratio of mortgage values to home price has increased (borrowers putting less down)
- Increased mortgage issuances with low / no documentation
- Increased use of second lien loans
Why are CMOs Biased Against the Investor
- Higher probability of default due to lower credit quality of borrowers
- Lower recovery values b/c when the assets needed tobe sold, they often sold under financial pressure
- High level of default correlation due to pooling mortgages from a similar location
- In the CDO^2 structure, the impact of errors in the estimates is magnified
Probability of 2 Dependent Events Happening: P(A ∩ B)
Probability of Only 1 Event Happening
P(A ∩ B) = P(A)P(B) + ρ * sqrt[ P(A)P(A’) * P(B)P(B’) ]
Only 1 event happening = P(A) + P(B) - P(A ∩ B)
p = 0 for independent | P(A’) = 1 - P(A)
