Flashcards in Coval Deck (34)

Loading flashcards...

1

##
Structured finance security

(Coval)

### pooling of economic assets (e.g. loans, bonds, and mortgages) and issuance of a prioritized capital structure of claims, or tranches, against these pools

2

##
Collateralized debt obligation (CDO)

(Coval)

### prototypical structured finance security that uses tranches to prioritize payments with the most junior tranches absorbing losses first, working up to the most senior tranches

3

##
CDOs and credit-ratings of senior tranches

(Coval)

### differing tranche priorities enables CDOs to convert underlying assets with high credit risk into highly-rated investment vehicles (credit rating of senior tranches is > average credit rating of underlying assets)

4

##
Goal of structured finance

(Coval)

### create as many senior tranches as possible with higher credit ratings than the average rating of securities in the pool

5

##
Problem with structured finance/CDO securities

(Coval)

### high ratings are extremely sensitive to assumptions regarding underlying assets such as default probabilities, correlations, and recovery rates

6

##
Correlation and relative safety of the most senior tranches

(Coval)

### lower correlation means relatively "safer" senior tranches

7

##
Overcollateralization of CDOs

(Coval)

###
degree of protection offered by the more junior tranches

more protection > higher rating of senior tranche

8

##
Notional value of CDO

(Coval)

### total potential bond payout (payments are made if bonds do not default)

9

##
Default for junior and senior tranches

(Coval)

###
junior tranches default if at least 1 bond defaults

senior tranches only default if all bonds default

10

##
Probability that one, both, and neither bond default in a 2-bond CDO structure

(Coval)

###
P(NN) = no bond defaults

= (1 - prob. default)^2 + rho * prob. default * (1 - prob. default)

P(DD) = both bonds default

= prob. default^2 + rho * prob. default * (1 - prob. default)

P(ND) = prob. 1 bond defaults

= 1 - P(NN) - P(DD)

rho = default correlation

11

##
Probability of default with > 2-bond CDO structure

(Coval)

###
uses a binomial distribution

p(k) = (n choose k) * prob default ^ k * (1 - prob. default)^(n - k)

12

##
Senior and junior tranche payouts of CDOs

(Coval)

###
senior tranche payout = min(size of senior tranche, total payout)

junior tranche payout = min(size of junior tranche, total payout - senior payout)

13

##
Expected payout for each tranche

(Coval)

### expected payout = probability weighted average of the tranche payouts

14

##
Relationships b/w expected payout of each tranche (2)

(Coval)

###
1. generally E[payout(Jr)] < E[payout(Sr)] due to increased riskiness

2. with perfect correlation (rho = 1), E[payout(Jr)] = E[payout(Sr)]

15

##
Relationships b/w correlation and default probabilities (3)

(Coval)

###
1. when bonds are uncorrelated (rho = 0), default prob. of senior tranche is much < default prob. of junior tranche

2. when bonds are perfectly correlated (rho = 1), prob. default for either tranche = prob. default for the individual bonds (senior tranche does not benefit from CDO)

3. As correlation decreases, pr(default - senior) decreases and pr(default - junior) increases

16

##
Relationship between default probability and expected bond payout

(Coval)

### as default probability increases, expected payoff decreases (junior tranche is the most sensitive)

17

##
Relationship between default correlation and riskiness of senior tranche

(Coval)

### as default correlation increases, more risk is shifted to the senior tranche

18

##
Price of a tranche in a CDO

(Coval)

### price = PV(expected tranche payout)

19

##
Relationship between price, yield, and correlation of junior and senior tranches in a CDO

(Coval)

###
generally price(Jr tranche) < price(Sr tranche) and the junior tranche will have higher yield due to increased riskiness

w/perfect correlation, price(Jr tranche) = price(Sr tranche)

20

##
Ways to ensure as many tranches as possible have credit ratings > average credit rating of the underlying assets (2)

(Coval)

###
1. increase the # of assets in the pool

2. apply the CDO structure more than once

21

##
CDO^2

(Coval)

### CDO structure consisting of 2 or more junior tranches (ex: junior tranche from the original CDO + a junior tranche of a separate CDO)

22

##
Credit ratings are typically based on (2)

(Coval)

###
1. likelihood of default

or

2. severity of a loss, given default

>> measure of expected payoff

23

##
Issues with determining credit ratings of structured finance securities/CDOs (2)

(Coval)

###
1. underlying pool may have many correlated assets

2. CDOs magnify the impacts of imprecise default estimates (and CDO^2s even more so)

24

##
Sub-prime mortgages and relationship to structured finance securities

(Coval)

###
mortgages that did not meet size & credit quality requirements to be packaged into mortgage-backed securities and resold on the capital markets with a government guarantee

sub-prime mortgages were repackaged into non-backed collateralized mortgage obligations (CMOs) that were similar to CDO^2s

25

##
Impacts of increased default rates on mortgage-backed securities during the sub-prime crisis (4)

(Coval)

###
there was:

1. higher than expected default correlation from overlapping geography & vintages of mortgages

2. higher than expected probability of default b/c of deteriorating credit quality of sub-prime borrowers

3. lower than expected asset recovery values b/c of low housing prices

4. prevalence of CMOs (= CDO^2s) magnified the impacts of the preceding assumptions differing from expectations

26

##
Systematic risk in the context of CDOs (and high and no systematic risk)

(Coval)

###
whether a security is more likely to default when there is a recession or stock market decline

high systematic risk when default likelihood is high when the economy is poor

no systematic risk when default likelihood is independent of economic state

27

##
Credit ratings and systematic risk

(Coval)

### credit ratings do not consider systematic risk

28

##
Implication of credit ratings ignorance of systematic risk

(Coval)

### possible for 2 securities with the same credit rating to have drastically different exposure to systematic risk

29

##
Relationship b/w degree of systematic risk and yield spread (2)

(Coval)

###
1. if there is no systematic risk, yield spread is consistent with expected losses

2. if there is high systematic risk, a significant yield spread is required to compensate for additional systematic risk

30