Coval

Question 1

Structured finance security

Coval

Answer 1

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

Question 2

Collateralized debt obligation (CDO)

Coval

Answer 2

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

Question 3

Purpose of CDOs and credit-ratings of senior tranches

Coval

Answer 3

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)

Question 4

Goal of structured finance

Coval

Answer 4

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

Question 5

Problem with structured finance/CDO securities

Coval

Answer 5

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

Question 6

Correlation and relative safety of the most senior tranches

Coval

Answer 6

lower correlation means relatively “safer” senior tranches

Question 7

Overcollateralization of CDOs

Coval

Answer 7

degree of protection offered by the more junior tranches

more protection > higher rating of senior tranche

Question 8

Notional value of CDO

Coval

Answer 8

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

Question 9

Default for junior and senior tranches

Coval

Answer 9

junior tranches default if at least 1 bond defaults

senior tranches only default if all bonds default

Question 10

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

(Coval)

Answer 10

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

Question 11

Probability of default with > 2-bond CDO structure

Coval

Answer 11

uses a binomial distribution

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

Question 12

Senior and junior tranche payouts of CDOs

Coval

Answer 12

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

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

Question 13

Expected payout for each tranche

Coval

Answer 13

expected payout = probability weighted average of the tranche payouts

Question 14

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

Coval

Answer 14

1. generally E[payout(Jr)] < E[payout(Sr)] due to increased riskiness
2. with perfect correlation (rho = 1), E[payout(Jr)] = E[payout(Sr)]

Question 15

Relationships b/w correlation and default probabilities (3)

Coval

Answer 15

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

Question 16

Relationship between default probability and expected bond payout and tranche sensitivity

(Coval)

Answer 16

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

Question 17

Relationship between default correlation and riskiness of senior tranche

(Coval)

Answer 17

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

Question 18

Price of a tranche in a CDO

Coval

Answer 18

price = PV(expected tranche payout)

Question 19

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

(Coval)

Answer 19

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)

Question 20

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

(Coval)

Answer 20

1. increase the # of assets in the pool

2. apply the CDO structure more than once

Question 21

CDO^2

Coval

Answer 21

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

Question 22

Credit ratings are typically based on (2)

Coval

Answer 22

1. likelihood of default

or

2. severity of a loss, given default

> > measure of expected payoff

Question 23

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

(Coval)

Answer 23

1. underlying pool may have many correlated assets

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

Question 24

Sub-prime mortgages and relationship to structured finance securities

(Coval)

Answer 24

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

Question 25

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

Answer 25

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

Question 26

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

Answer 26

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

Question 27

Credit ratings and systematic risk | Coval

Answer 27

credit ratings do not consider systematic risk

Question 28

Implication of credit ratings ignorance of systematic risk | Coval

Answer 28

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

Question 29

Yield spread with and without systematic risk | Coval

Answer 29

without systematic risk: yield spread is consistent with expected losses with high systematic risk, a significant yield spread is required to compensate for additional systematic risk

Question 30

Systematic risk of senior tranches in CDOs | Coval

Answer 30

high systematic risk exposure in senior tranches because losses are magnified as the economic conditions worsen

Question 31

Reasons the yields on structured finance products (/CDOs) did not reflect the underlying risks (2) (Coval)

Answer 31

1. credit ratings understated default risks b/c they were based on favorable extrapolations of economic conditions 2. yields did not account for exposure to systematic risk

Question 32

Other issues related to the rise & fall of the structured finance market (4) (Coval)

Answer 32

1. rating agencies misestimated default probabilities and correlations 2. banks were happy to collect fees for structuring and origination 3. bond issuers pay for credit ratings > conflict of interest 4. analysts & managers knew how actions would affect profits which conflicted with accurate risk assessments

Question 33

Coval's solution to parameter uncertainty in the structured finance market and its implication (Coval)

Answer 33

use a Bayesian approach to acknowledge parameter uncertainty in the credit rating process implication: fewer AAA-rated tranches

Question 34

Recovery rate | Coval

Answer 34

amount of potential payment paid in the event of default

Question 35

How to measure sensitivity of tranches to changes in default rates (Coval)

Answer 35

calculate probability of jr & sr default before and after change largest change is most sensitive (senior)