Note: Sample below may appear distorted but all corresponding word document files contain proper formattingExcerpt from Term Paper:
The credit risk is transferred through true sale of assets; the practice is applicable in the case of cash-flow CDOs which is based upon the traditional securitization mechanisms.
The tranches of CDO are issued in different proportions in synthetic securitization structures, these structures are entirely funded, partially funded or unfunded, and 'the main considerations in the design of these funding structures are the cost and management of counterparty risk' (Schmidt, 2002). The fully funded structure is less vulnerable to any counterparty, but it bears higher investment, 'the CDO encompasses a series of securities whose issuance amount is equal to that of the reference portfolio'. The originator of the transaction and the SPV does not entail cash payments, and the credits defaults are exchanged between both the authorities, therefore ' proceeds from the sale of tranches are reinvested in risk-free assets, which in most of the cases is government bonds' (Olivier, 2005).
The non-occurrence of the credit event offer incentives to the issuing entity, such that 'the issuing entity can cover costs of setting up the structure as well as the interest payments to the tranche holders by using the interest from the collateral pool together from the CDS entered into by the SPV' (Amato, 2003). Such exercise shall be useful in offering compensation to the 'originator by selling part of the risk-free assets' by the SPV; however 'for the other tranche holders, this sale results in a loss in the form of a reduction in the repayment of the principal of the tranches' (Darrell, 2001). The CDO is supported by the CDS, in case of the unfunded structures. The financial ability of SPV can be estimated through the extent of compensation offer to the originator, 'if a credit event occurs which is dependable upon the creditworthiness of the buyers of CDOs' (Schmidt, 2002). The partially funded CDOs are the most common, where the 'risk is transferred to investors partly via CDS and partly through issuing securities, these structures generally comprise a CDS whose notional amount is large in relation to the tranches issued, known as a super senior swap as it benefits from the subordination of the senior tranche and is therefore the part of the structure best protected against losses' (Olivier, 2005).
The merit of such structure is with reference to the transfer of the significant amount of credit risk by the originating banks, and therefore the banks are independent enough 'free up large amounts of regulatory capital, at a much lower cost than that of funded CDOs thanks to the substantial reduction in the value of tranches to be placed with investors' (Li, 2000). The interest rate paid on AAA-rated senior tranche with reference to the credit risk is more than 'the cost of buying protection via a super senior tranche is much lower' (Schmidt, 2002).
WHY WOULD YOU INVEST in or ISSUE a CDO
The single-tranche CDOs are 'recent but far-reaching financial innovation in the CDO market', and were launched in 2003. The CDOs are synthetic in nature; 'the arranger sells a single tranche at the mezzanine level to a single investor, instead of selling all the tranches i.e. equity, mezzanine and senior'. Such CDOs have following advantages i.e. 'they are attractive to investors because the tranche is tailored to the requirements of the buyer, which can choose the names in the underlying portfolio, the subordination level of the tranche and its size, this avoids some of the dangers of traditional CDO structures, such as the risks of moral hazard or adverse selection in the choice of the names in the portfolio or conflicting interests between the holders of the different tranches'. Furthermore, such CDOs 'are attractive to the arrangers because single-tranche CDOs are relatively easy to set up, unlike traditional CDOs, these save the cost and the time of selling different classes of tranches; moreover, selling costs are lower because in general the investor contacts the arranger, and not vice versa'. Previously, 'the arranger does not take the risk: its role is mainly to sell tranches, or to originate the transaction in the case of arbitrage CDOs. According to the current regulations, the risk is fully transferred to the investors via the SPV' (Schmidt, 2002). The arranger is the direct counterparty of the investor due to the absence of no vehicle structure. It has been researched that, 'the seller of the CDO and the buyer of protection on the single tranche of the CDO it sells, which makes it vulnerable to changes in credit spreads on the underlying portfolio of the CDO and to defaults on this portfolio' (Olivier, 2005). The Single-tranche CDOs is 'often presented as leveraged products, as the delta is higher than 1, which is between 5 to 10 for the mezzanine tranche, this leverage can be ascribed to the fact that much of the credit risk of the reference portfolio is concentrated in the subordinated tranches i.e. mezzanine and equity, due to the sequential allocation of losses' (Schmidt, 2002).
The financial evaluation of the CDO 'is apparent in the fact that the CDO's spread income from the reference portfolio can compensate investors in the CDO tranches and also cover transactions costs'. It is evident from the common and increased number of cases of adoption of the CDO technology by the credit investor that 'the cost of creating a CDO is less than the cost a credit investor would incur to assemble a portfolio of bonds and/or loans to meet the investor's diversification and risk-return targets' (Christian, 2003). The factors related to the high bid-ask spreads, which is expected to be exercised by the investor will be responsible for the 'high cost of investing directly in a portfolio of bonds or loans, reflecting the illiquidity of bond and loan markets'. It is general observation that well-designed and robust structures have supported CDOs, 'these can greatly facilitate the dispersion of credit risk across a wide range of investors; their underlying portfolio can span many names and economic sectors, with the share of each name and each sector in the portfolio remaining limited to a very low level'. Such factors have been critically evaluated by the credit rating agencies, and all such conditions have been reviewed 'which are determinant in the process of rating CDO tranches' (Olivier, 2005). The Synthetic CDOs 'enables investors to take positions on names that are not represented in the bond market, thus contributing to the completeness of the credit market and at the same time facilitating portfolio diversification'. In European countries, 'the corporate bond market is concentrated in a small number of sectors, which are often overweighed in portfolios' (Schmidt, 2002). The synthetic CDO tranches 'are therefore a way of obtaining a more balanced and diversified exposure, making it possible to appropriately weight given names or sectors within a portfolio' (Darrell, 2001).
Amato, Jeffery, Eli Remolona. 2003. The Credit Spread Puzzle. BIS Quarterly Review Vol. 51.
Andersen, Leif, Jakob Sidenius, Susanta Basu. 2003. All Your Hedges in One Basket vol. 67.
Boscher, Hans, Ian Ward. 2002. Long or Short in CDOs. Risk Vol. 125.
Duffle, Darrell, Nicolae Garleanu. 2001. Risk and Valuation of Collateralized Debt Obligations. Financial Analysts Journal Vol. 41.
Goodman, Laurie S. 2002. Synthetic CDOs: An Introduction. Journal of Derivatives Vol. 60.
Li, David. 2000. On Default Correlation: A Copula Function Approach. Journal of Fixed Income Vol. 115.
Schmidt, Wolfgang, Ian Ward. 2002. Pricing Default Baskets. Risk Vol. 115.
Olivier, Rahmouni. 2005. The CDO Market: Functioning and Implications in terms of Financial Stability. Financial Stability Review Vol. 6.
Michael S. Gibson. 2004. Understanding the Risk of Synthetic CDOs. Trading Risk Analysis Section. Division of Research…[continue]
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