Financial Risk Management of
Insurance Enterprises
Collateralized Debt Obligations
(CDOs)
Overview
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Introduction
History
Fundamentals
Attributes
Parties
Credit Ratings
Synthetic CDOs
Valuation models
Current events
Introduction of CDOs
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Asset-backed security
Structured credit product
Portfolio of fixed-income assets
Tranches
History
• First CDOs, 1987
– High yield bond portfolios
• Next CDOs, 1989
– Mortgage Backed Securities
– John Meriwether, Salomon Brothers
• Liar’s Poker
• Long Term Capital Management
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Credit Risk Transfer (CRT) vehicles
Loans
Securitization
CDOs Growth
Synthetic CDOs
Fundamental Concepts behind CDOs
• Corporate entity raises capital
• Invests in financial assets
• Distributes cash flows
Four Key Attributes of CDOs
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Assets
Liabilities
Purposes
Credit Structure
Assets
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Corporate bonds
Residential Mortgage-Backed Securities
Commercial Mortgage-Backed Securities
Asset-backed Securities
Liabilities
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Senior debt
Junior debt
Subordinated debt
Equity
Purposes
• Balance sheet
– Shrink balance sheet
– Reduce required regulatory capital
– Lower funding costs
• Arbitrage
– Asset manager increases fund size and fees
• Origination
– Issuing securities to CDO as CDO issues liabilities
Structure
• Market value CDOs
– Enhance returns through trading
– Credit quality derives from the ability to liquidate
assets and repay debt tranches
• Cash flow CDOs
– Cash flows from assets pays the interest and
principal of tranches
Cash Flow CDOs
• Distribution of cash
flows: waterfall
• Coverage test
– Overcollateralization
– Interest coverage
Structural Matrix
Parties
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Asset managers
Asset sellers
Investment bankers and structurers
Monoline bond insurers and financial
guarantors
Credit Ratings
• Collateral diversification
• Likelihood of default
• Recovery rates
Synthetic CDOs
• Does not own assets on which it bears the
credit risk
• Sells protection via Credit Default Swaps
• Buys protection via tranches issued
Valuation models
• Gaussian copula model
– Default correlation
• Dynamic model
– Hazard rates with deterministic drift with periodic
impulses
CDOs on CDOs
• CDOs based on a tranche from a CDO
• Example:
– CDO^2 based on a tranche (e.g. BBB) of a CDO
– CDO^n based on a tranche of a CDO^(n-1)
• It gets very complicated very quickly
Current events
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Subprime mortgage crisis
Counterparty credit risk
Liquidity issues
Prices drops
– ABX index
• Rating agencies are blamed for inaccurate
credit ratings
Concerns with CRT vehicles
• ‘Clean’ risk transfer
• Risk of failure of market participants to
understand associated risk
• Potentially high concentration of risk
• Adverse selection