relieves the need for individual verification, and tradability sees to it that risk vendors may not even have to own the obligation that they sell to risk takers; they may be acting purely as intermediary.
For seller, buyer and intermediary, risk management should be seen as an integral part of the cost of transferring credit exposure to third parties. For marketability and credit risk management purposes, the originator bank may initially transfer the credit risk arising from the underlying portfolio to an independent special purpose vehicle (SPV), thereby separating the credit risk on the securitized port- folio from other exposures that are its own.
In other cases, the reference obligations are not sold directly to the special pur- pose vehicle. Instead, they remain on the originator bank’s balance sheet, along with the credit risk that they represent. Some practitioners believe that this is a negative, as far as diversification of credit exposure is concerned.
For the economy as a whole, high concentration of credit risk, which is gener- ally characteristic of derivatives markets, is worrisome from a systemic risk view- point. In the opinion of some experts, the rapidly growing derivatives trades add to global financial imbalances, which, from a financial stability perspective, represent an important vulnerability for the global financial system – with disturbances leading to changes sparking large trade and price adjustments.
Central bankers also think that a potential withdrawal from the market by one or two of the major intermediary banks in derivatives is sure to result in a serious short-term liquidity risk. In many cases it is very difficult to distinguish a severe short-term illiquidity from a credit institution’s insolvency, and the former might precipitate the latter.
Unlike asset-backed securities (ABSs), CDOs are not backed by a large, rather homo- geneous and granular pool of assets. Rather, what underpins them is a heterogeneous asset pool. Based on credit default swaps (CDSs, see section 5), synthetically cre- ated CDOs have become a popular vehicle for transferring corporate-related credit risk from the banking sector to other financial players.
The fact that several tranches of securities with different degrees of seniority in the event of bankruptcy are issued to investors allows re-engineering of the risk and return profile of the underlying collateral pool into different levels of exposure. The European Central Bank says that three elements are required to evaluate CDO tranches:9
● Probability of default (PD), within a given horizon such as one year
● Loss-given default (LGD), usually assumed to equal a constant percentage, i.e. 40%
● Correlation, the simultaneous link between the defaults of several entities included in the pool (Chapter 4).
In terms of mechanics, the first-loss tranche, known as equity, absorbs the risk of payment defaults, or delays. Mezzanine, the next highest tranche, will incur losses if the equity tranche is exhausted. Through this credit-enhancing tech- nique, the senior tranche, which lies above the mezzanine, could achieve AAA rating even if the other tranches have a much lower one.
This layered structure sees to it that, as far as credit risk assumed by investors is concerned, defaults of assets from the collateral pool are initially incurred by the first-loss (lowest) tranche, which also features a higher interest rate. But after this tranche had been exhausted, the next tranche(s) will be called upon.
The pros say that CDOs are fairly secure instruments because losses in senior tranches occur only in the case of significant deterioration of credit quality of the asset pool. This means that senior tranches usually have a higher rating than the average rating of the securitized assets, but at the same time pay less interest than the more risky tranches. Sceptics answer that investors:
● Have no information other than the rating about the creditworthiness of entities in the pool, and
● Specifically absent is the correlation of default probability characterizing the underlying reference pool (more on this later).
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A key task, therefore, is to establish the likelihood of an individual firm being unable to repay its debt – as determined by the distance between the value of its assets and the nominal value of its debt (Chapter 5) – followed by the correlation. The value of assets, which represents a measure of a firm’s ability to repay its liabilities:
● Is modelled as a stochastic process, and
● Default is assumed to occur when a firm’s assets are insufficient to cover its debt.
In exchange for good fees, many hedge funds are selling insurance against corpor- ate defaults. If there is no default during the life of the contract, the seller pockets the fee. But in the event of a default, the seller must pay out the face value of the contract. To raise that money, the hedge fund must often sell its most liquid assets, sometimes in a falling market.
Distress selling by several hedge funds was, for instance, observed on 10 May 2005 and subsequent days. At the time, experts suggested that member states of euroland and their companies were extremely vulnerable to CDO crisis and panics in the general credit derivatives market, as 50% of all CDOs are euro denominated (and they continue to be so).
The June 2005 ‘Financial Stability Review’ by the European Central Bank (ECB) had this to say on the May 2005 events:
‘… The volatility implied in options prices remained at very low levels across several asset classes, possibly induced, in part, through an arbitrage process with credit spreads via collateralized debt obligation markets … Moreover, the interplay between equity market volatility and credit spreads may have served to underpin a trend of rising leveraged credit investment – where CDOs of CDOs gained in popularity. This may have left credit derivatives markets vulnerable to adverse disturbances.’
The prevailing opinion is that CDOs contribute to the financial markets, but they also present new risks. However, there is a downside. From a financial stability viewpoint, regulators have expressed concerns about mispricing and inadequa- cies in risk management. Most importantly, supervisory authorities face chal- lenges in tracking credit risk around the financial system.
On the positive side, CDOs can assist in mitigating asymmetric information problems that are present in single-name credit risk transfer markets. This represents a diversification of credit risk in a portfolio, making risk and return profiles less sensitive to the performance of individual obligors.
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In the general case, the CDO tranche risk depends on the correlation of probabil- ity of default of the underlying reference pool:
● If there is a low default correlation,
● Then reference assets evolve relatively independently of each other in terms of credit quality.
This means that the probability distribution is centred on the expected portfolio loss. As we already saw, depending on their degree of subordination, individual CDO tranches react differently to correlation changes. Figure 6.1 provides the reader with a framework that includes all key factors with an impact on the per- formance of a CDO.
A risk-conscious investor should appreciate that subordinated CDO tranches are financial instruments with leverage, which need to be appropriately stress
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Special purpose vehicle (SPV)
Probability of default of each entity in the pool
Loss given default (taken as constant percentage)
Correlation of probabilities of default
Individual rating of each tranche Interest paid by
each tranche
Investor
Figure 6.1 Framework chacterizing risk and return with collateralized debt obligation Ch06-H8422.qxd 7/4/07 4:36 PM Page 136
tested for their risk and return characteristics prior to commitment. Depending on the volume of the tranche and position in the loss distribution:
● Decreases in value of the reference pool have a magnified impact on expos- ure, and
● This can quickly lead to considerable loss of the nominal amount of the tranche.
While the investor remains exposed to the deterioration of a leveraged instru- ment, the originator bank usually protects itself against downgrading in credit quality by selling credit protection in the credit derivatives market, for assets contained in the reference pool. As already mentioned, hedge funds are active in this market. Insurance companies are also protection sellers.