SIMSR

Collateralized Debt Obligation

Rahul Krishna M

Roll no:159PGDM-Finance

Under the guidance ofProf A K Pradhan

SIMSR

ContentsAbstract.................................................................................................................................................3

Introduction...........................................................................................................................................4

Development of CDO’s..........................................................................................................................6

CDO Life cycle........................................................................................................................................6

Types of CDO’s.......................................................................................................................................6

The CDO Market....................................................................................................................................8

The Rise and fall of the CDO..................................................................................................................8

Current Financial crisis.........................................................................................................................13

Mathematical Challenges in Modelling the Mechanism of CDOs........................................................14

Challenge of Rating Structured Finance Assets....................................................................................15

Financial Stability Implications............................................................................................................17

Four good reasons for CDO business...................................................................................................18

Pros and cons of CDO’s........................................................................................................................19

Foreign Market Scenario.....................................................................................................................22

Indian Scenario....................................................................................................................................23

Conclusion...........................................................................................................................................25

References...........................................................................................................................................25

2

AbstractThis paper aims to reveal the mechanism of Collateralized Debt Obligations (CDOs) and how CDOs extend the current global financial crisis. We first introduce the concept of CDOs and give a brief account of the development of CDOs. We then explicate the mechanism of CDOs within a concrete example with mortgage deals and we outline the evolution of the current financial crisis. Collateralized debt obligations (CDOs) have been responsible for $542 billion in write-downs at financial institutions since the beginning of the credit crisis. In this paper, we get into the causes of this adverse performance, looking specifically at asset-backed CDO’s (ABS CDO’s). Using novel, hand-collected data from 735 ABS CDO’s, I document several main findings. First, poor CDO performance was primarily a result of the inclusion of low quality collateral originated in 2006 and 2007 with exposure to the U.S. residential housing market. Second, CDO underwriters played an important role in determining CDO performance. Lastly, the failure of the credit ratings agencies to accurately assess the risk of CDO securities stemmed from an overreliance on computer models with imprecise inputs. Overall, my findings suggest that the problems in the CDO market were caused by a combination of poorly constructed CDOs, irresponsible underwriting practices, and flawed credit rating procedures. This paper explores the market of CDOs and synthetic CDOs and their use in bank balance sheet management. It discusses about the details regarding the CDO as an instrument and how it has been performing in the credit market. Here we consider both the foreign market scenario and the Indian market scenario from which we will be analysing the advantages and disadvantages of CDO’s as an instrument and the required changes that need to happen for developing a successful market for the Collateralised Debt Obligation both in India as well as in abroad. Apart from this we will be looking upon the learning’s that we get from the failure of the ICCDO and the reasons for its failure.

3

IntroductionCollateralized Obligations (COs) are promissory notes backed by collaterals or securities. In the market for COs, the securities can be taken from a very wide spectrum of alternative financial instruments, such as bonds (Collateralized Bond Obligations, or CBO), loans (Collateralized Loan Obligations, or CLO), funds (Collateralized Fund Obligations, or CFO), mortgages (Collateralized Mortgage Obligations, or CMO) and others. And frequently, they source their collaterals from a combination of two or more of these asset classes. Collectively, these instruments are popular referred to as CDOs, which are bond-like instruments whose cash flow structures allocate interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection of CDO securities to their investors. The most popular life of a CDO is five years. However, 7-year, 10-year, and to a less extent 3-year CDOs now trade fairly actively. A CDO can be initiated by one or more of the followings: banks, non-bank financial institutions, and asset management companies, which are referred to as the sponsors. The sponsors of a CDO create a company so-called the Special Purpose Vehicle (SPV). The SPV works as an independent entity and is usually bankruptcy remote. The sponsors can earn serving fees, administration fees and hedging fees from the SPV, but otherwise has no claim on the cash flow of the assets in the SPV. According to how the SPV gains credit risks, CDOs are classified into two kinds: cashflow CDOs and synthetic CDOs. If the SPV of a CDO owns the underlying debt obligations (portfolio), that is, the SPV obtains the credit risk exposure by purchasing debt obligations (e.g. bonds, residential and commercial loans), the CDO is referred to as a cashflow CDO, which is the basic form in the CDOs market in their formative years. In contrast, if the SPV of a CDO does not own the debt obligations, instead obtaining the credit risk exposure by selling CDSs on the debt obligations of reference entities, the CDO is referred to as a synthetic CDO; the synthetic structure allows bank originators in the CDOs market to ensure that client relationships are not jeopardized, and avoids the tax-related disadvantages existing in cashflow CDOs. After acquiring credit risks, SPV sells these credit risks in tranches to investors who, in return for an agreed payment (usually a periodic fee), will bear the losses in the portfolio derived from the default of the instruments in the portfolio. Therefore, the tranches holders have the ultimate credit risk exposure to the underlying reference portfolio. Tranching, a common characteristic of all securisations, is the structuring of the product into a number of different classes of notes ranked by the seniority of investor's claims on the instruments assets and cashflows. The tranches have different seniorities: senior tranche, the least risky tranche in CDOs with lowest fixed interest rate, followed by mezzanine tranche, junior mezzanine tranche, and finally the first loss piece or equity tranche. A CDO makes payments on a sequential basis, depending on the seniority of tranches within the capital structure of the CDO. The more senior the tranches investors are in, the less risky the investment and hence the less they will be paid in interest. The way it works is frequently referred to as a “waterfall” or cascade of cash flows. In perfect capital markets, CDOs would serve no purpose; the costs of constructing

4

and marketing a CDO would inhibit its creation. In practice, however, CDOs address some important market imperfections. First, banks and certain other financial institutions have regulatory capital requirements that make it valuable for them to securitize and sell some portion of their assets, reducing the amount of (expensive) regulatory capital that they must hold. Second, individual bonds or loans may be illiquid, leading to a reduction in their market values. Securitization may improve liquidity, and thereby raise the total valuation to the issuer of the CDO structure.In light of these market imperfections, at least two classes of CDOs are popular: the balance-sheet CDO and the arbitrage CDO. The balance-sheet CDO, typically in the form of a CLO, is designed to remove loans from the balance sheets of banks, achieving capital relief, and perhaps also increasing the valuation of the assets through an increase in liquidity. An arbitrage CDO, often underwritten by an investment bank, is designed to capture some fraction of the likely difference between the total cost of acquiring collateral assets in the secondary market and the value received from management fees and the sale of the associated CDOs structure.The CDO functions in the following way

Objective of the study:

The purpose of the research would be to find out the reasons for the non-existence of CDO’s in the Indian Financial Markets. The research analyses the evolution of CDO’s in the global markets and the reasons for the failure of the instrument describing the various effects in the economy that resulted in the disaster for the CDO market. It also envisages on the difficulties that the issuers and the investors have in making decisions for trading with the CDO instruments.

Scope and Research Methodology :

Since CDO’s are currently non-existent in India, International markets will be studied to find out more about their relevance, preference and penetration. The focus of this research would be to identify the factors that prevented CDO’s from entering the Indian markets. Some of the factors that will be studied are the eligibility criteria put forth by RBI, valuation of this instrument and calculating the default risk on interest payments.

5

The Research methodology would be to study and analyse the secondary data in the form of research paper, white paper, thesis and dissertations.

Development of CDO’sThe market for CDO’s began as early as 1980’s. At that time CDO’s were sharing the market with CMO’s which had a similar functionality as of CDO’s. By the late 1990’s CDO’s were becoming a strong instrument being traded in the market and the volumes had also increased by huge numbers. There were many indicators of this development:

1. Issuance volume was rising constantly.2. Cross-border investment into CDO’s also began to rise.3. The asset classes that were being used as the collateral had been increasing.4. Apart from all these there were also some changes in the legislation and regulations

which benefitted CDO’s a lot.

But by the period of 2001 the demand for the credit derivatives had increased a lot which resulted in some new instruments which were the synthetic products of the CDO’s came into existence and began to take over the market share of the CDO’s. An example for this can be given as the CDO’s of CDO’s developed during the year of 2002 where a portfolio of CDO’s were assembled and sold to the potential buyers. The main reason for the popularity and the high amounts of trading of CDO’s in the market was the increasingly deteriorating credit quality.

CDO Life cycleThe lifecycle of CDO typically revolves around three periods:

1. Ramp-up period- Collateral portfolio is decided and formed during this period.2. Cash-flow period-It covers the major part of the CDO’s life-span. This is the time

when the collateral portfolio is functional in the market, during this period the manager can actively speculate with it or just leave it to generate cash-flows.

3. Unwind period-This is the period when the investors are repaid with their principal investment.

Types of CDO’sThe CDO’s can be basically divided into two types:

1. Balance sheet CDO’s2. Arbitrage CDO’s

Balance sheet CDO’s are those in which the loans of one institution generally banks are transferred to the other institution. The latter institution that purchases the loans gets a

6

discount on the book value which is the amount that it charges for undertaking the default risk of those loans. The relative low coupon attached to these assets, results in a smaller spread cushion than the corresponding arbitrage structure. However, given their relative superior quality, they require less subordination when used in a CDO deal.

Arbitrage CDOs are those where the originator looks to extract value by repackaging the collateral into tranches. The main objective for the trading of the Balance sheet CDO’s is for the institutions to hedge their default risks by transferring it to the other institutes where as in the case of Arbitrage CDO’s the main criteria is the arbitrage profits that the institutions receive. Arbitrage CDO’s can again be divided into two types:

1. Arbitrage market value CDOsArbitrage market value CDOs, unlike balance sheet CDOs where there is no active trading of loans in the portfolio; go through a very extensive trading by the collateral manager, necessary to exploit perceived price appreciations.This type of CDO relies on the market value of the pool securitised, which is monitored on a daily basis. Every security traded in capital markets, with estimated price volatility, can be included in this type of CDO.In fact, the primary consideration is the price volatility of the underlying collateral.The important aspect is the collateral manager’s capacity to generate a high total rate of return. The CDO manager has a great deal of flexibility in terms of the asset included in the deal. During the revolver period, the collateral manager can increase or decrease the funding amount that changes the leverage of the structure.

2. Arbitrage cash flow CDOsBy their very nature, collateral assets have been purchased at market price and are negotiable instruments, therefore most assets are bonds. However syndicated loans, usually tradable, have been included in past transactions. As arbitrage deals, the collateral assets can be refinanced more economically by re -tranching the credit risk and funding cost in a more diversified portfolio. Unlike arbitrage market value CDOs, the collateral assets are not traded very frequently.These two types of CDO’s are the most basic type of CDO. These types of CDO’s are also termed as Cash CDO’s.

Synthetic CDO

A form of collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other non-cash assets to gain exposure to a portfolio of fixed income assets. Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. Initial investments into the CDO are made by the lower tranches, while the senior tranches may not have to make an initial investment.

All tranches will receive periodic payments based on the cash flows from the credit default

7

swaps. If a credit event occurs in the fixed income portfolio, the synthetic CDO and its investors become responsible for the losses, starting from the lowest rated tranches and working its way up.

Other types of CDO’s

CDO Squared

It is also known as CDO2 note, is simply a CDO issue using other CDO notes as collateral. The process is called re-securitisation. In case of default among any of the underlying CDO’s, the SPV loses its corresponding principal investment and in response passes this loan to its own investors so that they lose their principal in order of their seniority.

The CDO MarketThe market for Collateralized Debt Obligations has grown continuously over the past ten years, both in absolute and relative market terms. In 2005, it was the second largest credit derivative market after the credit default swaps.

Although the CDO market began with Cash CDO’s, by now the most commonly traded CDO type is the synthetic CDO that builds on other credit instruments instead of the direct sale of the underlying assets. The popularity of the synthetic CDO’s over the cash CDO’s is in part explained by their feature of allowing the issuer-normally a bank-to maintain the direct relationship with the client, without having to sell or move the loans off his balance sheet. Synthetic CDO’s are also attractive for the geographic markets where the originator for legal reasons is not allowed to make a full transfer or full sale of assets; the synthetic derivative then provides access to that market’s investor community. From an investment perspective, the synthetic CDO allows a clearer investment opportunity for the buyer: The synthetic CDO only brings credit risk, whereas the cash CDO, with its complete transfer of the asset to the SPV, brings in addition to the credit risk all the normal risks associated with owning an asset, such interest rate, prepayment and currency risk.

The Rise and fall of the CDOEvery player was benefiting from CDOs and issuance exploded, reaching $50 billion in 2006. The rating agencies were making record profits as the demand for rated structured products skyrocketed. Institutional investors loved the high-yielding AAA securities created from ABS CDOs, CDO underwriters collected fees and achieved regulatory capital relief by off-loading their assets, and CDO collateral managers earned hefty returns by retaining the equity tranches, benefiting from the low cost of funding senior tranches. However, by 2003, several changes in CDOs were working to create the perfect storm that was unleashed upon financial markets in 2007.

8

First, the collateral composition of CDOs changed as collateral managers looked for ways to earn higher yields. The managers began investing more heavily in structured finance securities, most notably subprime RMBS, as opposed to corporate bonds. Furthermore, they invested in the mezzanine tranches of these securities, moves designed to create higher-yielding collateral pools. Table documents the evolution of ABS CDO assets from 1999-2007, illustrating the profound increase in subprime RMBS (HEL) collateral, with 36% of the 2007 CDO collateral comprised of HEL bonds.

Average Principal Allocations by Asset-Class

Source: Lehman Live (2009-CDO meltdown)(Table summarizes the average collateral composition for of 735 ABS CDO deals originated between 1999-2007)HEL – home equity loan (includes all RMBS less than prime)RMBS – residential mortgage-backed securities (by prime borrowers)CMBS – commercial mortgage backed securitiesOther ABS – other asset-backed securities (including auto-loans, credit-cards, etc.)

In response to the explosion in CDO issuance, the increased demand for subprime mezzanine bonds began to outpace their supply. This surge in demand for subprime mezzanine bonds helped to push spreads down – so much so that the bond insurers and real estate investors that had traditionally held this risk were priced out of the market. The CDO managers that now purchased these mortgage bonds were often less stringent in their risk analysis than the previous investors and willingly purchased bonds backed by ever-more exotic mortgage loans. Clearly, the bonds in the CDOs have performed worse, indicating that there might have been a degree of adverse selection in choosing the subprime bonds for CDOs.

9

Repackaging of Subprime Bonds into CDOs

(Source: The Story of the CDO Market Meltdown: An Empirical Analysis by Anna Katherine Barnett-Hart)

In addition to the increased investment in risky mortgage collateral, the next development was the creation of the notorious “CDO squared,” (and the occasional “CDO cubed”), which repackaged the hard-to-sell mezzanine CDO tranches to create more AAA bonds for institutional investors. Lastly, the advent of synthetic CDOs significantly altered the evolution of the CDO market. Rather than investing in cash bonds, synthetic CDOs were created from pools of credit-default swap contracts (CDS), essentially insurance contracts protecting against default of specific asset-backed securities. The use of CDS could give the same payoff profile as cash bonds, but did not require the upfront funding of buying a cash bond. Furthermore, using CDS as opposed to cash bonds gave CDO managers the freedom to securitize any bond without the need to locate, purchase, or own it prior to issuance.Taken together, these observations indicate that CDOs began to invest in more risky assets over time, especially in subprime floating rate assets. Essentially, CDOs became a dumping ground for bonds that could not be sold on their own – bonds now referred to as “toxic waste.” As former Goldman Sachs CMBS surveillance expert Mike Blum explains: Wall Street reaped huge profits from “creating filet mignon AAAs out of BB manure.”

10

Collateral Composition Trends in ABS CDOs

(Source: Lehman Live)The deterioration in CDO collateral quality was matched by a decrease in the credit support of the rated tranches, leaving investors more exposed to losses on the collateral. The subordination levels have decreased slightly for all tranches, with the most pronounced decline in the AAA-rated tranches, which went from an average of 25% subordination in 2002 to less than 15% in 2007. With the issuance of CDOs growing unabated and the quality of their collateral declining, both the rating agencies and the investment banks failed to recognize the amount of risk inherent in these products. The below figure shows the dramatic increase in realized default levels of ABS CDOs, with over 40% of the 2007 CDO assets in default.

Historical Realized Default Levels

(Source: The Story of the CDO Market Meltdown: An Empirical Analysis by Anna Katherine Barnett-Hart)

11

Credit ratings have been vital to the development of the CDO market, as investors felt more confident purchasing the new structures if they were rated according to scales that were comparable to those for more familiar corporate bonds. Investors came to rely almost exclusively on ratings to assess CDO investments: in essence substituting a letter grade for their own due diligence. In addition, credit ratings from agencies deemed to be “nationally recognized statistical organizations” (NRSRO) were used for regulatory purposes by the SEC. While there are five credit rating agencies with the NRSRO qualification, only three were major players in the U.S. structured finance market: Moody’s, Fitch, and Standard and Poor’s (S&P). While S&P and Moody’s rated almost all CDO deals, Fitch’s market share declined to less than 10% by 2007. The rating agencies earned high fees from the CDO underwriters for rating structured finance deals, generating record profits as seen in Diagram C. Table 3 shows the amount of CDO business each of the CRAs did with the various CDO originators. Problems with CDO ratings rapidly developed as the rating agencies came under enormous pressure to quickly crank out CDO ratings and the market exploded faster than the number or knowledge of analysts. Analysis of CDOs came to rely almost completely on automated models, with very little human intervention and little incentive to check the accuracy of the underlying collateral ratings.The advent of CDOs in the mid-1980s was a watershed event for the evolution of rating definitions. Until the first CDOs, rating agencies were only producers of ratings; they were not consumers. With the arrival of CDOs, rating agencies made use of their previous ratings as ingredients for making new ratings – they had to eat their own cooking. For rating CDOs, the agencies used ratings as the primary basis for ascribing mathematical properties (e.g., default probabilities or expected losses) to bonds.Not only did the rating agencies fail to examine the accuracy of their own prior collateral ratings, but in many cases, they also used other agency’s ratings without checking for accuracy. To correct for any shortcomings in the other agency’s rating methodology, they created the practice of “notching,” whereby they would simply decrease the rating of any collateral security that they did not rate by one notch. In other words, if Moody’s rated aCDO that was composed of collateral rated BB+ by Fitch only, Moody’s would instead use a rating of BB in their own CDO model because it was not their rating. They never went back and reanalyzed the other rating agency’s rating, conveniently assuming that decreasing it by a notch would compensate for any shortcomings in the initial risk analysis.The inputs and definitions associated with the models were frequently changed, generating confusion and inconsistencies in the ratings: Fitch’s model showed such unreliable results using its own correlation matrix that it was dubbed the “Fitch’s Random Ratings Model.” Furthermore, it became clear that similarly rated bonds from different sectors (i.e. ABS vs. corporate bonds, RMBS vs. CMBS) had markedly different track records of realized default probabilities, and the agencies began to adjust their meanings and models haphazardly in an attempt to correct their previous mistakes. However, investors thought, and were encouraged to believe, that the ratings of CDOs corresponded to similar default distributions as individual corporate bonds, thereby further fueling the asset-backed frenzy. Lastly, as CDO structures became more complex, incorporating features such as super senior tranches, payment-in-kind (PIK) provisions, and

12

a diversity of trigger events that could change the priority of liability payments, CDO ratings became even less meaningful. In addition to the problems with the accuracy of the ratings, there was also the fact that the ratings themselves were not meaningful indicators for assessing portfolio risk. Furthermore, ratings are a static measure, designed to give a representation of expected losses at a certain point in time with given assumptions. It is not possible for a single rating to encompass all the information about the probability distribution that investors need to assess its risk. Investors often overcame these limitations by looking at ratings history, filling in their missing information with data about the track record of defaults for a given rating. Since there was little historical data for CDOs, investors instead looked at corporate bond performance. However, as noted above, asset-backed ratings have proven to have very different default distributions than corporate bonds, leading to false assessments.The heavy reliance on CDO credit ratings made it more devastating when problems with the models and processes used to rate structured finance securities became apparent. The Bank for International Settlements commissioned a report summarizing the difficulties in rating subprime RMBS. They found that the credit rating agencies underestimated the severity of the housing market downturn, which in turn caused a sharp increase in both the correlation among subprime mezzanine tranche defaults and their overall level of realized defaults, while decreasing the amount recovered in the event of a default (i.e. loss given default). In addition, the ratings of subprime RMBS relied on historical data confined to a relatively benign economic environment, with very little data on periods of significant declines in house prices.

Current Financial crisisThe main reason for the current financial crisis is the US subprime mortgage financial crisis. The crisis happened because of the excess boom in the US housing market which raised the supply levels in the market to level far greater than the demand levels in the market. This resulted in the suppliers bearing huge amounts of losses due to which they began to default the borrowings from the different banks and financial institutions. Initially the institutions that got affected because of this default were the banks and institutions that used to provide credit for home construction. But as we now that it’s rarely possible that one sector is getting affected and the other sectors function in the normal way. In this case the money rose for the home construction purpose was not only raised through banks but also a number of reputed institutions issued bonds in order to raise capital. As a result the liquidity in the market came down by a huge level and also the risk aversion of the lenders had increased which resulted in a higher interest even for non-housing borrowings and also the availability came down making it difficult for the other sectors to satisfy their capital requirements. Also ‘Securitisation’ became an important factor for giving loans and this resulted in the development of the Asset Backed Securities (ABS). In early 2007, when defaults were rising in the mortgage market, New York's Wall Street began to feel the first tremors in the CDOs world. Hedge fund managers, commercial and

13

investment banks, and pension funds, all of which had been big buyers of CDOs, found themselves landed in trouble, as many CDOs included derivatives that were built upon mortgages—including risky, subprime mortgages. More importantly, the mathematical models that were supposed to protect investors against risk weren’t working. The complicating matter was that there was no market on which to sell the CDOs. CDOs are not traded on exchanges and even not really structured to be traded at all. If one had a CDO in his/her portfolio, then there was not much he/she could do to unload it. The CDO managers were in a similar bind. As fear began to spread, the market for CDOs' underlying assets also began to disappear. Suddenly it was impossible to dump the swaps, subprime-mortgage derivatives, and other securities held by the CDOs.

Mathematical Challenges in Modelling the Mechanism of CDOsThe basis of a CDO was not a mortgage, a bond or even a derivative, but the metrics and algorithms of quant and traders. The credit for the success of CDO’s during the period of 2001 can be mainly given to the invention of the Gaussian Copula. With this formula pricing of the CDO had become very easy but only after a period of time that it was realised that there were some flaws while pricing the CDO using these formulas. The main criteria for financial institutions to trade instruments are the availability of a model to price those instruments, in the absence of which the institutions will try to not include these instruments in their profile. Many of the investors had felt that investing in CDO’s reduced their risk as CDO had included a large number of individual bonds that underlie a particular deal, but only later it was found that all these bonds were highly correlated and the amount of risk wasn’t coming down as the amount of diversification due to the CDO’s was very less.

Pricing a CDO is mainly to find the appropriate spread for each tranche (level) and its difficulty lies in how to estimate the default correlation in formulating models that fit market data. With the empirical evidence of the existence of mean reversion phenomena in efficient credit risk markets, mean-reverting type stochastic differential equations are considered. In addition, the CDOs market has seen the phenomenon of heavy tail dependence in a portfolio, which draws the attention to use modelling with heavy tail phenomenon as a feature. Besides, the efficiency in calibrating pricing models to market prices should be paid much attention. A well calibrated and easily implemented model is the right goal.

The market standard model is the so-called one factor Gaussian copula model. The assumptions of the one factor Gaussian copula model about the characteristics of the underlying portfolio simplify the analytical derivation of CDOs premiums but are not very realistic. Thereafter more and more extensions have been proposed to pricing CDOs: homogeneous infinite portfolio is extended to homogeneous finite portfolio, and then to heterogeneous finite portfolio which represents the most real case; multifactor models are considered other than one factor model; Gaussian copula is replaced by alternative

14

probability distribution functions; the assumptions of constant default probability, constant default correlation and deterministic loss given default are relaxed and stochastic ones are proposed which incorporate dynamics into pricing models.

Challenge of Rating Structured Finance AssetsCredit ratings are designed to measure the ability of issuers or entities to meet their future financial commitments, such as principal or interest payments. Depending on the agency issuing the rating and the type of entity whose creditworthiness is being assessed, the rating is either based on the anticipated likelihood of observing a default, or on the basis of the expected economic loss – the product of the likelihood of observing a default and the severity of the loss conditional on default. As such, a credit rating can intuitively be thought of as a measure of a security’s expected cash flow. In the context of corporate bonds, securities rated BBB- or higher have come to be known as investment grade and are thought to represent low to moderate levels of default risk, while those rated BB+ and below are referred to as speculative grade and are already in default or closer to it.These estimates are derived from a study of historical data and are used in Fitch’s model for rating collateralized debt obligations (Derivative Fitch, 2006). It is noteworthy that within the investment grade range, there are ten distinct rating categories (from AAA to BBB-) even though the annualized default rate only varies between 0.02 and 0.75 percent. Given the narrow range of the historical default rates, distinguishing between the ratings assigned to investment grade securities requires a striking degree of precision in estimating a security’s default likelihood. By contrast, the ten rating categories within the speculative grade range (from BB+ to C) have default rates ranging from 1.07 to 29.96 percent.In the single-name rating business, where the credit rating agencies had developed their expertise, securities were assessed independent of one another, allowing rating agencies to remain agnostic about the extent to which defaults might be correlated. But, to assign ratings to structured finance securities, the rating agencies were forced to address the bigger challenge of characterizing the entire joint distribution of payoffs for the underlying collateral pool. The riskiness of collateralized debt obligation tranches is sensitive to the extent of commonality in default among the underlying assets, since CDOs rely on the power of diversification to achieve credit enhancement.The structure of collateralized debt obligations magnifies the effect of imprecise estimates of default likelihoods, amounts recovered in the event of default, default correlation, as well as, model errors due to the potential misspecification of default dependencies. These problems are accentuated further through the sequential application of capital structures to manufacture collateralized debt obligations of CDO tranches, commonly known as CDO-squared (CDO2). With multiple rounds of structuring, even minute errors at the level of the underlying securities, which would be insufficient to alter the security’s rating, can dramatically, alter the ratings of the structured finance securities.A large fraction of collateralized debt obligations issued over the course of the last decade had subprime residential mortgage-backed securities as their underlying assets.

15

Importantly, many of these residential mortgage-backed securities are themselves tranches from an original securitization of a large pool of mortgages, such that CDOs of mortgage-backed securities are effectively CDO2s. Moreover, since substantial lending to subprime borrowers is a recent phenomenon, historical data on defaults and delinquencies of this sector of the mortgage market is scarce. The possibility for errors in the assessment of the default correlations, the default probabilities, and the ensuing recovery rates for these securities was significant. Such errors, when magnified by the process of re-securitization, help explain the devastating losses some of these securities have experienced recently.When credit rating agencies started rating both structured finance and single-name securities on the same scale, it may well have lured investors seeking safe investments into the structured finance market, even though they did not fully appreciate the nature of the underlying economic risks. In the logic of the capital asset pricing model, securities that are correlated with the market as a whole should offer higher expected returns to investors, and hence have higher yields, than securities with the same expected payoffs (or credit ratings) whose fortunes are less correlated with the market as a whole. However, credit ratings, by design, only provide an assessment of the risks of the security’s expected payoff, with no information regarding whether the security is particularly likely to default at the same time that there is a large decline in the stock market or that the economy is in a recession. Because credit ratings only reflect expected payoffs, securities with a given credit rating can, in theory, command a wide range of yield spreads – that is, yield in excess of the yield on a U.S. Treasury security of the same duration – depending on their exposure to systematic risks. For example, consider a security whose default likelihood is constant and independent of the economic state, such that its payoff is unrelated to whether the economy is in a recession or boom, whether interest rates are rising or falling, or the behaviour of any other set of economic indicators. An example of this type of a security is a traditional catastrophe bond. Catastrophe bonds are typically issued by insurers, and deliver their promised payoff unless there is a natural disaster, such as a hurricane or earthquake, in which case the bond default. Under the working assumption that a single natural disaster cannot have a material impact on the world economy, a traditional catastrophe bond will earn a yield spread consistent with compensation for expected losses. Investors are willing to pay a relatively high price for catastrophe bonds because their risks are uncorrelated with other economic indicators and therefore can be eliminated through diversification.At the other end of the range, the maximum yield spread for a security of a given rating is attained by a security whose defaults are confined to the worst possible economic states. If we assume that the stock market provides an ordering of economic states – that is, if the Standard and Poor’s 500 index is at 800, the economy is in worse condition than if that same index is at 900 – then the security with maximal exposure to systematic risk is a digital call option on the stock market. A digital call option pays $1 if the market is above a pre-determined level (called a “strike price”) at maturity and $0 otherwise. Because this security “defaults” and fails to pay only when the market is below the strike price, it represents the security with the greatest possible exposure to systematic risk. By selecting the appropriate

16

strike price, the probability that the call fails to make its promised payment can be tuned to match any desired credit rating. However, because a digital call option concentrates default in the worst economic states, investors will insist on receiving a high return as compensation for bearing the systematic risk, and require the option to deliver the largest yield spread of all securities with that credit rating. The process of pooling and tranching effectively creates securities whose payoff profiles resemble those of a digital call option on the market index. Intuitively, pooling allows for broad diversification of idiosyncratic default risks, such that – in the limit of a large diversified underlying portfolio – losses are driven entirely by the systematic risk exposure. As a result, tranches written against highly diversified collateral pools have payoffs essentially identical to a derivative security written against a broad economic index. In effect, structured finance has enabled investors to write insurance against large declines in the aggregate economy. Investors in senior tranches of collateralized debt obligations bear enormous systematic risk, as they are increasingly likely to experience significant losses as the overall economy or market goes down. Such a risk profile should be expected to earn a higher rate of return than those available from single-name bonds, whose defaults are affected by firm-specific bad luck. If investors in senior claims of collateralized debt obligations do not fully appreciate the nature of the insurance they are writing, they are likely to be earning a yield that appears attractive relative to that of securities with similar credit ratings (that is, securities with a similar likelihood of default), but well below the return they could have earned from simply writing such insurance directly—say, by making the appropriate investment in options on the broader stock market index. Coval, Jurek, and Stafford (2008) provide evidence for this conjecture, showing that senior tranches in collateralized debt obligations do not offer their investors nearly large enough of a yield spread to compensate them for the actual systematic risks that they bear.The fact that corporate bonds and structured finance securities carry risks that can, both in principle and in fact, be so different from a pricing standpoint, casts significant doubt on whether corporate bonds and structured finance securities can really be considered comparable, regardless of what the credit rating agencies may choose to do.

Financial Stability ImplicationsThe BIS reports that the market-making activities associated with CRT are concentrated with a limited number of dealer/broker firms. In addition, hedge funds are major investors in the equity tranches of CDOs and particularly active in correlation-related trading.At the company level, high transaction costs of these CRT structures, and the mispricing of credit they generate: “…either CDO’s are evidence of a substantial and pervasive market imperfection [in the fixed income market], or they are being used to create one. The second possibility seems more likely.”Among their reform suggestions:- Stricter disclosure requirements (register credit derivatives transactions, centralized pricing service; disclose the effect of credit derivatives transactions on companies’ risk exposure)

17

- Competition in credit ratings industry- There may be room for non-bank financial institutions to narrowly specialize on the monitoring and credit risk assessment roles that traditionally have played by banks(Annex: Key Facts and Numbers on Structured Credit and Credit Derivatives13)The volume of outstanding credit derivatives has grown from less than $1 trillion in 2001 to $26 trillion in 2006 according to Isda. See table below.The volume of outstanding cash CDOs stands at $986 billion at the start of 2007, according to Creditflux Data+The volume of synthetic CDO tranches traded in the past three years is $739 billion, according to Creditflux Data+The most important users of credit derivatives have historically been banks (see chart below). But anecdotal evidence suggests that hedge funds, insurance companies, mutual funds, pension funds and other buy-side firms are the fastest growing sectors of the market.

Four good reasons for CDO businessBesides the four motivations summarized in the sequel, tax and legal arbitrage play an important role in CDO structuring.

1. Spread arbitrage opportunities: On the asset side premiums are collected on a single-name base, whereas premium/interest payments to the super senior swap counterparty and the note holders refer to a diversified pool (CDS agreements are made with different institutions)

Total spread collected on single credit risky instruments at the asset side of the transaction exceeds the total ‘diversified’ spread to be paid to investors on the trenched liability side of the structure.

2. Regulatory capital relief: ‘D’ in ‘CDO’ becomes an ‘L’ standing for ‘loan’.

The only regulatory capital requirement the originator has to fulfil regarding the securitized loan pool is holding capital for retained pieces.

A full calculation of costs compared to the decline of regulatory capital costs is required to judge about the economics of such transactions.

3. Funding: Involves a true sale ‘off balance sheet’ of the underlying reference assets to an SPV which then issues notes in order to refinance/fund the assets purchased from the originating bank.

The advantage of refinancing by means of securitizations is that resulting funding costs are mainly related to the credit quality of the transferred assets and not so much to the rating of the originator.

18

4. Economic risk transfer: Such a transaction divides the loss distribution in two segments First loss refers to losses carried by the originator (e.g., by retaining the equity piece).The excess loss of the first loss piece, taken by the CDO investors.

Pros and cons of CDO’sCDO-squared have the similar advantages and disadvantages to CDOs. However, due to the unique structure of CDO-squared there are still some differences between CDO and CDO-squared. We will illustrate advantages and disadvantages of CDO-squared from the aspects of both originator and investors.

Advantage to Originator

1. Risk transference to increase the ratio of capital to risky assets and ROEThe main purpose of the securitization is to make the debt off-balance sheet. There are some limits about capital of the banks and some financial institution, for example, the capital adequacy ratio. Therefore, the originator can change the risky assets into cash which is considered less risky, or transfer these risky assets to other insurance company and other institution to sustain. That would increase the ratio of capital to risky assets and largely reduce the requirement of the risky assets reservation of the banks and financial institution. Furthermore, it would increase the ROE. There is one important thing is that the CDO-squared just can transfer parts of risk and not similar to CDO which can totally transfer all of it. Hence, the issuer has to sustain this part of credit risk.

2. Reducing capital costThe reference obligors are packed and strengthen their credit level. It always can make CDO squared have higher credit rating than the originator; therefore, SPV can reduce its funding cost. In addition, SPV fund through CDO-squared can reduced the capital requirement, reservation requirement; moreover, SPV can get cash which is considered risk less through this process. Moreover, it would reduce the capital cost.

3. Improving the liquidity of assets and efficiency of the use of working capitalThe individual bond or loan which the banks hold may be illiquid in the market and the price may be underestimated. However, these assets can be more liquid through packing into small unit of CDO-squared. In addition, CDO-squared can transfer mid-term or long-term loan or asset into high liquid short-term asset and largely improve the efficiency of working capital.

4. Provide another way to fundThe enterprises which have high quality asset may be not easy to fund money when their credit ratings are not good enough. CDO-squared provide another choice for financial institution to fund, and expand to the global capital market.

19

5. Receive fixed and periodic service revenueThe originator plays the role of servicer and receives the cash flow of origination for SPV.The originator can earn the fixed and periodic service revenue from issuing the CDO-squared through SPV.

Advantage to Investor

1. Having one more choice of investment instrument and can diversify unsystematic riskThrough securitized, the SPV can repack reference CDOs into securities with different maturity, interest rate, and risk. It makes investors have much more choices, and investors can choose products based on their needs and their risk preferences. Therefore, CDO-squared can diversity unsystematic risk and even have higher degree of diversity achieved than CDO, because CDO-squared have several underlying CDOs which already have many CDSs in it.

2. Higher safe and liquidity instrumentThere are many criterions by government in issuing the CDO or CDO-squared, and these securities have to strength their credit and supervised by credit rating institutions. Therefore, the investors of CDOs or CDO-squared have less default risk and more liquidity.

3. Earn higher spreadsThe CDO-squared is double-lay structure; therefore, it provides investors more choice of investing in credit and earns higher spreads.

4. Reduce the adverse selection problemThere is a lot of unpublicized information about the credit risk issue of junk bonds or the loans of the banks. Thus, on average, investors willing to offer lower price than it should be under they have symmetric information. In this case, the SPV have the adverse selection problem.

As we know, when the adverse selection problem occurs, it would make the price of commodity lower and the price difference is called Lemon’s premium. This kind of problem cannot totally avoid by securitized, but this problem would be released. When the SPV issue CDOs to make the price higher and the adverse selection problem will concentrate in equity tranche and not affect other tranches. Hence, if the issuer can keep the equity tranche by itself and just sell other tranches, the other tranches can get more funds.

20

Disadvantage to Originator

1. The net benefit of securitization may be negativeThe securitization involves many professional institutions, i.e. SPV, the credit rating company, and the counterparty of credit default swap. Therefore, it will be more transparent through the market operation. However, the relative fee may be higher than the benefit which it brings.

2. High quality of long-term loan would be hard to acquireWhen the originator securitizes the high quality loan, it may be not to get such good assets again. The originator may lose the stable interest.

Disadvantage to Investor

1. The more complicated the commodity, the more difficult to valuateAlthough the CDO-squared can achieve the higher spread, it also reflects the complicated and the unique of this derivative. Therefore, CDO-squared is more difficult to valuate than CDOs or CDS.

2. Undertake higher credit riskCDO-squared can achieve the higher spread, but also bring more risk than CDO. This is due to the slight change of underlying reference credits would lead to big change of value of CDO-squared, even bigger than value of CDO.

3. Maybe have moral crisis problemThe SPV can transfer the credit risk into the insurance company and the investors through securitization. It may make the originator lend money without careful survey the credit of borrower. Or, the originator would take the poor quality loans to securitize and keep the higher quality loans. It would let investors face the moral crisis problem.

21

Foreign Market Scenario:

Global CDO Issuance Volume

Year USD billion2004 157.42005 251.32006 520.62007 481.62008 61.92009 4.2

Data Ref: Collateralized debt obligation-Wikipedia

There were several reasons for the fall in the volumes of issuance of CDO’s after 2006 due to several reasons. Some of them are

1. Housing Effect: Residential mortgage collateral has performed poorly, caused by a combination of declining underwriting standards by mortgage originators and the collapse in home values.

2. Vintage Effect: Collateral from 2006 and 2007 vintages showed worse performance and even there was a decline in underwriting standards during this period.

3. Complexity Effect: Increasing complexity in CDO assets also made people shift towards other instruments.

4. Underwriter Effect: CDO performance varied based on the underwriting bank as it plays the main role in developing and marketing the CDO through which it earns its service fee. Amount of due diligence conducted by the underwriter had a great influence on the performance of the CDO transaction.

5. Size Effect: Performance of an underwriter’s CDOs varies according to the size of their CDO business, with overly-aggressive or very inexperienced banks issuing worse CDOs, as measured by their ex-post defaults and rating downgrades. Certain banks might have been better CDO underwriters for unknown reasons; it is possible that the variation in underwriting standards is a function of the size of the bank’s CDO business.

6. Originator Effect: Performance of a CDO depends on the specific entities that originated its collateral assets. Lending standards of the originating entity will affect the ultimate performance of the CDO assets.

7. Recycled Ratings Effect: The rating agencies relied almost exclusively on the prior ratings of the underlying collateral, without making sufficient distinctions for different asset types.

8. Peer Pressure Effect: CRAs were worried about ratings shopping, causing more liberal ratings when they knew another agency was also rating the deal, in fear that they would lose business if their rating were less desirable than their competitors.

22

Indian Scenario The activity in the ABS market is picking up in India; the number of investors for securitized paper is very limited. In the absence of a Securitization Act, there are taxation and legal uncertainties with the securitization vehicle. In India, transfer of secured assets as required for securitization, can attract a stamp duty as high as 10% in some states precluding transaction possibilities. With favourable legislation and taxation regime, the ABS market in India can hope to see a lot of activity in future.Though securitisation has been in place in India over last 6 years or so, there has been no CDO/ CLOICICI Ltd. during 2002 announced the launch of India's first multi-tranched Collateralised Debt Obligation named Indian Corporate Collateralised Debt Obligation Fund. The ICCDO did not perform well when compared to the other instruments in the ABS and also the eligibility criteria that had to be met in order to issue CDO’s in the market were very difficult to implement. A major concern for investors is the valuation of this instrument. The confusion probably cropped up due to the fact that the instrument is to be traded like another bond; however the valuation was to be done as per any other mutual fund unit. Its NAV was to be declared every week as is mandatory under SEBI rules.Bank valuation is done on category wise basis, depending on which category the investment falls under viz. ‘Available for Trading’, ‘Available for Sale’ and ‘Held to Maturity’. For ‘Available for Trading’ category, the valuation is done on a daily/ weekly basis, as and when the NAV is published. In ‘Available for Sale’ category, the valuation is done on a quarterly / half yearly / annual basis and for ‘Held to Maturity’ category, no valuation is required. For valuation, the price considered is either the NAV or the repurchase price, whichever is lower.Though securitisation has been in place in India over last 10 years or so, there has been no CDO/ CLO. There have been several loan sales by financial institutions. ICICI’s CDO is the first CDO/ CLO in India. Called Indian Corporation Collateralised Debt Obligation Fund. It is a balance sheet CDO, consisting of a pool of bonds, PTCs held by ICICI. Capital relief could not be the purpose: if capital regulations as in BIS are applied, the deal will lead to capital erosion. In terms of the distribution schedule, it is essentially a pass through structure - reinvestments only if bondholders opt for growth plan.Mutual fund is certainly the most efficient possible SPV for a CDO:• Avoids any withholding tax by obligor• No tax on the vehicle• Distributions suffer 10% dividends tax• No tax on the unit holdersBut it creates an enormous tax haven in the system. Taxable incomes become tax free (other than dividends tax): the originating institution paying tax before, now earns tax free income. Nothing stops the originator from repackaging his own portfolio into units through the mutual fund and holds them tax free. The interest on debt paid by the obligors gives them 38% tax relief, distribution of the same taxable only 10% - a 28% tax shelter

23

Not merely bonds, even loans have been indirectly made tax free: existing loans first securitised. PTCs thereafter re-securitised because mutual funds cannot buy loans, but can buy PTCs.

There are a number of factors that need to be taken care before introducing CDO into the Indian market:ELIGIBILITY CRITERIA FOR INVESTORSCo-Operative Banks and Regional Rural BanksCo-operative Banks are not allowed to invest in Mutual Funds except for schemes floated by UTI. This regulation did not allow them to invest in the ICCDO. Even RRBs are not allowed to invest in mutual funds. Co-operative banks cannot invest in corporate paper. RRBs are allowed to invest in corporate paper with a cap of 5% of their incremental deposits.

Mutual FundsMutual Funds preferred to stay away from the issue. The main reason has been the issuance of the securities in the form of Mutual Fund units. MFs cannot invest more than 5% of their Net Asset Value in other mutual funds. If a Mutual Fund invests in another MF unit they also lose out on AMC fees. If Mutual Funds had come in as investors into this issue, it would have been a positive boost for secondary market liquidity of this instrument, as they (MFs) are the most active traders.

VALUATION OF THE PAPER IN THE BOOKS OF INVESTORSA major concern for investors is the valuation of this instrument. The confusion probably cropped up due to the fact that the instrument is to be traded like a other bond, however the valuation was to be done as per any other mutual fund unit. Its NAV was to be declared every week as is mandatory under SEBI rules.Bank valuation is done on category wise basis, depending on which category the investment falls under viz. ‘Available For Trading’, ‘Available For Sale’ and ‘Held To Maturity’. For ‘Available For Trading’ category, the valuation is done on a daily/ weekly basis, as and when the NAV is published. In ‘Available For Sale’ category, the valuation is done on a quarterly / half yearly / annual basis and for ‘Held To Maturity’ category, no valuation is required. For valuation, the price considered is either the NAV or the repurchase price, whichever is lower.

CONCERN ABOUT THE UNDERLYING POOL OF ASSETSThe inclusion of certain assets, which has defaulted on interest payments to institutions, has made investors skeptical about the motive behind this securitisation transaction. Investors wrongly felt that ICICI is trying to take out bad assets out of its books. The best way to allay these fears is if the Originator continues to hold some assets of the same Obligors, after securitising a part. If to say that nearly all the assets continue to remain on ICICI’s books.

24

However, it should be well emphasized to the investors that since it is very unlikely that all assets would default at the same time, the cushion in terms of cash reserve and tranching is sufficient to protect investors from any yield loss to certain extent.

ConclusionCDO market arose from a combination of poorly constructed CDOs, irresponsible underwriting practices, and flawed credit rating procedures. One of the main factors associated with the underperformance of CDOs was the inclusion of low quality collateral originated in 2006 and 2007 that was exposed to the residential housing market. The majority of CDOs issued after 2005 contained remarkably high levels of this collateral, allowing the decline in housing prices to cause a rapid deterioration in the financial health of CDOs. Second, the CDO underwriters played an important role in determining CDO performance, even after controlling for the asset and liability characteristics of their CDOs. The unobserved causes for this underwriter effect might be the ability, diligence, or philosophy of the underwriting bank. Lastly, the credit ratings of CDOs failed in their stated purpose, namely to provide a reflection of the CDO’s ability to make timely payments of principal and interest. This failure arose from a combination of over-automation and heavy reliance on inputs whose accuracy was not easily judged. While the collateralized debt obligation will not be the cause of another financial maelstrom, it is likely that the same combination of market imperfections, misaligned incentives, and human excesses that spawned this financial monster will not disappear.

References 1. Collateralised Debt Obligations-Domenico Picone

2. On the Mechanism of CDOs behind the Current Financial Crisis and Mathematical Modeling with Lévy Distributions- Hongwen Du, Jianglun Wu, Wei Yang

3. Credit Derivatives-George Chacko, Anders Sjoman, Deto Motohashi, Vincent Dessain

4. The Story of the CDO Market Meltdown: An Empirical Analysis by Anna Katherine Barnett-Hart.

5. The Economics of Structured Finance by Joshua D. Coval, Jakub Jurek,Erik Stafford.

6. Securitization in India – Opportunities & Obstacles by V.Sridhar.

7. CDO Modelling: Techniques, Examples and Applications by Christian Bluhm

8. Collateralised Loan Obligations – A Primer –Andreas A.Jobst

25