PRESENTATION ON CDO’s

By:Manas Upadhyay

What is CDO?

• Collateralized Debt Obligation.• Breaking up each we get:• Collateralized : To secure (a loan) through use

of collateral.• Debt: a liability to pay or render something.• Obligation: an act or course of action to which

a person is morally or legally bound; a duty or commitment.

Defining CDO

• According to Investopedia:“A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors.”

Tranches?

• Tranche is French word meaning slice.• So, Tranches are pieces, portions or slices of a

deal or structured financing.• This portion is one of several related securities

that are offered at the same time but have different risks, rewards and/or maturities.

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Types of Tranches

• Senior: Less risky, first payment in case of default, less return and high ratings.

• Mezzanine: moderate risk, second payment in case of default, moderate return, moderate rating.

• Junior: high risk, last to receive payment in case of default, low return, low rating.

History

• First created in 1983 by the investment banks Salomon Brothers and First Boston for the U.S. mortgage liquidity provider Freddie Mac.

• Problems before CDO’s?1. Long tenure bonds traditionally2. Prepayment risk3. Reinvestment risk as repayment of principal on

loans.4. Default risk

Problems Addressed by CDO’s

• CDO is formed by group of mortgages:1. Keep some securities with long tenure and some

with short tenure.2. A group of mortgages with high rating and other

with low.3. A group of Principal only and another of Interest

only.

NOTE: Risk is increased or decreased is based on structure of CDO formed.

Problem with CDO’s?

• Under collateralization is biggest and only problem.

• When amount of default exceeds the value of collateralized asset value.

• Happened during US sub prime crisis. • Hence CDS ( Credit Default Swap) was

introduced.

Parties/Participants:• Securities firms, who approve the selection of

collateral, structure the notes into tranches and sell them to investors. Investment Banks like: Morgan Stanley, Goldman are some of the examples.

• CDO managers, select the collateral and often manage the CDO portfolios;

• Financial guarantors, who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments, insurance agencies using CDS;

• Investors such as pension funds and hedge funds.

CDS?

• A financial swap agreement• The seller will compensate buyer in event of

loan default.• Buyer pays a premium or fee to seller.• In event of default buyer gets the face value of

loan and;• Seller takes possession of defaulted loan.• Naked CDS, without any interest in security

Not understood, don’t worry!

• As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated.

• As CDS provide a cover like insurance, to CDO’s?

LOOKS EVERYTHING IS FINE ? IF WE HAVE CDO’S BACKED BY

CDS?

Well answer is a big NO.

Well answer lies in Housing Crisis of 2008.

•Why comes the question?

American Housing Crisis- 2008

Having massive private gains at public loss

Main reasons for crisis

• Deregulation• Loans at higher rates without having proper

collateral. (Sub prime loans)• Forming CDO’s of such risky securities.• Rated AAA by rating agencies.• Use of unregulated over the counter derivative

product such as CDS.• Huge Compensation• Fall in demand of housing, hence fall in prices

How we got here?

• Rise in financial sector in US since 1980.• Deregulation of financial sector by

government, allowing saving and deposit companies to make risky investment.

• Amending “glass steagall” act for merger of Citi and travellers group. (Preventing consumer deposit company to merge with investment banking activity)

• Borrowers went to banks for loan, they sold these loans to investment banks who then sold it by combining it and making CDO’s.

• These CDO’s were sold to investors to all over world.

• Rating agencies gave CDO’s AAA rating (even to subprime loans CDO)

• Banks/ lender didn’t worried about repayment so more riskier loans were given

• Investment banks didn’t worried too, more CDO’s they sold higher profits they earned.

• Since loans were given easily, prices of houses sky rocketed.

• Deregulation on leverage money. ROLE OF CDS:

• AIG sold CDS of these CDO’s, which was bought by speculators as naked CDO’s.

• Huge compensation paid to top executives out of profits, no reserves were made.

• Goldman and Morgan Stanley started buying CDS of CDO’s, they sold, they were betting against CDO’s Sold by them .

CRISIS• Now suddenly, default on loan rose; making

CDO’s worthless.• House property value fall due to rise in

foreclosure.• All the highly rated AAA CDO’s became

worthless.

Outcome of crisis

• Raised unemployment.• Banks became bankrupt, Lehman Brothers

closure.• Pension funds of various states vanished.• Collapse of AIG.• Huge loss to tax payer money.• Prices of houses plunged.

CONCLUSION

• Going into depth of any security is important specially of securities which has some derivative products otherwise results would be catastrophic.