[Vision2020] Collaterized Debt Obligations

[Jeff Harkins]

Collaterized Debt Obligations (CDO's) are not all that 
complicated.  However, once one is invested in a CDO, a whole host of 
options are available for managing the risks associated with the 
derivative.  I have appended an excellent paper that describes the 
general structure for CDO's and ways that one can effectively manage 
the risks and returns.

The paper is entitled "The Promise and Perils of Credit Derivatives" 
authored by Partnow and Skeel

Below is the abstract and here is the link to the full 
article:(http://lsr.nellco.org/cgi/viewcontent.cgi?article=1129&context=upenn/wps

Before you read the abstract, be sure to note that collateralized 
debt is secured by some form of property (land, building, 
leasehold).  That underlying value provides the basis for all 
subsequent derivative instruments.

Also, one must note that requiring the debtor to have an equity 
position in the collateral provides some credit risk protection for 
all holders of derivative instruments that are built from the 
original debt (usually a mortgage).

Fannie and Freddie probably created the debacle - they loaned money 
to home buyers for zero down - thus no initial equity, hence no room 
for ups and downs in the value of the collateral for the lender - and 
a spiral effect begins.

The article is excellent.

>Abstract
>In this Article, we begin what we believe will be a fruitful area of 
>scholarly inquiry:
>an in-depth analysis of credit derivatives. We survey the benefits and risks
>of credit derivatives, particularly as the use of these instruments 
>affect the role
>of banks and other creditors in corporate governance. We also hope to create a
>framework for a more general scholarly discussion of credit derivatives.
>We define credit derivatives as financial instruments whose payoffs are linked
>in some way to a change in credit quality of an issuer or issuers. 
>Our research
>suggests that there are two major categories of credit derivative. 
>First, a credit
>default swap is a private contract in which private parties bet on a 
>debt issuer's
>bankruptcy, default, or restructuring. For example, a bank that has loaned $10
>million to a company might enter into a $10 million credit default swap with a
>third party for hedging purposes. If the company defaults on its 
>debt, the bank
>will lose money on the loan, but make money on the swap; conversely, 
>if the company
>does not default, the bank will make a payment to the third party, reducing
>its profits on the loan.
>Second, a collateralized debt obligation (CDO) is a pool of debt 
>contracts housed
>within a special purpose entity (SPE) whose capital structure is 
>sliced and resold
>based on differences in credit quality. In a "cash flow" CDO, the 
>SPE purchases a
>portfolio of outstanding debt issued by a range of companies, and 
>finances its purchase
>by issuing its own financial instruments, including primarily debt but also
>equity. In a "synthetic" CDO, the SPE does not purchase actual 
>bonds, but instead
>enters into several credit default swaps with a third party, to 
>create synthetic exposure
>to the outstanding debt issued by a range of companies. The SPE finances its
>purchase by issuing financial instruments to investors, but these 
>instruments are
>backed by credit default swaps rather than any actual bonds.
>In the Article's first substantive part, we discuss the benefits 
>associated with both
>types of credit derivatives, which include increased opportunities 
>for hedging, increased
>liquidity, reduced transaction costs, and a deeper and potentially 
>more efficient
>market for trading credit risk. We then discuss the risks associated with
>credit derivatives, such as moral hazard and other incentive problems, limited
>disclosure, potential systemic risk, high transaction costs, and the 
>mispricing of
>credit. After considering the benefits and risks, we discuss some of 
>the implications
>of our findings, and make some preliminary recommendations. In particular,
>we focus on the issues of disclosure, regulatory licenses associated 
>with credit
>ratings, and the special treatment of derivatives in bankruptcy.


At 12:16 PM 9/23/2008, you wrote:
>I've heard CDOs -- the main sort of security that's the problem here
>-- described as "too complex for even Wall Street to understand." But,
>actually, after looking into it, it's not terrifically hard to
>understand *what* they are, though it's not so obvious *how they
>work*. Everybody's talking about them, so I thought I'd do two things
>(a) share my understanding of them, and (b) get beat by people
>better-informed than myself for being wrong.
>
>In order to construct a CDO, a bank starts with a number of mortgages,
>both prime and subprime. These mortgages are pooled together, a simple
>way to spread the risk out across the entire security. Next, the pool
>is split, with every share of the CDO representing a fraction of both
>prime and subprime mortgages.
>
>The pool is then sold in multiple forms: a highly rated bond, a less
>rated bond, and an unrated bond. If losses occur, they are assigned
>from the bottom up: the unrated bond takes losses first, then the less
>secure bond, and then finally the highly-rated bond. The existence of
>the low-rated bonds serves to buffer the highly-rated bond against
>potential dips in the housing market; they soak up the losses before
>they hit the highly rated bond.
>
>As the mortgage crisis progressed, the losses to CDOs slowly climbed
>the ladder. The unrated bonds ate tremendous losses as subprime
>mortgages began to default, then the low-rated bonds, and then the
>highly-rated bonds. Unlike mortgage-backed securities backed solely by
>prime mortgages, however, the highly-rated structured CDOs weren't
>entirely isolated from the subprime crisis: they were still
>collateralized out of a pool containing subprime mortgages. This sent
>the financial services sector into a frenzied game of musical chairs
>where no one wanted to be the last person to have CDOs on their
>balance sheet. Everyone wants to sell. No one wants to buy. Worse,
>since the subprime collateralization of the assets has collapsed, no
>one is sure how much of the asset underlying the securities (the
>mortgages comprising the pool) remains.
>
>Which means that those assets are utterly worthless until either (a)
>maturity or (b) until Wall Street establishes some plan for rationally
>valuing those assets.
>
>Because the Bernanke/Paulson plan proposes to purchase the CDOs at
>close to maturity value rather than by reverse auction, it represents
>a socialization of tremendous Wall Street losses. The reason that no
>one on Wall Street wants CDOs anymore is that much of the property
>collateralizing the securities is no longer attached to the CDO: the
>owners have defaulted. This reduces the underlying maturity value of
>the assets, especially if the government plans to purchase unrated
>bonds structured to absorb losses for the AAA-rated 'straw-into-gold'
>bonds.
>
>Does anyone actually want to defend this?
>
>-- ACS
>
>=======================================================
>  List services made available by First Step Internet,
>  serving the communities of the Palouse since 1994.
>                http://www.fsr.net
>           mailto:Vision2020 at moscow.com
>=======================================================