Cdos and the Sub-Prime Crisis

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FINC2012 – Essay

CDOs and the sub-prime crisis

Yuzhou Fang

SID: 310303885

Semester 2

2010

The protagonist of sub-prime crisis: CDOs

Synopsis
The most exciting developments in financial market in recent decades have been in credit derivatives market. This essay will focus on one prevalent credit derivatives: CDOs. By describing what CDO’s are and how they operate, the author try to reveal the charisma of CDOs and show why banks and financial institutions are enchanted by them, then readers will see how the overdeveloped CDOs led to the sub-prime crisis in the summer of 2007.

1. Introduction to CDOs
CDOs or collateralized debt obligations are a type of security back by a diversified pool of debt instruments. CDOs are split based on the different underlying credit risk of different components of the asset. (Jones and Peat, 2008) In itself it is a particularly popular kind of asset-backed securities that expanded tremendously in recent years before the sub-prime crisis. In 2006 global CDO issuance reached the peak, up to over 520 billion USD (Securities Industry and Financial Markets Association, 2010).

2. Participants of CDOs market and how it works
The creators of CDO, include banks and other financial institutions, found a special purpose vehicle or SPV to hold collateral and issue securities. The SPV attains packaged mortgages (MBSs) from a mortgage originator. SPV holds the mortgages, the only asset of it, on trust for bondholders. The credit risk of the underlying asset is split into several levels and then sold to bondholders in these different tranches. (Jones and Peat, 2008) Income generated by bonds is passed to bondholders of tranches by the SPV. The most senior tranche will first receive the promised return, then turn to the second most senior tranche, then to third most senior and so on. Senior and mezzanine tranches of the CDO are rated by major credit rating agencies such as Standard and Poor’s and Moody’s. Usually senior tranches are rated above A, and mezzanine tranches may receive ratings from B to BBB. More junior tranches are unrated and held by SPV as equity tranches.

Figure 1: a simplified CDO structure

(Hull, 2009)

Generally as tranches go more senior, the high credit rating it receive, the lower the expected return, the less likely to suffer a default. For example, the CDO in Figure 1 will first pay 5% return to investors in Tranche 3, if possible, residual cash inflow will pay investors in Tranches 2 at 10%, finally, remaining are used to provide Tranche 1 investors with a return up to 30%. But, when some underlying asset experience default losses, Tranche 1 investors will be the first to lose their return, followed by Tranche 2 investors and finally Tranche 3 investors. It is common to see some defaults result in principal loss in Tranche 1 and 2, and, if default is adequate high, Tranche 3 may lose its principal. In reality, few people want to hold mezzanine tranches. To overcome this problem, dealers repackage a number of mezzanine tranches from different securities into a new asset-backed security with similar tranches. Rating agencies are persuaded to rate these tranches from AAA to unrated. (Hull, 2009)

3. Advantages and disadvantages of CDOs as a type of derivatives As it is stated in Financial stability review (June 2002), credit derivatives like CDO are a number of markets for the transfer of credit risk. Development of these markets benefits financial stability since they allow the origination and funding of credit to be separated from the efficient allocation of the resulting credit risk. CDOs have created new investment opportunities that otherwise would not be available to investors as well as provided substantial diversification opportunities. Some low rated investors might not be qualified to buy underlying bond, some other investors that can buy the underlying bond would have to pay a high charge....
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