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Ec4024 2009 Lecture 16 CDOs


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A lecture on CDOs, CDS, and Ireland.

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Ec4024 2009 Lecture 16 CDOs

  1. 1. CDOS, CDS,THE SUBPRIME CRISIS AND IRELAND, 2007-2009 Dr Stephen Kinsella
  2. 2. LAST TIME Financial Fragility in Ireland Corporate Governance lacking, financial innovations disrupt normal running of markets.
  4. 4. MOVING L17-L18
  5. 5. TODAY CDO + CDS, Definitions & Examples. How do they relate to Ireland today?
  6. 6. Defini- Securitization… is the process of packaging (illiquid) liabilities and debt instruments, thus converting them tion into liquid tradable “asset-backed securities.”
  7. 7. BASIC STRUCTURE The bank The SPV sells a issues portfolio of bonds loans Special Purpose Investors Bank Vehicle (SPV) Payment for Proceeds loan from the portfolio issue
  8. 8. Central Bank policies (next week) Interest rate policies and regimes. Funding cost changes. Exchange Rate policies. Models, Pricing knowledge, fast and accurate calculation of ‘Greeks’, Hedging ability Leads to innovations in structured credit markets
  9. 9. What is a structured Credit asset ? Reasons for using structured assets Anatomy of a structured asset CLE CDO Examples -- Pricing and sensitivity
  10. 10. A structured asset is, at the end… an asset incorporating a derivative strategy. But this notion gets broader in Credit The notion of correlated events become central
  11. 11. Individual Credit Risk: Credit Exposures by tranches T R Super A Portfolio Senior N of N Credit C Exposures AAA H To Be I Mezzanines Covered N Equity G
  12. 12. A COLLATERALIZED DEBT OBLIGATION (CDO) IS A STRUCTURED PRODUCT WHERE A portfolio of securities is transferred to a SPV SPV issues tranches of notes with different seniority and there is also an equity stub The CDO tranches are rated based on portfolio credit quality, portfolio diversification, and subordination. Single tranche…bespoke CDO/CDO-squared
  13. 13. LIABILITIES ASSETS Reference Portfolio Super Senior +25 ABS – [83%] (3.32% each) +3 CDO Tranches – [17%] (5.6% each) ABS Bucket ♦RMBS [60.00%] Senior AAA ♦Credit Cards [12.00]% [2.48]% ♦? ABS [12.00]% ♦Consumer Credit [8.00]% ♦Auto Loans [4.00]% Junior AAA [0.99]% ♦Student Loans ABS [4.00]% CDO Bucket AA [1.03]% ♦Total number investment grade ♦Corporate Reference ? is 42% ♦100 names per CDO Equity [1.36]% ♦Portfolio average rating: A/BBB+ See
  14. 14. By reallocating the default probability CDO tranches can generate returns of 15-20% from very small default probabilities… But, more importantly… …they generate assets with different sensitivities to (default) correlation
  15. 15. Buy Equity tranche… …Sell Mezzanine tranche. The effects of default probability will cancel out. And the correlation effect can be isolated. This can be traded.
  16. 16. Innovation is essential to make money …and structured products are a major way of doing this.
  17. 17. CDS Credit default swap (CDS) market is a large and fast-growing market that allows investors to trade credit risk. Credit default swap (CDS) is a contract between two parties, where a protection buyer pays a premium to the protection seller in exchange for a payment if a credit event occurs to a reference entity. CDS are customizable, over-the-counter products and can be written to trigger in the event of bankruptcy, default, failure to pay, restructuring, or any other credit event of the reference entity.
  19. 19. NEXT TIME The European Central Bank & Investor Behaviour. Reading: Buiter, W: Why the United Kingdom Should Join the Eurozone.