Synthetic CDOs Workshop Capital Markets Credit Analysts Society

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Synthetic CDOs Workshop Capital Markets Credit Analysts Society

  1. 1. Synthetic CDOs Workshop Capital Markets Credit Analysts Society Georges Benoliel, March 6 2007
  2. 2. Disclaimer <ul><li>This communication is being made for informational purposes only and does not constitute an offer, or the solicitation of an offer, to buy or sell any securities, futures or other financial instruments or products, to participate in any transaction or trading strategy or to provide any investment banking or other services. No information contained herein should be used in connection with any such offer or solicitation. </li></ul><ul><li>All transactions in securities, futures, derivatives and options involve significant risks. Prior to making any investment or participating in any transaction, you should consult, to the extent necessary, your own independent legal, regulatory, accounting or tax advisors and other professional advisors to ensure that any investment or transaction is suitable for you in the light of your financial capacity and your specific investment and other objectives. Nothing contained herein is intended as specific investment advice and no person should make any investment decision based solely on any information contained in this communication. </li></ul><ul><li>This communication does not constitute legal, regulatory, accounting or tax advice. The products and services discussed herein may have tax, accounting or other consequences and, therefore, you should consult your tax, accounting and legal advisors in order to understand the tax, accounting and other consequences of any product or service mentioned. </li></ul><ul><li>This communication does not constitute a research report and was prepared by SGCIB personnel who are not employed by SG’s Research Department. SG may have material relationships with issuers or parties mentioned in this communication and may be seeking engagements from such issuers or other parties. </li></ul><ul><li>© 2006 Société Générale Group (“SG”), SG Americas Securities, LLC (“SGAS”) and their affiliates. All rights reserved. Société Générale Corporate & Investment Banking (SG CIB) is a marketing name for corporate and investment banking businesses of SG and its subsidiaries worldwide. Capital markets and investment banking activities and securities services in the United States are offered through SG Americas Securities, LLC, a broker-dealer registered with the U.S. Securities and Exchange Commission and member of the NYSE, NASD and SIPC. Securities products offered are not guaranteed or endorsed by SGAS, are not FDIC insured and may lose value. Lending, derivatives and other commercial banking activities are performed by Société Générale and its banking affiliates. </li></ul><ul><li>IRS CIRCULAR 230 NOTICE:SOCIÉTÉ GÉNÉRALE AND ITS AFFILIATES DO NOT PROVIDE TAX ADVICE. ACCORDINGLY, ANY DISCUSSION OF U.S. TAX MATTERS CONTAINED HEREIN IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, IN CONNECTION WITH THE PROMOTION, MARKETING OR RECOMMENDATION BY ANYONE UNAFFILIATED WITH SOCIÉTÉ GÉNÉRALE OF ANY OF THE MATTERS ADDRESSED HEREIN OR FOR THE PURPOSE OF AVOIDING U.S. TAX-RELATED PENALTIES. </li></ul>
  3. 3. Credit Default Swap (CDS) – Definition <ul><li>A Credit Default Swap is a contract whereby the protection buyer transfers the risk that the Reference Entity will default </li></ul><ul><li>In return for protection the buyer pays a fee (the CDS SPREAD ) to the protection seller </li></ul><ul><li>Upon occurrence of a credit event, the protection seller pays par for bonds or loans of the defaulted Reference Entity (the Physical settlement) … </li></ul><ul><ul><li>Protection buyer has to deliver a portfolio of obligations of the Reference Entity </li></ul></ul><ul><ul><li>Protection seller pays the nominal amount </li></ul></ul><ul><li>… or settle a net cash amount in case of Cash settlement </li></ul><ul><li>In case a Credit Event occurs the loss for the protection seller = 1- RECOVERY of the Ref Entity </li></ul>Reference Entity Protection Buyer Protection Seller Contingent Payment Upon Default Risk Spread
  4. 4. Cash CDO vs. Synthetic CDO <ul><li>SYNTHETIC CDO </li></ul><ul><li>Composed of credit default swaps (CDS) </li></ul><ul><li>Underlying assets not actually owned: “synthetic” exposure </li></ul><ul><li>Receives periodic Spreads as a CDS protection seller </li></ul><ul><li>Spreads received are used to pay the tranche coupons </li></ul><ul><li>Not all tranches need to be issued since the underlying assets are not purchased </li></ul><ul><li>CASH CDO </li></ul><ul><li>Composed of Bonds or Loans </li></ul><ul><li>Underlying pool of assets are purchased </li></ul><ul><li>Takes directly the credit risk of the underlying asset </li></ul><ul><li>Receive periodic coupons from Bonds or Loans </li></ul><ul><li>Coupons received are then used to pay the tranche coupons </li></ul><ul><li>The whole capital structure must be issued in order to raise funds to purchase the underlying assets </li></ul><ul><li>No conflict of interest between the equity holders and the other investors </li></ul><ul><li>More liquid for each pricing parameter has a bid/offer </li></ul>
  5. 5. First Came the Static “Fully Tranched” Synthetic CDOs… (2000/2001) <ul><li>Product developed in 2000/2001 </li></ul><ul><ul><li>Backed by the strong development of the CDS market </li></ul></ul><ul><li>Benefits: </li></ul><ul><ul><li>Bullet maturity </li></ul></ul><ul><ul><li>Currency (EUR/USD) </li></ul></ul><ul><ul><li>Simplicity </li></ul></ul><ul><ul><li>Well known collateral (investment grade, blue chips) </li></ul></ul><ul><ul><li>Attractive returns for the mezzanine holders </li></ul></ul><ul><li>Drawbacks: </li></ul><ul><ul><li>Distribution of the first loss (size limitation) </li></ul></ul><ul><ul><li>Static portfolios </li></ul></ul><ul><ul><li>Mostly driven by “rating arbitrage” </li></ul></ul>“ Rating arbitrage”: Rating agencies models rely mostly on historical default rates (derived from the rating of the credit), historical recovery rates (derived from the country) and correlation (derived from the industry) Hence banks were incited to select entities that were trading with a high risk premium (e.g. Philip Morris because of tobacco litigation risks) or with recent financial news that were not yet incorporated in the then rating of the company Consequences: migration risk , overlap between different transactions Credit Portfolio Senior 92% Equity 1.4% Rated Mezzanine 6.6% Tranching/Pricing CDS #1 CDS #2 CDS #3 … … CDS #119 CDS #120 Sources: Creditflux, S&P, Bloomberg Illustration: “Repon 15”, March 2001
  6. 6. … then Came the “Fully Tranched” Managed Synthetic CDOs… <ul><li>Initially derived from balance sheet transaction… </li></ul><ul><ul><li>Loans were replaced by CDS, originating bank was retaining the equity tranche </li></ul></ul><ul><ul><li>Very light management, significant conflict of interests </li></ul></ul><ul><li>… then structured in a way much closer to a traditional cash flow CBO </li></ul><ul><ul><li>Structure closer to traditional cash flow CDO </li></ul></ul>
  7. 7. … and the Revolution of the “Single Tranche” Synthetic CDOs <ul><li>The development of credit risk modeling … </li></ul><ul><ul><li>Banks were often left with unsold pieces of fully tranches static transactions , and hence needed to hedge such exposures </li></ul></ul><ul><ul><li>In the meantime, models were developed in order to manage the first to default transactions (first generation of correlation products) </li></ul></ul><ul><ul><li>Natural extension towards portfolio products </li></ul></ul><ul><li>… resulted in the emergence of a new product… </li></ul><ul><ul><li>Thanks to the delta hedging technology , banks were able to offer “ single tranche” CDO </li></ul></ul><ul><ul><li>Static portfolios of liquid CDS, equity and super senior retained by the bank </li></ul></ul><ul><li>… and the birth of a new market (Correlation products)… </li></ul><ul><ul><li>Relevant pricing of the mezzanine tranche </li></ul></ul><ul><ul><li>Development of correlation trading desks </li></ul></ul><ul><ul><li>Investors learning curve </li></ul></ul><ul><li>… and a large range of correlation products </li></ul><ul><ul><li>Capital guaranteed + Equity Tranche coupons, Combo Note, Funding support, … </li></ul></ul>
  8. 8. Single Tranche CDO: Definitions & Characteristics <ul><li>Key Definitions </li></ul><ul><ul><li>SUBORDINATION = ATTACHMENT POINT </li></ul></ul><ul><ul><li>TRANCHE SIZE </li></ul></ul><ul><ul><li>DETACHMENT POINT = SUBORDINATION + TRANCHE SIZE </li></ul></ul><ul><li>Mechanisms </li></ul><ul><ul><li>Losses are observed through a Cash Settlement mechanism ( Floating or Fixed Recovery) </li></ul></ul><ul><ul><li>Tranche is unaffected as long as credit losses do not exceed the Subordination </li></ul></ul>Senior Equity Rated Mezzanine Tranching/Pricing SG Investor Packaging Credit Default Swap X bps Cash Settlements <ul><li>Key CDS parameters: </li></ul><ul><ul><li>SPREAD </li></ul></ul><ul><ul><li>RECOVERY </li></ul></ul><ul><ul><li>CREDIT EXPOSURE </li></ul></ul>SUBORDINATION DETACHMENT POINT TRANCHE SIZE -> LEVERAGE Credit Portfolio CDS #1 CDS #2 CDS #3 … … CDS #99 CDS #100
  9. 9. Synthetic Tranche – Numerical example <ul><li>Portfolio : 100 Reference Entities equally weighted ( 1% per name ) </li></ul><ul><li>Tranche characteristics: </li></ul><ul><ul><li>6% Subordination, 2% Tranche Size </li></ul></ul><ul><li>Economics: </li></ul><ul><ul><li>One Credit Event => Loss = weight of the name * (1- Recovery) </li></ul></ul><ul><ul><li>Recovery = Final Price = highest bid resulting from request to 5 dealers </li></ul></ul><ul><ul><li>Assuming R = 50% for each defaulted Reference Entity: 1 Loss = 1% x 50% = 0.5% </li></ul></ul><ul><ul><ul><li>The tranche can sustain 12 defaults (= Subordination / 1 Loss = 6% / 0.5% = 12) </li></ul></ul></ul><ul><ul><ul><li>The initial Nominal represents 4 defaults (= Tranche Size / 1 Loss = 2%/0.5% = 4) </li></ul></ul></ul><ul><ul><ul><ul><li>For each subsequent default from the 13 th to the 16 th the Initial Nominal will be reduced by 25% </li></ul></ul></ul></ul><ul><ul><ul><ul><li>=> LEVERAGED investment </li></ul></ul></ul></ul><ul><ul><ul><li>If 16 defaults occur the tranche will not reimburse anything </li></ul></ul></ul><ul><li>Flows in case of a Credit Linked Notes: </li></ul><ul><ul><li>Coupons are paid on the remaining nominal of the tranche during the life of the transaction </li></ul></ul><ul><ul><li>The R edemption price at maturity = the remaining nominal of the tranche </li></ul></ul><ul><ul><ul><li>= Tranche Size – Losses on the Tranche </li></ul></ul></ul><ul><ul><ul><li>= Tranche Size – min (max (Total losses in the portfolio – Subordination, 0) ; Tranche Size ) </li></ul></ul></ul>
  10. 10. Synthetic Single Tranche: a Tailor-Made Product <ul><li>Customized portfolios: different asset-classes: IG, HY, ABS, CDO </li></ul><ul><ul><li>The investor has a full flexibility and can rely on its own experience to select names, sectors and region exposures (not driven by banks balance sheet or equity investors) </li></ul></ul><ul><li>Static, Self managed (i.e. Substitutions by investor) or Managed </li></ul><ul><ul><li>If Managed: light or dynamic management </li></ul></ul><ul><li>Subordination level </li></ul><ul><li>Size of the tranche </li></ul><ul><li>Target rating </li></ul><ul><li>Coupon: Floating/Fixed, CMDS, CMS, Range Accrual, Zero-Coupon </li></ul><ul><li>Maturity </li></ul><ul><li>Currency </li></ul><ul><li>Recovery: Floating (determined upon default) or Fixed (known at inception) </li></ul><ul><li>Losses (if any) settled when Credit Event occurs or at Maturity </li></ul><ul><li>Format: Swap or Note (listed or not) </li></ul><ul><li>Liquidity (just need to unwind the hedge) </li></ul><ul><li>Risk return profile : i.e. rating/spread choice </li></ul><ul><ul><li>leverage of the structure customized </li></ul></ul>
  11. 11. Pricing & Sensitivities
  12. 12. Synthetic Tranche: main Pricing parameters <ul><li>Recovery Rates </li></ul><ul><ul><li>Assumptions derived from historical rates, industry specificities or balance sheet analysis </li></ul></ul><ul><ul><li>For very risky names Recovery can be observed in the CDS market (upfront quotes) </li></ul></ul><ul><ul><li>Emergence of “Recovery swap” </li></ul></ul><ul><ul><li>Tranche sensitivity to this parameter is relatively low </li></ul></ul><ul><li>Default Probability </li></ul><ul><ul><li>Derived from market spreads (and not from historical default rates) </li></ul></ul><ul><ul><li>Can be deducted from the whole credit curve </li></ul></ul><ul><li>Default Time Correlation : a Fundamental Pricing Parameter </li></ul><ul><ul><li>i.e. the likelihood of multiple credits to default together over a given period of time </li></ul></ul>Asset CDS Portfolio Senior Liabilities Equity Mezzanine K2 K1 Attachment points, or strikes
  13. 13. Systemic risk and Idiosyncratic risk <ul><li>Study of default exposure and spread sensitivity </li></ul><ul><ul><li>“ Relative” spread risk of equity tranches is low </li></ul></ul><ul><ul><li>Mezzanine/senior are more exposed to systemic risk (general widening of spreads) </li></ul></ul><ul><ul><li>Equity is more exposed to idiosyncratic risk (individual widening/default) </li></ul></ul><ul><ul><li>Correlation market is hence exhibiting the distribution of value between these two factors </li></ul></ul>Senior AAA Mezzanine BBB Equity NR Default Exposure Spread Sensitivity
  14. 14. Correlation and CDO Spreads (I) <ul><li>The relationship between a CDO spread and correlation depends on the subordination of the CDO tranche: </li></ul>Equity Spread Tightens when Correlation Increases Senior Spread Widens when Correlation Increases Equity [0%,3%] Strikes = [0%, 3%]. Average spread = 43bp, maturity = 5yr Source: SG Credit Research Strikes = [12%, 22%]. Average spread = 43bp, maturity = 5yr Source: SG Credit Research Idiosyncratic Risk Correlation up => “All or nothing” => Probability nothing happens increases Systemic Risk Correlation up => Risk higher for Senior 0 200 400 600 800 1000 1200 1400 0% 25% 50% 75% Correlation Tranche Spread 0 20 40 60 80 100 0% 25% 50% 75% Correlation Tranche Spread Senior [12%,22%]
  15. 15. Correlation and CDO Spreads (II) <ul><li>Mezzanine tranches offer a remarkable feature: </li></ul><ul><ul><li>For a given tranche, it is possible to exhibit one correlation so that the tranche is not sensitive to a change in correlation… </li></ul></ul><ul><ul><li>… this optimal correlation maximizes the spread of the mezzanine tranche </li></ul></ul>Tranche Spread Mezzanine [3%,6%] Optimum Spread Correlation Considered 0 50 100 150 200 250 300 350 0% 25% 50% 75% Correlation
  16. 16. Correlation Sensitivity <ul><li>When correlation increases, the risk of an equity tranche decreases: long equity tranche investments are long correlation positions (correlation up, MtM up). </li></ul><ul><li>Mezzanine tranches are close to a correlation-free level. </li></ul><ul><li>A long senior position is short correlation (correlation up, MtM down). </li></ul><ul><li>Correlation sensitivity (“Rho”): </li></ul>-0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 3% 9% 15% 21% 27% 33% 39% 45% Upper Attachment Point Rho Equity Tranche Mezzanine Tranches Senior Tranches
  17. 17. Other Risks Managed by the CDO Arranger <ul><li>The dynamic delta hedging is a risk-free position only for a small spread variation </li></ul><ul><ul><li>For larger movements SG’s position is still at risk: this second order risk is the spread convexity risk </li></ul></ul><ul><ul><li>The convexity risk is measured by the change in delta corresponding to the shift in CDS spread </li></ul></ul><ul><li>Other second order risks are to be managed by the arranger: </li></ul><ul><ul><li>Correlation sensitivity </li></ul></ul><ul><ul><li>Recovery Rate sensitivity </li></ul></ul><ul><ul><li>Risk of a sudden default </li></ul></ul><ul><ul><li>Time decay </li></ul></ul><ul><li>In order to reduce these risks SG can: </li></ul><ul><ul><li>Enter into offsetting trades on tranches with similar characteristics </li></ul></ul><ul><ul><li>Place other single tranches on the underlying credit portfolio that complete the capital structure of the whole CDO </li></ul></ul><ul><li>In practice SG aggregates all tranches into a “correlation trading book” and manages the overall sensitivities of the book to all parameters </li></ul>
  18. 18. Hedging Spread Risk (I) <ul><li>The main risk (the first order risk) SG has to manage is the spread risk . Hedging is done by selling protection on every name of the portfolio via the CDS market </li></ul><ul><li>The amount of CDS to be sold on each name is called the delta (  ) </li></ul><ul><li>The objective is to neutralize SG marked-to-market </li></ul>Investor Tranche Spread Tranche Losses  1 × CDS 1  2 × CDS 2  n × CDS n Hedge on CDS 1 Hedge on CDS 2 Hedge on CDS n
  19. 19. Hedging Spread Risk (II) <ul><li>The delta on one name, for a given shift in the credit spread of that name, is the ratio of the sensitivity of the CDO tranche to the sensitivity of that name’s CDS: </li></ul><ul><li>The credit spread curve is shifted by a small amount, usually between 1 bp and 10 bps </li></ul><ul><li>The delta value ranges between 0% and 100% </li></ul><ul><li>The direction and magnitude of deltas depend on several factors: subordination of the tranche, CDS spread curve, correlation and time to maturity </li></ul><ul><li>As credit spreads move during the life of the tranche, SG has to adjust the deltas dynamically in order to get a risk free position: the gamma hedging </li></ul><ul><li>However there are limits to dynamic hedging: </li></ul><ul><ul><li>The bid/offer cost on each rebalancing </li></ul></ul><ul><ul><li>The delta amount does not exactly correspond to the size of the traded CDS contract </li></ul></ul><ul><ul><li>The CDS contract in not liquid and the rebalancing in itself changes the price </li></ul></ul>
  20. 20. Sensitivity to Individual CDS Spread <ul><li>A credit whose spread widens is expected to default earlier and is more likely to hit the equity tranche </li></ul><ul><ul><li>Therefore, the delta of the equity tranche increases, while the senior tranche delta decreases </li></ul></ul><ul><ul><li>This is one of the senior tranches most remarkable features : their hedging requires selling less protection on the riskiest issuers, and more on the safest ones </li></ul></ul>0% 5% 10% 15% 20% 25% 30% 35% 25 30 35 40 45 Individual Credit Spread Delta Equity[0%,3%] Mezzanine [3%,6%] Super Senior [32%,100%]
  21. 21. Average CDS Spread Impact <ul><li>The higher the average spread of the basket, the greater the premium on the Tranche: </li></ul>Sensitivity to the Average Spread of the Basket 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 0.50% 1.00% 1.50% 2.00% 2.50% Average Spread Tranche Spread Tranche Spread (8%-13%) Tranche Spread (3%-8%)
  22. 22. Pricing Sensitivity – Illustration <ul><li>Considered Portfolio: </li></ul><ul><ul><li>iTraxx Index, 125 Refence Entities, 5yr, 100% European </li></ul></ul><ul><ul><li>Average Spread: 37bps </li></ul></ul><ul><ul><li>Tranche 3.00-6-00 pays ~ 87bps </li></ul></ul><ul><li>Subordination </li></ul><ul><ul><li>Lower Subordination > Higher Spread </li></ul></ul><ul><ul><li>2.50-5.50 tranche pays ~ 141bps </li></ul></ul><ul><li>Tranche Size </li></ul><ul><ul><li>Lower Tranche Size > Higher Spread </li></ul></ul><ul><ul><li>3.00-4.50 tranche pays ~ 127bps </li></ul></ul><ul><li>Portfolio Spread </li></ul><ul><ul><li>Higher Average Spread > Higher Spread </li></ul></ul><ul><ul><li>3.00-6.00 tranche with 42bps of average portfolio spread pays ~ 112bps </li></ul></ul><ul><ul><li>Leverage of about 6x (= (112 – 87)/(42-37)) </li></ul></ul>
  23. 23. Delta Hedging & Leverage <ul><li>Hedge ratio is higher than the tranche nominal… </li></ul><ul><ul><li>Example: the 3%-6% Itraxx tranche (size = 3%) requires a total hedge of 15% of the underlying portfolio </li></ul></ul><ul><ul><li>Hence if the average spread of the portfolio moves by 0.01%, the spread of the tranche will move by: 0.01% × 15%/3% = 0.01% × 5 =0.05% </li></ul></ul><ul><li>...Concept of “leverage ratio” </li></ul><ul><ul><li>In the 3%-6% example the leverage is ~ 5 </li></ul></ul><ul><li>Behaviour of Leverage </li></ul><ul><ul><li>Leverage is decreasing with subordination (like for an “in the money” option compared to an “out of the money” option) </li></ul></ul><ul><ul><li>Leverage is decreasing with the Size of the tranche </li></ul></ul><ul><ul><li>Leverage is decreasing over time for Senior tranches </li></ul></ul>

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