The document discusses collateralized debt obligations (CDOs). It defines CDOs as financial products that pool together cash-generating assets and repackage them into tranches of varying risk and return. The document outlines the history of CDOs, how they address issues like prepayment risk, and the parties involved like investment banks, CDO managers, and investors. It then discusses problems like undercollateralization that contributed to the 2008 housing crisis, when highly rated CDOs became worthless due to rising mortgage defaults.

1. PRESENTATION
ON CDO’s
By:
Manas Upadhyay

2. 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.

3. 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.”

4. 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.

6. 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.

7. 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 traditionally
2. Prepayment risk
3. Reinvestment risk as repayment of principal on
loans.
4. Default risk

8. 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.

9. 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.

10. 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.

11. 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

12. 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.

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

15. Well answer lies in Housing Crisis of
2008.
•Why comes the
question?

17. American Housing Crisis-
2008

18. 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

19. 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)

20. • 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.

22. • 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 .

23. 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.

24. 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.

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