Rating Structured Financial Products

cdo2

From Investopedia:

What is a ‘Collateralized Debt Obligation – CDO’

“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. A collateralized debt obligation (CDO) is so-called because the pooled assets – such as mortgages, bonds and loans – are essentially debt obligations that serve as collateral for the CDO. The tranches in a CDO vary substantially in their risk profile. The senior tranches are relatively safer because they have first priority on the collateral in the event of default. As a result, the senior tranches of a CDO generally have a higher credit rating and offer lower coupon rates than the junior tranches, which offer higher coupon rates to compensate for their higher default risk.

BREAKING DOWN ‘Collateralized Debt Obligation – CDO’

As many as five parties are involved in constructing CDOs:

  • Securities firms, who approve the selection of collateral, structure the notes into tranches and sell them to investors;
  • CDO managers, who select the collateral and often manage the CDO portfolios;
  • Rating agencies, who assess the CDOs and assign them credit ratings;
  • Financial guarantors, who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments; and
  • Investors such as pension funds and hedge funds.The earliest CDOs were constructed by Drexel Burnham Lambert – the home of former “junk bond king” Michael Milken – in 1987 by assembling portfolios of junk bonds issued by different companies. Securities firms subsequently launched CDOs for a number of other assets with predictable income streams, such as automobile loans, student loans, credit card receivables and even aircraft leases. However, CDOs remained a niche product until 2003-04, when the U.S. housing boom led the parties involved in CDO issuance to turn their attention to non-prime mortgage-backed securities as a new source of collateral for CDOs.CDOs subsequently exploded in popularity, with CDO sales rising almost 10-fold from $30 billion in 2003 to $225 billion in 2006. But their subsequent implosion, triggered by the U.S. housing correction, saw CDOs become one of the worst-performing instruments in the broad market meltdown of 2007-09. The bursting of the CDO bubble inflicted losses running into hundreds of billions on some of the biggest financial institutions, resulting in them either going bankrupt or being bailed out through government intervention, and contributing to escalation of the global financial crisis during this period.”

The scheme below illustrates the mechanism:

CDO_-_FCIC_and_IMF_Diagram

In essence, a CDO is composed of the following tranches: Senior AAA (sometimes known as “super senior”); Junior AAA; AA; A; BBB; Residual. A simple representation of the structure of a CDO is illustrated below.

CDO_OK

In this case, the complexity and resilience footprint of the Senior AAA and Junior AAA tranches is evidently very high. In essence, the impact of the ‘junk’ part of the CDO on the complexity and resilience of the whole is negligible. Things look quite different in the case below, where the ‘junk’ part dominates.

CDO_KO

By the way, the above maps change with time as does the value of the underlying collateral. The changes in the structure reflect the overall dynamics of the markets and, ultimately, of the global economy.

When a tranche has a high complexity footprint what it means in practice is this:

  • The dynamics of that particular tranche drives the dynamics of the CDO
  • The overall rating of the CDO is dominated by that of the tranche with the highest footprint.
  • Any properties of that particular tranche, such as volatility or fragility, will spillover into the remainder of the tranches, rendering the CDO similar in character. This is true particularly in cases in which the corresponding Complexity Map of the CDO is dense (i.e. has many interdependencies between the branches).

It is OK to assign AAA ratings to genuinely triple-A tranches but how long does a AAA remain AAA? Clearly, in virtue of the turbulence of the economy nothing stays the same. Think of the value of post-Brexit real-estate in the UK, or the impact of scandals and law suits on the value and stocks of companies and banks.

A second issue is that of frequency. With what frequency are CDOs rated? We can rate them in real-time. This may not be easy for certain asset classes but it is also evident that complex and dynamic products do not have a ‘static rating’. In order to capture their true dynamics, one should focus on the rating gradients (rating trends) not static ratings. How can there be anything static in a rapidly changing dynamic world? Basically, in order to be of significance and value, a rating should not be static – we need to transition to a dynamic rating concept.

 

In September 2007 Princeton economist Alan Blinder wrote:
…. the C.D.O.’s, for collateralized debt obligations, were probably too complex for anyone’s good…. Investors placed too much faith in the rating agencies — which, to put it mildly, failed to get it right. It is tempting to take the rating agencies out for a public whipping. But it is more constructive to ask how the rating system might be improved. That’s a tough question because of another serious incentive problem. Under the current system, the rating agencies are hired and paid by the issuers of the very securities they rate — which creates an obvious potential conflict of interest. If I proposed that students pay me directly for grading their work, my dean would be outraged. Yet that’s exactly how securities are rated.
And just how complex are CDOs? If you want to find out, write to us. We measure complexity.

By the way, have you ever actually seen the structure of a structured product?

 

 

 

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