CDO and CDS

SECURITIZATION AND FINANCIAL PRODUCTS

I am currently an apprentice software engineer at AXA INVESTMENT MANAGER, where I am required to manipulate data from investments in various financial products, particularly structured products: ABS, CDO, Regulatory Capital Transaction, Catastrophe Bond...

This paper is intended for students in engineering school/universities curious to know the products used on the credit market. We will focus on the study of ABS, CDO and CDS products.

INTRODUCTION

These products are based on securitization. Securitization is a financial practice that transforms outstanding receivables or loans held by a company or a bank into negotiable financial securities through a specialized financial company. These negotiable financial securities are offered to investors (such as AXA INVESTMENT MANAGER).

Why securitization?

Banks have become reluctant to retain the credit risk of their clients, securitization allows them to transfer the risk [of default on these loans] to an investor while keeping the loan in their balance sheet.

Essential definitions:

"BOND": A debt security in which the bond investor lends principal in return for a coupon payment + repayment of principal at a set date. The entity that issues a bond is the one that wants a loan.

To further familiarize ourselves, investing (i.e. buying) in a bond is like lending an amount of money against coupons + return of principal (the amount borrowed).

Conversely, issuing a bond is equivalent to borrowing a fixed amount involving repayment of the principal + payment of coupons.

MINTRODUCTIONBS "Mortgage Backed Securities": A security made up of a set of mortgage loans purchased from the banks that issued them and then sold to investors.

ABS "Asset Backed Securities": A security created from cash flow (inflows and outflows of cash) from financial assets such as loans, bonds, credit cards, home loans, auto loans.

AD-HOC company: A separate legal structure created specifically to manage a transaction or group of similar transactions on behalf of a company (in this case bank). The special purpose entity is organized in such a way that its activity is in fact carried out solely on behalf of that enterprise, by making assets available or providing goods, services or capital.

Study of the ABS financial product:

A portfolio of assets is sold by the issuer to the SPV, a special purpose vehicle, which transforms the portfolio into a principal amount (also called "notional value") of 100 million divided into tranches:

80 million to the senior tranche with a return of LIBOR + 60 bp
15 million to the mezzanine tranche with a return of LIBOR + 250 bp
5 million in the equity tranche with a return of LIBOR + 2000 bp

At first sight, we notice that the equity tranche seems the most interesting. In reality, this is not always the case because the allocation of the cash flows generated by the underlying loans within the tranches is based on a cascade principle :

The cash flows collected are first paid to the senior tranches until the promised profitability is reached, then the remaining cash flows go to the mezzanine tranches, similarly if the expected profitability is reached, the remaining cash flows go to the junior tranches and so on. Note that the cascade principle applies to the repayment of principal and payment of interest.

Conversely, losses on the principal of the portfolio are stored from the lower tranche to the upper tranche, i.e. from the Equity tranche to the Senior tranche. The Equity tranches are therefore the riskiest: if there are losses, they are the first to be affected. If the cumulative losses exceed the outstanding amount of the tranche, investors no longer receive any payments (neither interest nor principal repayments). New losses are backed by the next tranche in the order of subordination and so on.

Rating agencies such as FITCH, S&P, MOODY'S rate loans according to their risk. The rating of a debt reflects the probability of default by its issuer as well as the severity of loss to its holder.

Thus the tranches that group together loans :

Very low risk are rated AAA SENIOR TRANCHE
Low risk are rated BBB MEZZANINE TRANCHE
Very risky are rated B EQUITY TRANCHE

Study of the CDO financial product

In reality there are more than three tranches and the range of associated ratings can be much wider, here we simplify things for a better understanding of the functioning of ABS.

To compensate for the risk, the gains are much greater in the investment on the risky tranches (equity tranches) than on the low-risk tranches.

The investment can be done by single tranche, for example, I can decide to invest only in the equity tranches if I want to maximize my return on investment but take a high risk of never having a return or simply be in loss. For example, hedge funds, to achieve high returns, must invest in risky assets.

In addition, investors are easily found for the Senior tranche of an ABS created from loans and rated AAA and therefore very low risk. Also the Equity tranche, which is very risky, is usually held by the issuer or resold by a hedge fund. As long as the Mezzanine tranche is more technical to market, we will see how it is done in practice.

Therefore, financial engineers, in order to market these, create from the Mezzanine tranches a new ABS, thus an ABS of ABS, this new product is later called CDO "Collateralized Debt Obligation. Here below is an explanatory diagram.

The percentages are established as an example to analyze the CDO transaction and its impacts.

We note here that approximately 65% of the assets were at risk (present in the initial Mezzanine ABS tranche) and then, through the construction of the CDO, became risk-free (present in the senior ABS CDO tranche) in the market. Thus the initial loans are upgraded, the initial rating is updated by the creation of the CDO. A consequence of this effect is that it removes the transparency of the quality of the products.

Finally, CDOs can be differentiated according to the nature of the assets underlying them:

CBO "Collateralised Bond Obligations": A particular type of CDO where the underlying portfolio is composed of bonds.

CDO of CDOs: A particular type of CDO where the underlying portfolio is itself composed of CDO tranches.

CLO "Collateralised Loan Obligations": A particular type of CDO where the underlying portfolio is composed of bank loans.

CSO "Collateralised Synthetic Obligations": A particular type of CDO where the underlying portfolio is composed of credit derivatives

Study of the financial product CDS

The CDS is a bilateral financial contract by which a protection buyer periodically pays a premium in exchange for the protection seller's commitment to indemnify him in the event of a credit event on the entity referenced by the contract:

The CDS buyer acquires the right to sell an obligation (reference obligation) issued by the reference entity: the CDS buyer will transfer the original obligation (that between the bank and the reference entity) to the CDS seller and receives in return the nominal value of the obligation. Thus, the company will no longer owe a debt to the bank but to the CDS seller, while the CDS seller gives the principal to the bank.

The credit risk on the part of the reference entity may be due to :

Inability of the reference entity to meet the repayment at the due date.
Debt restructuring.
Bankruptcy of the reference entity.

Example of use:

A CDS can be used to hedge a position on a bond. Suppose an investor has purchased a 5-year bond with a coupon rate of 7% per annum on its face value and at the same time, in order to hedge, he has purchased a 5-year CDS. We assume that the spread of the CDS is equal to 200bp = 200*0.01%= 2% per year.

So we have two cases:

If there is no default on the bond, the investor will receive annually (7-2)% = 5%, plus the principal.
If the bond defaults at a time $T $ 5 years, the investor will receive annually until T 5\%, then at time T he can exchange his bond.

The opening questions:

Setting in situation which is going to put forward the questions which one could be brought to be asked.

We suppose that a bank wants to protect itself against the risk of default by the reference entity to which it has lent a sum of N. To protect itself, it will buy a CDS or invest in a CDS or create a CDS or enter into a CDS (there are several ways of saying the same idea). To evaluate this CDS, several parameters are taken into account