27.1.1 Credit-Related Motivations for CDOs

The CDO structure was born in the late 1980s. One of the first major uses of the structure was to place a portfolio of high-yield (i.e., speculative or non-investment-grade) bonds into a CDO structure to serve as its collateral and to issue securities (tranches) against that collateral. The portfolio of non-investment-grade bonds inside the CDO offers diversification benefits, and the remaining risks can be partially reduced through credit enhancements, which are discussed later. The risks of the portfolio are then distributed to various tranches. The tranches vary in the degree to which they bear credit risk, from junior tranches that bear the brunt of the risk to senior tranches that bear risk only from the most extreme levels of losses.

The key to the use of the CDO structure in the case of credit risk is that a large portion of the financing of the CDO (i.e., the security tranches) can be in the form of senior tranches, which contain relatively little credit risk compared to the CDO's underlying collateral portfolio. Thus, a large portion of a capital structure financing high-yield debt (or other credit-risky assets) can be rated as investment grade by the rating agencies. Many institutions, such as insurance companies and banks, are restricted from directly holding non-investment-grade debt. The use of CDO structuring can transform undesirable securities (high-yield debt) into desirable securities (highly rated senior tranches).

The high credit ratings given to senior tranches when the underlying collateral pool consists of non-investment-grade bonds are based on three primary justifications: (1) the senior position; (2) the diversification inherent in the collateral portfolio; and (3) credit enhancements that were structured into the deal, such as a major bank providing additional safety features.

Exhibit 27.1 adds to the list of two economic motivations for structured products begun in Exhibit 25.4 of Chapter 25. The first two additional economic motivations in Exhibit 27.1, #3 and #4, relate to the CDO structuring of non-investment-grade debt just discussed. CDOs provide diversified investment opportunities to investors by assembling highly diversified collateral pools. Further, the CDOs allow financial institutions restricted from substantial investments in high-yield debt to obtain indirect exposure without violating regulations. Strong arguments can be made that using CDOs to circumvent regulations on high-yield debt offerings does not interfere with the goals of the regulations. It is reasonable to believe that financial institutions investing in a senior position of a CDO holding a highly diversified and credit-enhanced portfolio of high-yield debt are taking less risk than are financial institutions that concentrate their portfolios in the investment-grade bond market. In other words, in this situation, the regulations interfere with diversification, and CDO structuring enables institutions to achieve the benefits of better diversification.

Originally, these deals focused on bonds and were called collateralized bond obligations (CBOs). Following on the heels of CBOs, banks began to realize that they had assets on their balance sheets (e.g., leveraged loans) that could be repackaged into a collateral pool and sold to investors. Hence, collateralized loan obligations (CLOs) were born in the early 1990s. From these two streams of asset-backed securities, CDOs were born. A CDO can be a security that is backed by a portfolio of bonds and loans together. However, the term CDO is often used broadly to refer to any CLO or CBO structure. CDOs are usually designed to repackage and transfer risk, typically credit risk. But CDOs can also be used to transfer the uncertainty of insured mortgages with regard to the timing and size of prepayments. Often, CDOs of mortgages are called collateralized mortgage obligations (CMOs).

27.1.2 General Structure of CDOs

In most CDOs, there is a three-period life cycle. First, there is the ramp-up period, during which the CDO trust issues securities (tranches) and uses the proceeds from the CDO note sale to acquire the initial collateral pool (the assets). The CDO's trust documents govern what type of assets may be purchased. The second phase is normally called the revolving period, during which the manager of the CDO trust may actively manage the collateral pool for the CDO, potentially buying and selling securities and reinvesting the excess cash flows received from the CDO collateral pool. The last phase is the amortization period. During the amortization period, the manager of the CDO stops reinvesting excess cash flows and begins to wind down the CDO by repaying the CDO's debt securities. As the CDO collateral matures, the manager uses these proceeds to redeem the CDO's outstanding notes.

A major bank usually serves as the sponsor for the trust. The sponsor of the trust establishes the trust and bears the associated administrative and legal costs. At the center of every CDO structure is a special purpose vehicle. A special purpose vehicle (SPV) is a legal entity at the heart of a CDO structure that is established to accomplish a specific transaction, such as holding the collateral portfolio. Usually, an SPV is set up as either a Delaware or a Massachusetts business trust or as a special purpose corporation (SPC), typically Delaware based. The SPV owns the collateral placed in the trust, and issues notes and equity (tranches) against the collateral it owns.

SPVs are often referred to as being bankruptcy remote. Bankruptcy remote means that if the sponsoring bank or money manager goes bankrupt, the CDO trust is not affected. In other words, the trust assets remain secure from any financial difficulties suffered by the sponsoring entity so that investors in the CDO tranches have a direct claim on the collateral. In structured products and elsewhere, investments that are bankruptcy remote provide enhanced liquidity by lowering the probability that an investment will become tied up in a bankruptcy process.

Each tranche of a CDO structure may have its own credit rating. Typically, most of the tranches of notes issued by the CDO receive an investment-grade rating by a nationally recognized statistical rating organization (NRSRO), with the exception of highly subordinated fixed-income tranches or the equity tranche. The equity tranche is the first-loss tranche. It is the last tranche to receive any cash flows from the CDO collateral and the first tranche on the hook for any defaults or lost value of the CDO collateral. Often, the issuer of the trust holds the equity tranche.

27.1.3 Terminology and Details of CDOs

The underlying portfolio or pool of assets (and/or derivatives) held in the SPV within the CDO structure is also known as the collateral or reference portfolio. Every CDO active manager must balance risk and return. The risk and return of credit-risky collateral assets is often described using three major terms: weighted average rating factor, weighted average spread, and diversity score.

Risk is typically measured with the weighted average rating factor of the underlying collateral pool and its diversity score. The weighted average rating factor measures the average credit rating of the underlying collateral contained in the CDO trust. Return is typically measured as the weighted average return spread over LIBOR.

The weighted average rating factor (WARF), as described by Moody's Investors Service, is a numerical scale ranging from 1 (for AAA-rated credit risks) to 10,000 (for the worst credit risks) that reflects the estimated probability of default. The rating factor increases nonlinearly, with small numerical differences between the higher ratings and large numerical differences between the lower ratings. The WARF of a portfolio is an average of those numbers across the securities weighted by market values. The CDO indentures contain covenants as to the average rating factor of the collateral pool.

A diversity score is a numerical estimation of the extent to which a portfolio is diversified. Portfolios of 100 securities can have substantially different levels of diversification, depending on the extent to which the securities are correlated. The diversity score is designed to indicate the number of uncorrelated securities in a hypothetical portfolio that would have the same probabilities of losses as the portfolio for which the diversity score is being computed. For example, if all 100 of the securities in a portfolio were perfectly correlated, the portfolio would behave as if it contained only one large position in one security and would have a diversity score of 1. If all 100 of the securities were uncorrelated, the diversity score would be 100. Values between these two extremes are computed using estimates of correlations.

The CDO indentures often have a weighted average spread over LIBOR that they are required to maintain. The weighted average spread (WAS) of a portfolio is a weighted average of the return spreads of the portfolio's securities in which the weights are based on market values. The spread of each security is computed as the excess of the security's yield over a specified reference rate, such as LIBOR, with a specified maturity. Historically, there is a very strong positive relationship between rating factors and credit spreads. An active manager of a CDO can increase the WARF to get more yield (WAS). Conversely, the manager may increase the creditworthiness of the CDO collateral pool (lower the level of WARF), but only at the expense of yield (a lower WAS).

The tranche width is the percentage of the CDO's capital structure that is attributable to a particular tranche. Chapter 25 discussed attachment and detachment points. The tranche width is a positive percentage that is computed as the distance between those two points. Thus, a 10%/25% tranche would have a tranche width of 15% (i.e., 25% – 10%). The process of structuring a CDO typically involves altering the risk of the structure's assets and the widths of various tranches in an attempt to earn credit ratings for the more senior tranches that allow those tranches to be sold to investors at attractive financing rates.

27.4.1 Cash-Funded CDOs and Regulatory Capital

A cash-funded CDO involves the actual purchase of the portfolio of securities serving as the collateral for the trust and to be held in the trust. In other words, physical ownership of the assets is acquired by the CDO. As is discussed in the next section, an analogous result can be obtained through derivatives in the case of a synthetic CDO. However, one advantage of a cash-funded CDO to a bank is that it can be used to completely replace risky assets with cash on the bank's balance sheet, rather than synthetically removing only the risk through derivatives.

There are several potential advantages to the financial institution in divesting risky assets using a cash-funded balance sheet CDO. Banks are required by regulators to maintain a particular level of capital, depending on the risk of their assets. Higher-risk assets require higher quantities of regulatory capital. Banks maintain regulatory capital by obtaining financing through common stock and other sources of financing that are considered to be more expensive than sources of capital that do not serve as regulatory capital, such as deposits. Reducing risk-based/regulatory capital is the most important motivation for a bank to form a CDO trust. Most major banks are required to maintain risk-based capital, such as 8% of the outstanding balance of commercial loans. Using a CDO trust to securitize and sell a portfolio of commercial loans can free up regulatory capital that must be committed to support the loan portfolio.

Sometimes the equity tranche of the CDO trust is unappealing to outside investors and cannot be sold. In this circumstance, the sponsoring bank may have to retain an equity or first-loss position in the CDO trust. If this is the case, the regulatory capital standards require the bank to maintain risk-based capital equal to its first-loss position. Thus, the bank needs to maintain $1 in regulatory capital for each $1 of ownership in an equity tranche.

There are numerous economic motivations to banks for issuing cash-funded balance sheet CDOs. By selling existing loans into a CDO trust, a lending institution receives cash proceeds from the sale of its loans to the CDO trust that can be used to originate additional commercial loans or to strengthen its balance sheet. With its cash in hand, the bank can reduce its overall balance sheet by paying down its liabilities. Additionally, the selling bank may be able to reduce its credit exposure to one industry or group of borrowers if the bank deems that its exposures are too high. The bank can preserve relations with a particular client by lending to a higher credit exposure than it would otherwise wish in order to maintain its relationship with its borrower, and then reduce its exposure through divesting some of the loans into a CDO.

27.4.2 Mechanics of Synthetic CDOs

In a synthetic CDO, the CDO obtains risk exposure for the collateral pool through the use of a credit derivative, such as a total return swap or a CDS. Physical ownership of the underlying basket of securities is not transferred to the CDO, only the economic exposure. In effect, the CDO trust sells credit protection on a referenced basket of assets. For this protection and in the case of a CDS, the CDO receives income in the form of CDS payments from the credit protection buyer. The credit protection payments are then divided up among the CDO's investors into tranches, based on the seniority of the securities issued by the CDO.

In most cases, the CDO trust collects cash from the sale of the tranche securities and earns interest by investing the cash in low-risk collateral. Typically, the CDO invests the proceeds from issuing tranches in assets such as Treasury securities. The interest from the collateral combines with the CDS payments from the credit protection buyer to form a total return that should approximate the total return that would be received from physical ownership of the reference assets.

Synthetic CDOs are not limited to balance sheet CDOs. Synthetic arbitrage CDOs use derivatives to obtain desired risk exposure to reference assets similar to the exposure that could be attained through the cash purchase of the reference assets and avoid the need for any change in the legal ownership of the assets. Most synthetic balance sheet CDOs are constructed with a CDS. The CDO receives periodic payments from the credit protection buyer and must make a payment only if a trigger event such as a default occurs.

Synthetic arbitrage CDOs are used by asset management companies, insurance companies, and other investment shops with the intent of exploiting a mismatch between the higher income earned on the collateral and the lower cost of financing using the CDO tranches. Synthetic CDO structures are less administratively burdensome than cash-funded structures, particularly for attempting to transfer only a portion of a credit risk.

27.4.3 Comparison of Synthetic and Cash-Funded CDOs

There are three major potential advantages to synthetic CDOs over cash-funded CDOs. First, a synthetic CDO is less burdensome than the transfer of assets required for a cash-funded CDO. Commercial loans may require borrower notification and consent before being transferred to the CDO trust. This can take time, increase administration costs, and lead to dissatisfaction on the part of the bank's loan customers. These problems are avoided if the risk is transferred by a CDS or a total return swap. Second, synthetic CDO trusts can be used to provide economic exposure to credit-risky assets that may be relatively scarce and difficult to acquire in the cash market. Last, synthetic CDO trusts can employ leverage by using derivatives to sell credit protection on assets of a size that is greater than the level of assets in the collateral pool.

Two difficulties posed by synthetic CDOs relative to cash-funded CDOs are potential exposure to counterparty risk and reduction in bankruptcy remoteness. First, consider the difference between a cash-funded CDO that purchases bonds from Bank XYZ and a synthetic CDO that enters a credit derivative with Bank XYZ. The exposure to counterparty risk emanates from the use of a credit derivative to obtain risk exposure rather than from the actual purchase of collateral assets with risk exposures. The CDO is exposed to the risk of bankruptcy by counterparties to the credit derivatives at the same time that the credit derivatives have positive market values. Second, a major advantage of CDOs is that their bankruptcy remoteness enhances the safety of tranches by reducing the chances that payments to tranche holders will be bogged down by the financial distress of one of the entities providing the collateral assets. When the CDO has direct ownership and physical possession of the credit-risky collateral assets (cash funded), there are reduced potential legal entanglements than when the CDO has a relationship with an entity through one or more credit derivatives (synthetic).

27.6.1 Subordination

Subordination is the most common form of credit enhancement in a CDO transaction, and it flows from the structure of the CDO trust. It is an internal credit enhancement. Subordination is the process of protecting a given security (i.e., tranche) by issuing other securities that have a lower seniority to cash flows.

For instance, CDO trusts typically issue several classes or tranches of securities. The lower-rated, or subordinated, tranches provide credit support for the higher-rated tranches. The equity tranche in a CDO trust is the first-loss position and therefore provides credit enhancement for every class of CDO securities above it. Junior tranches of a CDO are rated lower than senior tranches; however, they receive a higher coupon rate commensurate with their subordinated status and therefore greater credit risk.

CDO structures can also be used for collateral assets with little or no credit risk, such as insured mortgages. In these cases, subordination affects the timing of payments to the various tranches rather than the credit risk of those payments. In a traditional sequential-pay CDO, the principal of the senior tranches must be paid in full before any principal is paid to the junior tranches. This sequential payment structure is often referred to as a waterfall. As interest and principal payments are received from the underlying collateral, they flow down the waterfall: first to the senior tranches of the CDO trust and then to the lower-rated tranches. Subordinated tranches must wait for sufficient interest and principal payments to flow down the tranche structure before they can receive a payment.

27.6.2 Overcollateralization

Overcollateralization refers to the excess of assets over a given liability or group of liabilities. Overcollateralization of a senior tranche occurs when there are subordinated tranches in a CDO. For example, consider a CDO trust with a market value of collateral trust assets of $100 million. The CDO trust issues three tranches: Tranche A is the senior tranche and consists of $70 million of securities; Tranche B consists of $20 million of subordinated fixed-income securities and is paid after the senior tranche is paid in full; finally, there is a $10 million equity tranche with the lowest seniority.

The level of overcollateralization is the ratio of the assets available to meet an obligation to the size of the obligation and all other obligations senior to that obligation. The overcollateralization rate for the senior tranche in this example is $100/ $70 = 143%. The numerator is the millions of dollars of assets. The denominator is the millions of dollars of value that would be necessary to pay off that obligation, as well as any other obligation of equal or greater seniority.

The funds used to purchase the excess collateral come from both of the subordinated tranches, Tranche B plus the equity tranche. The level of overcollateralization of Tranche B is $100/$90 = 111%. The equity tranche provides the overcollateralization to Tranche B. Overcollateralization is an internal credit enhancement.

27.6.3 Spread Enhancement

Another internal enhancement can be excess spread of the loans contained in the CDO collateral portfolio compared to the interest, or coupons, promised on the CDO tranche securities. In other words, the average coupon on the assets may exceed the average coupon on the tranches such that in the absence of default, the CDO should be able to receive more cash than it is required to distribute. This excess interest may be retained and serve to enhance the credit-worthiness of the outstanding tranches. The excess spread may arise because the assets of the CDO trust earn a premium for illiquidity or because the assets are of lower credit quality than the CDO securities and therefore yield a higher interest rate than the rate paid on the CDO securities. A higher yield on the trust assets may also result from a sloped term structure and mismatched assets and liabilities. This excess spread may be used to cover losses associated with the CDO portfolio. If there are no losses on the loan portfolio, the excess spread accrues to the equity tranche of the CLO trust.

27.6.4 Cash Collateral or Reserve Account

A reserve account holds excess cash in highly rated instruments, such as U.S. Treasury securities or high-grade commercial paper, to provide security to the debt holders of the CDO trust. Cash reserves are often used in the initial phase of a cash flow transaction. During this phase, cash proceeds received by the trust from the sale of its securities are used to purchase the underlying collateral and fund the reserve account. It is sometimes argued that cash reserves are not the most efficient form of internal credit enhancement because they generally earn a lower rate of return than that required to fund the CDO securities.

27.6.5 External Credit Enhancement

An external credit enhancement is a protection to tranche investors that is provided by an outside third party, such as a form of insurance against defaults in the loan portfolio. This insurance may be a straightforward insurance contract, the purchase of a put option by the CDO, or the negotiation of a CDS to protect the downside from any loan losses. The effect is to transfer the credit risks associated with the CDO trust collateral from the holders of the CDO trust securities to an outside company. These external credit enhancements from a third party guarantee timely payment of interest and principal on the CDO securities up to a specified amount and thereby enhance the credit ratings of the tranches.

27.7.1 Distressed Debt CDOs

Default rates on debt increased in the United States during 2000 and 2001 and again beginning in 2008. This increase in default rates led to an increased availability of and interest in distressed debt, which in turn led to the development of distressed debt CDOs. The emergence of distressed debt CDOs followed the pattern of using the CDO structure to facilitate investments in diversified portfolios of credit-risky assets.

As its name implies, a distressed debt CDO uses the CDO structure to securitize and structure the risks and returns of a portfolio of distressed debt securities, in which the primary collateral component is distressed debt. Distressed debt CDOs usually have a combination of defaulted securities, distressed but unimpaired securities, and nondistressed securities. The appeal of the CDO structure is the ability to provide a series of tranches of collateralized securities that can have an investment-grade credit rating, even though the underlying collateral in the CDO is mostly distressed debt. The CDO securities can receive a higher investment rating than the underlying distressed collateral through diversification, subordination, and one or several of the other credit enhancements described previously in this chapter. Investors are then able to diversify into the distressed debt market and to do so more effectively by choosing a distressed debt CDO tranche that matches their level of risk aversion.

Historically, the main suppliers of assets for distressed debt CDOs have been banks, which use the CDOs to manage the credit exposure on their balance sheets. Assets for a CDO are purchased at market value. When a bank sells a distressed loan or bond to a distressed debt CDO, it usually takes a loss because it issued the loan or purchased the bond at par value. It was after the issuance of the loan or bond purchase that the asset became distressed, resulting in a decline in market value. Banks are willing to provide the collateral to distressed debt CDOs for several reasons. First, it improves the bank's balance sheet by removing distressed loans and reducing its nonperforming assets. The divestiture of distressed debt also allows the bank to obtain regulatory capital relief by reducing the amount of regulatory capital it is required to maintain. Finally, the divestiture provides cash, or liquidity, to the bank.

27.7.2 Hedge Fund CDOs

Another new application of the CDO structure has been the extension of CDOs to hedge funds. A collateralized fund obligation (CFO) applies the CDO structure concept to the ownership of hedge funds as the collateral pool. This innovation came as a result of the tremendous amount of capital pouring into the hedge fund market prior to the financial crisis that began in 2007. The CDOs of hedge funds facilitate diversification and allow investors to have professional management and reduced difficulties due to minimum investment sizes. Because CFOs are structured, they can offer access to hedge funds with a spectrum of risks and returns.

27.7.3 Single-Tranche CDOs

Single-tranche CDOs provide a highly targeted structure of credit risk exposure. In a single-tranche CDO, the CDO may have multiple tranches, but the sponsor issues (sells) only one tranche from the capital structure to an outside investor. In a single-tranche CDO, the sponsor could sell just one of these tranches and potentially keep the rest for its balance sheet. A single-tranche CDO uses a CDS, just like a regular synthetic CDO. The main difference is that in a single-tranche CDO, only a specific slice of the portfolio risk is transferred to the investors, rather than the entire portfolio risk.

Single-tranche CDOs allow even more customization for an investor, such as collateral composition, maturity of the single-tranche note, and weighted average credit rating. As a result, single-tranche CDOs are the most fine-tuned of any structure. For this reason, single-tranche CDOs are sometimes referred to as bespoke CDOs, or CDOs on demand.

27.8.1 Risk from the Underlying Collateral

The risk of the underlying collateral is the single greatest driver of risk associated with an investment in a CDO structure. This chapter and the previous two chapters on structured products have focused on credit risk. But the CDO structure can also be used to engineer commodity price risk, private equity risk, hedge fund risk, and interest rate risk, such as risks inherent with unscheduled principal payments.

Note that a CDO structure does not change the risk of the assets in the underlying portfolio. Instead, the structure merely distributes the risks of the collateral pool to the various tranche holders of the CDO. The risks of the collateral portfolio can change due to either changes in market conditions or changes in the composition of the portfolio itself, and CDO investors bear the risk that the true nature of the collateral will differ from the previously understood nature. In other words, the nature of the actual portfolio may stray from the intended nature of the portfolio. Further, in times of stress, CDO managers may be slow or reluctant to write down or write off the poorly performing investments contained in the CDO trust. The investor may need to perform independent analysis to determine accurate values and risks of the actual portfolio.

Default rates are a key driver of returns to collateral portfolios exposed to credit risk. Further, collateral portfolio value is driven by the level of losses given default (i.e., the proportion of the underlying credit risk that is not recovered in the event of default). Low recovery rates can combine with high default rates to generate high credit losses.

27.8.2 Financial Engineering Risk

The massive losses beginning in 2008 on CDO investments that had the highest possible credit rating (AAA) illustrate just how wrong financially engineered products can go. Financial engineering involves powerful tools that can generate enormous benefits. For example, the securitization and structuring of residential mortgages have been estimated to have substantially reduced the costs of financing homes for more than three decades. However, financial engineering can also be used, intentionally or unintentionally, to allocate risks in highly complex manners that are not well understood. Financial engineering risk is potential loss attributable to securitization, structuring of cash flows, option exposures, and other applications of innovative financing devices.

The financial engineering of insured residential mortgages in the 1990s facilitated a cost-effective supply of mortgage financing. CMOs played an important role in facilitating efficient mortgage financing, developing more and more sophisticated and complex structuring of tranches. By 1994, the complexities of CMO structures had soared to the point that many CMO tranches contained enormous interest-rate-related risks, even though the underlying collateral assets were virtually free of default risk. In 1994, a CMO crisis was triggered by rising interest rates; several large entities failed, and many others suffered enormous unanticipated losses. Interest rates reversed their course by the end of 1994, and further damage was averted.

Despite the grave lessons that should have been learned from the 1994 CMO crisis, a larger and more serious crisis emerged in 2007, primarily due to the default risk of subprime mortgages. At the heart of the subprime debacle were mortgage loan borrowers with substantially greater default risk than prime-grade borrowers. Small banks and mortgage lenders made these loans and then sold them into pools that were eventually financed by mortgage-backed securities (MBSs). Large investment banks purchased these MBSs and repackaged them yet again into a second pool, a CDO trust. The structures were used to slice and dice the risks of the subprime MBSs. When the underlying subprime mortgages began to default at much faster rates than previously experienced, the whole financial structure collapsed, bringing down Fannie Mae, Freddie Mac, and several major investment banks.

The lesson that was apparently not fully learned in 1994, and that was again taught in 2008, is that financial engineering is powerful and complicated. All market participants are directly or indirectly exposed to risks from the use of financially engineered products. Therefore, market participants should be aware of financial engineering risk and participate directly in engineered products with care and concern.

27.8.3 Correlation Risk

CDOs are often called correlation products because the collateral pool of a CDO can reference numerous assets and because the correlations of the returns of those assets drive the aggregate risks of the portfolio. Higher correlation increases aggregate risk. Investors in a CDO are therefore exposed to correlation risk. The major risk of large losses comes from numerous defaults occurring at or near the same time. Thus, large losses occur when defaults are correlated. If defaults are uncorrelated, then the risk is diversified, and default rates tend to be steady. The safety of more senior tranches is maximized when correlation risk is minimized. That is, the senior tranche holders do not want numerous defaults to occur at the same time such that all subordinated tranches are wiped out. Rather, senior tranche holders want default risk diversified such that default losses do not reach the magnitude necessary to wipe out mezzanine tranches and more.

27.8.4 Risk Shifting

Risk shifting is the process of altering the risk of an asset or a portfolio in a manner that differentially affects the risks and values of related securities and the investors who own those securities. A potential conflict of interest exists between the issuer of the CDO and the investors in the CDO tranches. The issuer may have an incentive to divest or otherwise place assets into the collateral pool that contain worse credit quality than is recognized by the investors. Also, the managers of the assets of a CDO may take on increasing risk or greater risk than initially indicated. Or, the manager may fail to take risk-reducing actions when the risks of the portfolio change due to market conditions. To reduce moral hazard, sometimes the equity tranche is held by the issuer. The idea is that equity tranche holders are then first in line to bear losses from asset defaults and have an incentive to lessen the default risks. However, as shown in the next section, ownership of junior tranches can actually encourage risk taking.

27.8.5 The Effects of Risk Shifting and Correlation on Tranches

At first glance, it may appear that if higher-risk assets are placed into the collateral asset pool and/or if those assets are poorly diversified due to high return correlations, the higher risk will make all tranches less desirable. However, risk shifting in CDOs can have very different effects on different tranches. As discussed earlier, an equity tranche position in a CDO may be viewed as a call option. As a call option, equity tranches, and to a lesser extent other highly subordinated tranches, can actually benefit from increases in the risk of the collateral pool. The potential for equity holders to benefit from upward shifts in asset risks is detailed in the structural model approach in Chapter 25.

The relationship between the level of risk of the collateral assets of a CDO and the values of the CDO's various tranches is interesting. Let's assume that the risks of a CDO's assets can be altered substantially without having an immediate impact on the value of the assets. Generally, the sum of the values of all of the tranches, including the equity tranche of a CDO, should tend to equal the value of the collateral pool. However, a large change in the risks of the assets (e.g., an increase in the WARF) can have immediate effects on the relative values of the tranches. Specifically, increases in the risks of the CDO's assets tend to transfer wealth from the holders of more senior tranches to the holders of less senior tranches.

It is intuitively obvious that senior tranches become less valuable as the volatility of the CDO's assets rise (with asset values held constant). The senior tranches have less probability of being fully paid while the coupons remain fixed. It is less obvious why the junior tranches might gain in value. However, if the value of the assets remains constant and if the value of the senior tranches declines, then the value of the junior tranches should rise. This effect is also consistent with the structural model's view of equity as a call option and the well-known result of option theory that call option values increase when the volatility of the underlying assets increases. The most junior tranche may be viewed as a long call option on the collateral assets. The most senior tranche may be viewed as a long riskless bond and short an out-of-the-money put option on the collateral assets. Higher volatility of the collateral pool helps the tranches that are long options (i.e., long vega) at the expense of the tranches that are short options.

Finally, note that higher risk in the collateral asset pool can occur both from higher-risk assets and from higher return correlations among the assets (i.e., reduced diversification). Thus, a lower diversity score can shift wealth from senior tranches to junior tranches even when the WARF is held constant. Note that a very well diversified portfolio will generate a low but constant default rate. A low but constant default rate will spare senior tranches from losses, as all of the losses will be absorbed by the junior tranches. A very poorly diversified portfolio gives senior tranche holders an increased chance of losses (when the assets experience very large losses) and junior tranche holders an increased chance of bearing few or no losses (when assets experience minimal losses).

27.8.6 Other CDO Risks

The successful risk management of a CDO's portfolio requires understanding numerous potential risks. This section briefly surveys these risks.

A risk due to the difference in payment dates arises from a mismatch between the dates on which payments are received on the underlying trust collateral and the dates on which the trust securities must be paid. This risk can be compounded when payments on different assets are received with different frequencies, known as periodicity. This problem is often solved through the use of a swap agreement with an outside party, in which the trust swaps the payments on the underlying collateral in return for interest payments that are synchronized with those of the trust securities.

A type of basis risk occurs when the index used for the determination of interest earned on the CDO trust collateral is different from the index used to calculate the interest to be paid on the CDO trust securities. For instance, the interest paid on most bank loans is calculated on LIBOR plus a spread, but other assets may be based on certificate of deposit rates in the United States. The risk in this case is when a mismatch occurs and the indices underlying cash income from the collateral assets differ from the indices underlying payments to the tranche holders.

CDO tranches suffer when the collateral pool performs poorly. Collateral assets may perform poorly for several reasons. The market prices of collateral assets respond immediately to shifts in the levels, slope, or curvature of the yield curve of riskless rates. Yield curve shifts can cause the value of the collateral assets to change and can affect the cash flows available from reinvestment of cash flows from existing assets. Spread compression, when credit spreads decline or compress over time, reduces interest rate receipts from the CDO's collateral and may cause the CDO to face cash shortfalls even in the absence of defaults. A steeply upward-sloping yield curve can magnify the negative carry between the interest earned on the CDO's cash reserve accounts and the coupon rates of the CDO's tranches.

27.8.7 Modeling Credit Risk in CDOs

Initially, it may appear that modeling credit risk should not be that different from modeling other risks, such as equity, interest, currency, and commodities risks. For instance, in theory (such as in the CAPM), it could be argued that one should be able to calculate the beta of the CDO collateral portfolio and use that beta to estimate the beta of the various tranches. However, credit risk displays a number of properties that are not shared by these other sources of risk; thus, a different type of model is required. First, default is a relatively rare event. Most corporations currently in existence have never defaulted. Therefore, there are limited observations available with which to estimate various statistics through historical analysis. Second, many defaults occur due to systematic factors, such as changes in macroeconomic conditions, rather than idiosyncratic factors, such as mismanagement at the firm level. Third, many of the financial institutions that invest in credit products are not able to hold diversified portfolios of credit products to eliminate the idiosyncratic risks of these securities. Fourth, in some cases (e.g., sovereign debt), credit risk may arise not just because of the inability of the counterparty to pay but also because of its unwillingness to do so.

The drivers of losses to a CDO of underlying credit risks are the default rate and loss rate given default. The default rate refers to the percentage of the collateral assets experiencing default. The loss rate given default, as discussed in Chapter 26, is the percentage of the defaulted security values that cannot be ultimately recovered. The primary method for ascertaining the risks of tranches due to default risk in the CDO portfolio uses a copula approach.

A copula approach to analyzing the credit risk of a CDO may be viewed like a simulation analysis of the effects of possible default rates on the cash flows to the CDO's tranches and the values of the CDO's tranches. The idea behind the copula model of CDO default risk is that defaults are generated by two normally distributed factors: an idiosyncratic factor and a market factor. The idiosyncratic factor takes on a different value for each credit risk (i.e., bond) and generates hypothetical defaults whenever the factor's value for that particular bond is sufficiently high. The market factor is common to all credit risks in the CDO portfolio and reflects the tendency of defaults to occur in unison.

A parameter set by the user of the copula model determines the relative weights of the two factors (i.e., idiosyncratic versus market). Taken together, along with a user-specified expected default rate, the model allows simulation of the probabilities of various default levels for the collateral pool. The estimated probabilities of various default levels are then combined with a user-supplied loss rate given default (i.e., 1 – recovery rate) to estimate the probabilities of losses to each of the tranches in the CDO structure. Rating agencies have used the copula model to estimate return distributions for CDO tranches involving credit risk—both corporate bonds and uninsured mortgages. The copula model has been maligned as an important cause of the credit crisis that began in 2007. Specifically, the model was criticized for underestimating the risk of the most senior mortgage tranches from mortgage defaults. However, there is debate as to whether the difficulties, including apparently erroneous credit ratings, were caused by misunderstandings of the model, misspecification of the model, or misestimation of the model's parameters.

CDOs and other structured products are very powerful tools for engineering risk and other attributes. Those tools have been at the center of the 1994 CMO crisis as well as the financial crisis of 2007 to 2009. Whenever the next financial crisis occurs, highly engineered products will undoubtedly be involved, as a transmitter of risk or even as a contributor to risk. Accordingly, these powerful tools need to be well understood by their users.