07_Coval Flashcards
Explain how a collateralized debt obligation (CDO) is created.
A CDO is formed by pooling together fixed-income assets and prioritizing payments into tranches, where each tranche differs in seniority.
Briefly describe how CDOs can be used to convert underlying assets with high credit risk into highly-rated investment vehicles.
Under a CDO, the prioritization of losses allows senior tranches to obtain higher credit ratings than the underlying assets. Since junior tranches absorb losses first, the senior tranche is protected (which drives the credit rating for senior tranches up).
Assume that the senior tranche of a CDO has an attachment point equal to 50% - 100% of the notional principal. Explain what this means.
This means that the senior tranche begins to absorb losses once the portfolio loss exceeds 50 percent and continues to do until the portfolio loss reaches 100 percent.
Explain why junior tranches have higher promised yields than senior tranches.
Since junior tranches are riskier, they have a higher promised yield. This is meant to compensate investors for the increased risk.
Briefly describe two ways to increase the number of tranches with credit ratings higher than the average rating of the underlying pool of assets.
- Increase the number of assets in the underlying pool
[increasing number of securities in the CDO pool will reduce the default risk of the tranches and allow more of them to obtain a AAA rating - Create a CDO^2 by applying the CDO construction two times
[by pooling together any of the non-AAA (junior) tranches of the original CDOs, the senior tranches from this pool may obtain a AAA rating]
Identify two components that underlie credit ratings issued by rating agencies.
Explain why these two components often understate the true credit risk of security.
The components underlying credit ratings are as follows:
1. Likelihood of default
2. Severity of loss given a default
The components above understate the true credit risk of a security because they fail to consider systematic risk.
A CDO and a CDO^2 are formed using four-year bonds with an assumed default probability of 10% for each bond. In reality, the default probability for
each bond is 25%. Describe how the default probabilities and credit ratings of the most senior tranches of the CDO and CDO^2 will change as a result.
CDOs and CDO^2s are highly sensitive to imprecise estimates of underlying assumptions such as default probabilities. The default probabilities of the senior tranches for the CDO and CDO^2 will significantly increase. The CDO^2 will see
a larger increase than the CDO.
Oftentimes, this means the senior tranche of the CDO^2 will also experience a greater decline in its credit rating than the senior tranche of the CDO.
Fully describe how sub-prime mortgages contributed to the Great Recession.
Sub-prime mortgages were not eligible for purchase by government agencies. Instead, they were either held by the original issuer of the mortgage or sold directly in secondary markets.
Eventually, many of these mortgages found their way into private mortgage-backed bonds without a government guarantee. These mortgage-backed bonds were often repackaged into collateralized mortgage obligations (CMOs), which operated like CDO^2s.
As house prices declines, there was a significant increase in default rates. The impact on CMOs was much worse than expected due to imprecise estimates of important assumptions.
For example, the default correlation was higher than expected due to an overlap in geography and vintages in mortgage pools.
In addition, the probability of default was higher than expected due to a deterioration in the credit quality of sub-prime borrowers. The final result was a massive decline in asset values due to assets being sold off for extremely low prices.
Explain how exposure to systematic risk impacts the yield spread for a security.
If a security’s default likelihood is independent of the economic state (i.e. no systematic risk), then its yield spread will be consistent with compensation for expected losses.
If a security’s default likelihood is at its highest when the economy is poor, then it should command a significant yield spread to compensate for the additional systematic risk.
Describe two reasons why the yields associated with the senior tranches of CDOs did NOT adequately reflect the underlying risks.
- Credit ratings understated the default risks of these products since they were based on rating agencies’ extrapolation of favorable economic conditions
- The yields did not account for exposure of CDOs to systematic risk. As a result, Senior tranche investors were under-compensated for their risk exposure and Junior tranche investors were over-compensated for their risk exposure
Identify three model errors inherent in rating agency models that contributed to improper credit ratings in the lead-up to the Great Recession.
- Failed to consider the possibility of declines in home prices
- Failed to capture the impacts of imprecise estimates of default correlations
- Failed to capture the impacts of imprecise estimates of default probabilities
A rating agency uses default probability to assign ratings to these CDO. Describe whether the expected return of these securities should be higher or lower than the expected return of single-name securities with the same rating
Since the CDOs have greater exposure to systematic risk, they should receive additional compensation for that risk. Thus the expected return should be higher than the expected return of single-name securities with the same rating.
Discuss ways the risks associated with CAT bond CDOs differ from the collateralized mortgage obligations constructed before the subprime financial crisis.
low correlation for CAT bonds with market return, so they should not drop in value during market downturn
(MBS = Systematic Risk, CAT bond = diversifiable risk)
CAT reinsurance market is small compared to the overall financial market. therefore the CAT bond market is likely to be easily absorbed by the market. unlike the massive size of the CMO market before it collapsed
CAT bonds are fully collateralized therefore are not subject to credit risk like mortgages are
Discuss potential challenges arising from widespread construction and investment in the CAT bond CDOs that could contribute to a future financial crisis.
unforeseen correlation between or increased frequency of cat events such as due to effects like global warming or fracking
CAT can be highly correlation. eg. CAT hurricane is not independent of a CAT loss in South Carolina. it is possible that multiple CAT bonds could be in the CDO for the same region.
some CAT bonds use indemnity trigger and others can use index trigger. the trigger used incorporates different risk means CAT bond are less homogenous and payment of tranche harder to determine. prevent investors from understanding what they are buying
model risk - it is very difficult to model CAT events. So there is modeling error associated with the estimated probability of a CAT event happening and triggering a CAT bond payment
complexity and specialization of the CAT CDO would make it hard for rating agencies and investors to understand the risks they are assuming
Propose and briefly explain two possible regulations for construction or rating of the new CAT bond CDOs that could help alleviate some of the challenges in [CAT bored CDOs that could contribute to a future financial crisis], without greatly discouraging innovation and investment.
require correlations in the model to be conservative
require all bonds to have the same easily understood type of trigger, making risk more transparent and accurate
limit CDO^2
ensure transparency in the nature of the underlying bonds
limit the number of re-bundling (i.e. CDO^3)
sell limits on the amount of CAT bond CDOs that certain investors can hold
- A catastrophe bond.
- A junior tranche on a collateralized debt obligation (CDO).
- A senior tranche on a collateralized debt obligation squared (CDO2).
Assume that the probability of default on the underlying mortgages and the catastrophe bond increase by the same amount.
Explain how an investor should rank the three securities from most to least preferable.
The junior tranche absorbs the first losses and is affected the most if the probability of default increases.
The CAT bond is uncorrelated with the other bonds, so its probability of default increases one-to-one.
The senior tranche is the least affected as it is the last tranche to absorb losses after junior and mezzanine.
From most preferable to least preferable:
Senior tranche > CAT bonds > Junior tranche
- A catastrophe bond.
- A junior tranche on a collateralized debt obligation (CDO).
- A senior tranche on a collateralized debt obligation squared (CDO2).
Assume the correlation of defaults for the underlying mortgages moderately increases.
Explain the impact on the market price for each of the three securities.
The CAT bond is not impacted by the correlation of defaults.
The junior tranche price will increase as risk shifts to the higher tranche.
The senior tranche price will decrease as the risk increases from correlated defaults.
Explain how underestimating default probabilities for senior tranches of collateralized debt obligations led to the rise and fall of structured finance.
Because the probability of default was underestimated, the senior tranches were thought to be very safe with the junior and mezzanine tranches absorbing defaults first. As a result, the senior tranches received AAA ratings. Since bank capital requirements are tied to credit ratings, there was a large demand for AAA securities, leading to rapid grouth of structured finance. When the probability of default increases, the senior tranches are much less safe and their market value dropped substantially. The structure of CDOs amplified this effect. Those who held senior tranches lost a lot of money and now the demand for CDOs and structured securities are very low due to the sensitivity in assumption errors.
A bank pools some mortgages into collateralized debt obligations (CDOs)
List reasons why a senior tranche in the CDO created should not be treated the same as a single, unrelated bond with a similar assumed risk of default
- There is still a lot of correlation among the mortgage pools. The probability of default is therefore likely higher than that of a single security
- The CDO bears a high amount of systemic risk. If the market begins to decline significantly, the chance of default on the mortgages increases. The investor is not rewarded for bearing any extra systemic risk (should ask for a higher risk premium)
- A slight error in the estimation of probability of default and default correlation can significantly change the expected payout of a tranche.
1 reason creating CDO^3 would be desirable to an investor
1 reason why it would not
Desirable: it creates an asset with a probability of default of <2% from securities with much higher default probabilities
Undesirable: CDO^3 is much more sensitive to assumptions of default probability and correlation, making the resultant calculations highly uncertain
