Coval

Question 1

3 reasons senior tranches in the CDO should not be treated the same as a single security with a similar risk of default

Answer 1

1) Due to correlation, the probability of default is likely higher than that of a single security.
2) CDOs bear a high amount of systematic risk (if market declines, the chance of mortgage default rises). The investor is not rewarded for bearing any extra systematic risks but should ask for a higher risk premium.
3) A slight error in the estimation of probability of default and/or default correlation can significantly change the expected payout of a tranche.

Question 2

Tranche Default Correlations and Expected Payments

Answer 2

Senior tranche defaults when both default.
Senior Default Correlation = (Pdd - Pd^2) / (Pd x (1 - Pd))
E[payment] = (1 - Pdd) x Width

Junior tranche defaults when one or both defaults.
Junior Default Correlation = (Pnn - (1 - Pd)^2) / (Pd x (1 - Pd))
E[payment] = Pnn x Width

As a check, think of it as a bond with 2 payments where the sum of those payments = 2 x Width x (1 - Pd)

Question 3

Reason why CDO3 is un/desirable

Answer 3

Desirable:
- It creates an asset with a probability of default of less than securities with higher default probabilities

Undesirable:
- the CDO3 is much more sensitive to assumptions of default probability and correlation, making the resultant calculations highly uncertain.

Question 4

Tips on calculating CDOx

Answer 4

Draw a chart starting with the underlying asset.

CDO
Jr defaults when 1 or both assets defaults. Sr defaults when both assets default.

CDO2
Jr defaults when 1 or both jr CDO tranches default. Sr defaults when both jr CDO tranches default (not when the jr CDO2 defaults)

Under perfect correlation the probability of default will be the same for all tranches and all CDOs created.

Question 5

Key features that fueled the growth of repackaged risk

Answer 5

1) High credit ratings from agencies and overconfidence about their estimates of risks and correlation.
2) It substitutes risks that are largely diversifiable for risks that are highly systematic.

Question 6

Relation of structured finance to subprime crisis

Answer 6

• Government agencies tasked with encouraging home ownership.
• Banks write mortgages without much thought about default correlation.
• These mortgages are pooled and essentially sold as risk free assets.
• Ratings did not consider the possibility of an economic downturn.
• Yields did not consider sensitivity to systematic risk.

Question 7

Five reasons behind incorrect pricing of structured finance objects

Answer 7

1) Failure to consider decline in housing values.
2) Lack of appreciation of rating sensitivity to underlying assumptions.
3) Perverse incentives for banks compelled to provide more mortgages due to strength of MBS
4) Perverse incentives for rating agencies.
5) Mispricing of tranches in CDOs.