Coval Flashcards
Describe the essence of structured finance activities
the pooling of economic assets like loans, bonds, and mortgages, and the subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools.
Describe collateralized debt obligation (CDO)
A CDO is formed by pooling together fixed-income assets such as loans, bonds and mortgages and prioritizing payments into tranches.
2 problems with structured finance products
- the extreme fragility of their ratings to modest imprecision in evaluating underlying risks. (they are extremely sensitive to the assumptions regarding the underlying assets)
- their exposure to systematic risks.
How to manufacturing securities
tailoring the cash-flow risk of these securities - as measured by the likelihood of default and the magnitude of loss incurred in the event of a default - to satisfy the guidelines set forth by the credit rating agencies.
Involves two step procedure: Pooling and tranching
Describe pooling
A large collection of credit-sensitive assets is assembled into a portfolio, referred to as a “special purpose vehicle”. The special purpose vehicle is separate from the originator’s balance sheet to isolate the credit risk of its liabilities (the tranches) from the balance sheet of the originator.
Describe pass-through securitization
If the special purpose vehicle issued claims that were not prioritized and were simply fractional claims to the payoff on the underlying portfolio.
Describe tranches
Tranches are prioritized in how they absorb losses from the underlying portfolio. Used to manufacture a range of securities with different cash flow risks.
Describe overcollateralization
The degree of protection offered by the junior claims.
Senior tranches only absorb losses after the junior claims have been exhausted.
What’s the impact of having a large number of securities in the underlying pool
A progressively larger fraction of the issued tranches can end up with higher credit ratings than the average rating of the underlying pool of assets
Two ways to have credit ratings of the tranches better than the average rating of the underlying pool of assets
- Increase the number of assets in the underlying pool.
- Apply the CDO construction more than once. (CDO-squared, the collateralized debt obligations created from the tranches of other collateralized debt obligations)
Impact of default correlations across the underlying assets
The lower the default correlation the more improbable it is that all assets default simultaneously and therefore the safer the senior-most-claim can be made.
Conversely, as bond defaults become more correlated, the senior-most-claims become less safe.
Credit ratings issued by rating agencies are based on one of two things:
- The anticipated likelihood of observing a default
- The expected economic loss (severity of the loss conditional on default)
Investment grade vs. speculative grade
Securities rated BBB- or higher are investment grade, are thought to represent low to moderate levels of default risk.
Those rated BB+ and below are speculative grade and are already in default or close to it.
What does single-name basis mean
Where the credit rating agencies had developed their expertise, all securities are rated independently of each other and any default correlation between securities is ignored.
How does CDOs impact the estimates of default probabilities
CDOs magnify the effects of imprecise estimates of default probabilities, amount recovered in the event of default, default correlation, as well as model errors due to the potential misspecification of default dependencies.
This magnification is even more extreme for CDO-squared.
Describe sub-prime mortgages
Mortgages that did not meet the size and credit quality requirements
Impact on mortgage-based securities with an increase in default rates after house prices declines
- The default correlation was higher than expected due to an overlap in geography and vintages (age) in mortgage pools.
- The probability of default was higher than expected due to a deterioration in the credit quality of sub-prime borrowers.
- The asset recovery values were lower than expected due to assets being sold off for low prices.
- The prevalence of CMOs (CDO^2) magnified the negative impacts of the movements of the assumptions above from expectations.
The degree of systematic risk present in a security has a meaningful impact on the potential yield spread for the security
- If a security’s default likelihood is independent of the economic state (no systematic risk), then it’s yield spread will be consistent with compensation for expected loss. Example: CAT bond.
- Securities that are correlated with the market as a whole should offer higher expected returns to investors, hence have higher yields
Downside of credit rating
Credit rating only provide an assessment of the risks of the security’s expected payoff, with no information regarding whether the security is particularly likely to default at the same time that there is a large decline in the stock market or that the economy is in a recession.
So securities with a given credit rating can have a wide range of yield spread.
2 reasons that the yields associated with structured finance securities did not reflect the underlying risk (the yield is too low)
- 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 the systematic risk. As a result, Senior tranche investors were under-compensated for their risk exposure and Junior traches investors were over-compensated for their risk exposure
An approach to solve the issue of small errors that would not have a material impact in the single-name market are magnified when dealing with CDOs and CDO-squareds
A Bayesian approach can be used to explicitly acknowledge parameter uncertainty for assumptions such as default probabilities and default correlations.
this would ultimate lead to a fewer AAA-rated tranches.
