CDOs Current Practice and Controversies - Coursework Example

Running head: CDO’s Current Practice and Controversies CDO’s Current Practice and Controversies [Writer’s Name] [Institution’s Name] Bank Financial Management Collateralized Debt Obligations (CDOs) Credit derivative financing has become a global phenomenon as it allows the occurrence of financial transactions in which the value of a transaction lies in the risk likelihood based on the mortgage of bonds, financial certificates or other financial asset. The transaction done on the basis of such financing is always based on the credit risk which is dependant upon something other than the dealing entities not on the transaction itself. There are multiple methods involved in credit derivative financing. Moreover, credit derivatives are a legal source of credit generation and support the economy of certain countries. It has been defined by Edmond Parker (2008): “Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity”. In credit derivatives the parties transacting decide the terms and conditions for the deal before signing. The conditions that are mostly decided in credit transactions involve the possible risks like the inability to pay the credit, bankrupt, breaching of the agreement signed. Moreover, in case of a risk that a requirement of the reference entity will be required to gather pace, the bond will be declared instantly payable subsequent a default. Other risks like negation / freeze and restructuring (reforming) are also decided by the two parties before signing a deal. Collateralized Debt Obligations (CDOs) is a credit derivative instrument which is becoming popular in the modern era. This is because of the fact that Collateralized Debt Obligations has become a major gizmo in the financial banking to avoid the credit risk experience as compare to the other mortgage-bundling instruments. CDOs are basically, the type of mortgage in which security is granted to the investor on behalf of a fixed value asset. In this type of credit derivative, the tranches are used. The tranches are the similar kind of securities (security certificates) of different risk levels. These tranches are senior and junior, according to the seniority of the security and its class, preference for it varies. Interest and the major payments are made to the investors according to the order of precedence. The low-grade tranches present some coupon payments and sometimes low interest rates. It can also provide lower prices to pay off default risk in investments. On the other hand, the senior security is provided with grand payments. The investment banks usually issue the CDOs in order to earn a commission at the time of delivering and later on get management fees during the verve of the CDO. The power of earning significant fees lies in the services like: creation and making loan secure, together with the absence of any outstanding liability and in tilting the incentives of originators in favor of loan volume rather than loan quality. Sometimes CDOs are created out of other CDOs. Generating the CDOs from other CDOs may produce massive problems in accounting, letting the large ficsal institutions to exclude debt off their books by grouping their liabilities with other financial organizations and getting these debts back on to their books again making it a Synthetic CDO asset afterward. Creation of CDOs from other CDOs has permitted monetary institutions to conceal their losses, but has made them able to increase their income. History of CDOs reveal that use of such instruments grew by involvement of asset managers and investors and enlarged due to insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles. This is due to the fact that CDOs presented returns that were higher than the corporate bonds with the same credit rating. Its success may also be due to the fact that it provides greater profits to its manufacturers as well. Example of a CDO can be SPV which is created and issued in four classes A, B, C, and D of notes to investors. The seniority starts from A. The most junior note is D. All bonds mature in three years, and all investors will be repaid their investments if none of the companies default on their bonds. High risk is attached to the junior investment bond. When the bonds mature, the investor classes will be paid back in the order of seniority, that is, A, then B, then C, and lastly D. The class D investors would be paid a higher rate of interest to pay off them for the higher level of risk, since they are exposed to the first default in the portfolio. Besides its success and acceptance many bankers find it risky for the credit market where as some express fearless trust on this credit derivative tool. During last few years CDOs have shown magnificent intensification rate which made it reliable even if many risks are involved for the investors as well as for the manufacturing companies’ worldwide. “During 2005 a research firm named Celent predicted the size of the global CDO market at USD 1.5 trillion and projected that the market would grow to nearly USD 2 trillion by the end of 2006” (Celent, 2005-10-31) An evaluation which stands against the reliability of the financial market lies in the fact that it has not been tested in the grim monetary declines and turndowns. During the 2007 ‘sub-prime meltdown’ in credit markets of United States Of America, when the value of money fell down along with the decline in the values of CDOs, the arguments against CDOs got attention. Regardless of such absurd losses, CDOs or other types of seniority-based venture tools have higher probability to continue as investors aim at getting profit in their group by risk-management approach. But after the sub-prime meltdown 2007, the investors will move toward such investments in a different way as compared to the past. Now the prerequisite for the investors will, perhaps, be the assessment of instruments and their likely risk before buying them. Indeed assessment as such has become highly important along with risk management in credit market today. The transfer of credit risks between the investors, whether the counter party is a bank or an insurance firm, surely leaves impacts on the over all economy of the country. According to DeBenedictus, Mar (2008), the CDO market today can suitably be portrayed with: “One of the two definitions for the word "moribund": being in the state of dying, or being in a state of inactivity or obsolescence. The cascade of losses on existing CDOs is certainly no help”. Moribund has dual meanings one of which is a decline and other meaning is of seeing good days. DeBenedictus has well defined the situation of CDOs in just one word. Surely CDOs are based on the two acute conditions because of possible risk factor involved in investment. CDO investment can be good for the investors as well as can obliterate the whole credit market circumstances. There are many forms of CDOs based on the source of funds, motivation, funding, and tranches. In point of fact, CDO is a broader term which involves several kinds of products. The CDO source of funds involves the cash flow and market value CDOs. In Cash flow CDO tranche holders get interest along with the principal amount. Cash flow CDO uses the cash flows produced by the CDO's assets to provide interest and grand capital to the tranche holders. It mainly focuses on the organization of credit quality of the original portfolio. As the cash flow CDO focuses on the cash produced by the asset put as security, the market value CDO in contrast focuses on the market value by sale of asset. It goes to augment returns for the investing agents by regular trading and profitable sale of security assets. The focus of market value CDO is on the changes occurring in the market value of the assets. The cash flow CDOs are more common than market value CDOs. The CDO products based on motivation principle includes the arbitrage vs. balance sheet approaches. Arbitrage transactions involve both the cash flow and market value CDOs. Basically it locates the equity investors which are extended among comparatively high yielding assets and the lower yielding liabilities represented by the charged bonds. The Balance sheet transactions distinctively are a source of motivation for the issuing firm to remove their loans and other assets from their balance sheets. Balance sheet makes them insist on to decrease their assets necessities and to get better return on risk capital for their institution. A bank may wish to offload the credit risk in order to reduce its balance sheet's credit risk. There are two types of funding in CDOs: cash funding and synthetic CDOs. Cash CDOs include portfolios of cash (liquid) assets like: loans, asset-backed securities and mortgage documents. The issuing firm of CDO gets the ownership of asset in cash funding. The threat of loss on the property is parted amongst tranches in reverse order of seniority. Whereas the Synthetic CDOs attains credit coverage of a portfolio of fixed income assets without any concern to its ownership. Similar to the cash CDO, the risk of loss is divided into tranches. Moreover, a synthetic CDO tranche can be either funded or unfunded. Some of this credit exposure is funded at the time of investment and some are funded later on. Hybrid CDOs is a type of CDO which provide insight into both cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps of synthetic CDOs. Besides Hybrid CDOs the single tranche CDOs are also widely used. The motivation for securitizations may vary from CBO/CLOs. for the common securitizations, the stronger inspiration is liquidity. The motivation for the bankers, investors and brokers can be the capital relief, the risk transfer, arbitraging profits or the balance sheet optimization. Moreover, banks can go for CDO for gaining cheaper funds, conquer higher authoritarian capital, for the better asset and liability management, and to reduce the dysfunctional or under productive assets. In regard to suggest appropriate strategy for the risk management in the use of CDO derivatives and products, Jean-Paul Laurent (2007) provided strategies in his article that the future risk management approach should be a mix of thoughts from finance, insurance and must quit from the typical approaches used in partial markets like expected utility maximization. So as to ease the study and the disclosure of risk to be managed, the non-payment dates go behind a “multivariate Cox process”. The benefits of the securitization of bonds and bank loans have generated different types of CDOs in the proposal to eradicate the allocational disabilities originate from bonds and bank loans. According to Jobst, Andreas A (2003), an arbitrage CDO is an accepted type of securitization structure started by the investment banks to get pricing differences between the attainment cost of security assets in the secondary market and aggregation of value after bundling in a reference portfolio primarily the transaction of the related CDO structure. CDOs are planned and designed in such a way that it takes benefit of weaknesses in risk management systems. The actions of the evaluation agencies are significant in regard to measure risk factors in CDOs. With the passage of time, many people are forced to reorganize their threat strategies. These risk models will possibly show amplified unpredictability over past. Michael S. Gibson writes in his article ‘Understanding the risk of synthetic CDOs’: “Synthetic collateralized debt obligations, or synthetic CDOs, are popular vehicles for trading the credit risk of a portfolio of assets. the development of the synthetic CDO market, I draw on recent innovations in modeling to present a pricing model for CDO tranches that does not require Monte Carlo simulation. I use the model to analyze the risk characteristics of the tranches of synthetic CDOs. The analysis shows that although the more junior CDO tranches -- equity and mezzanine tranches -- typically contain a small fraction of the notional amount of the CDO's reference portfolio, they bear a majority of the credit risk. One implication is that credit risk disclosures relying on notional amounts are especially inadequate for firms that invest in CDOs. I show how the equity and mezzanine tranches can be viewed as leveraged exposures to the underlying credit risk of the CDO's reference portfolio. Even though mezzanine tranches are typically rated investment-grade, the leverage they possess implies their risk (and expected return) can be many times that of an investment-grade corporate bond” (Gibson, 2004). The subprime mortgage crisis was the one which affected the CDO market performances worldwide. It is an unending property and monetary predicament caused by a drastic increase in the credit negligence’s in the United States of America which affected the other developed countries as well including Australia. The major affected institutions were the banks and credit markets worldwide. The crisis became evident in 2007, uncovering the enveloping weaknesses in credit instructions and the international monetary system. During 2007 the home prices in US started to decline resulting in mortgage crimes, delinquencies, refinancing became intricate as adjustable-rate mortgages started to reorganize at higher rates. Securities backed with subprime mortgages lost their values which were mostly in possession of banks. This left banks in crisis and worldwide decline in the capital of banks. As a result of this subprime crisis the U.S. government supported enterprises in reduction of credit all over the globe. No country is ever in position to suffer such crisis. Australia has been paying high amount of national income in discharge of the interest dues during the subprime crisis in 2007.it means that most of the Australians are under the debt which is indefensible. Money lending and borrowing is something healthy for the growth of an economy of any country but the excess of anything may lead to failure. Due to the increased debt in 2007, the households of Australia suffered fallen standards of life along with fallen incomes as their mostly income was spent in payment of the interest of credit borrowed from banks. The interest rate was also increased by the banks during the same period to overcome the crisis from which the banks were going through. The monetary regulation is by the banks of a country if banks are in crisis the whole monetary system gets affected. In a report "Deeper in Debt: Australia's Addiction to Borrowed Money" released on 18th September, 2007, for the Centre for Policy Development, Associate Professor of Economic & Finance at the University of Western Sydney, Dr Steve Keen disclosed that the amount of Australia's private debt to GDP has grown by 4.2 % every year since 1964 and is currently 156% of GDP. The huge debt indicates that Australian economy was relying on the private borrowings. This proportion is not reducing rather it is increasing with the passage of time. In his ideas Australia was not in the position to borrow without doing any proper economic planning for the country. His emphasis on the economic policy making was due because Australia had no other choice to get out of such monetary crisis. Americans faced subprime crisis due to irresponsible lending of money but Australia was in crisis during the same period due to high debts. In such circumstances, Australia could not meet the expense of reducing provision of debts as it could also harm the country’s economy by hampering investment and increasing the unemployment besides. At the same time Australia was not in the position to afford high cost households. Dr Keen (2007) found that Australian dwellings were not expensive as they became during the time of crisis. In such circumstances, Australia took very cautious steps and tackled the problem to prevent the world from another crunch of credit market. Reforms that were introduced by the government as a check to meet the crisis were based on the rules and regulations for the lenders. Provision to pay the loan was made to base on the capability to pay back, instead of the asset-price conjecture. Lack of public housing was addressed by the state. Policy approaches regarding inflation and government strategies were reviewed to overcome debt induced downfall. “Lehman was the most active marketer of CDOs in Australia at the retail level following its acquisition of Grange Securities three years ago. There is already another group of two dozen councils signed up for a lawsuit against failed Wall Street bank Lehman. That action is spearheaded by the Wingecarribbee council claim. Lehman was the most active marketer of CDOs in Australia at the retail level following its acquisition of Grange Securities three years ago” (West, 2008). Risk of losses in CDO is prevented by hedging that is a strategy in which the price fluctuations along with variation in value is undisclosed before the parties. To do so, the methods of swaps and making of CDO out of other CDOs is done. When a bond losses its value it is resold with new name by the banks and investors. Hedging is mostly done for interest rate, equity maintenance and security lendings. Equity is taken by the consumer of portfolio when he wants to avoid risk in future. In such cases the investors go for the opposite portfolio to prevent loss in future. Other methods for risk management are also adopted by the credit firms. In spite of risk involved in the CDO products the demand of it is still high as its gains are higher as compare to the other financial banking products. A careful regulatory process is needed worldwide to run CDO credit markets effectively without risks of loss. Bibliography ‘CDO and risk management’, available at: http://phorgyphynance.wordpress.com/2007/07/10/cdos-and-risk-management/ Reference An Introduction to CDOs and Standard & Poor's Global CDO Ratings, Available at: http://www.taiwanratings.com/en/criteria/CDO.asp?category=Criteria (Celent, 2005-10-31). "Collateralized Debt Obligations Market". Press release. http://www.celent.com/PressReleases/20051031/CDOMarket.htm. Retrieved 2009-02-23. ) DeBenedictus, M. (2008), ‘Technology's Role in Restoring The CDO Market’, Publication: Mortgage Banking, available at: http://www.allbusiness.com/banking-finance/banking-lending-credit-services/11736625-1.html. Dr Steve Keen report summary included in article “Unsustainable debt: Australia’s own subprime crisis”, Published Tuesday, 18th September, 2007. available at: http://cpd.org.au/mediarelease/australias-own-subprime-crisis Gibson, M. S. (2004), Understanding the risk of synthetic CDOs, available at: http://ideas.repec.org/p/fip/fedgfe/2004-36.html History of CDO’s, available at: http://www.oscn.net/applications/oscn/deliverdocument.asp?citeid=433720 Located in footnote of court document Jobst, A. A. (2003), ‘Asset-backed securitisation--motivation and advantages of collateralised debt obligations (CDOs)’, Publication: The Securitization Conduit, available at: http://www.allbusiness.com/finance/551175-1.html Laurent, J. (2007), ‘A Note on the Risk Management of CDO’, available at: http://www.defaultrisk.com/pp_crdrv133.htm Parker, E. (2008), available at: http://www.mayerbrown.com/london/article.asp?id=4234&nid=1575. Accessed on: 24th September, 09. Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney and a fellow of the Centre for Policy Development. Copies of the paper are available on request from the Centre for Policy Development - or download it from http://cpd.org.au/paper/deeper-debt West, M. (2008), ‘Local government lottery’, business day on November 17, 2008. Available at: http://www.smh.com.au/business/local-government-lottery-20081117-688i.html Read More