The Establishment of the Collateralized Debt Obligations - Coursework Example

Topic: Accounting oversea transaction assignment 22309 Student Names and student NUMBERS: DUE DATE: _________________________ DATE SUBMITTED: ______________ VERIFICATION OF ORIGINAL WORK: I/We verify that this assignment is my/our own work and has not been submitted for academic credit in this unit or any other course. I/We declare that all sources have been duly and appropriately acknowledged. Signature of Students: ______________________________________________ Date: ________________ ______________________________________________ Date: ________________ ______________________________________________ Date: ________________ ______________________________________________ Date: ________________ ______________________________________________ Date: ________________ ______________________________________________ Date: ________________ ______________________________________________ Date: ________________ Introduction: A few years ago many of the local councils have purchased a set of financial instruments which they were considering as the safe investments in the shape of Collateralized Debt Obligations (CDOs), but in reality that investment was a risky transaction as the returns associated with these investments was neither safe nor profitable(Sheffrin 2003)(1). CDOs are a kind of structured Asset-Backed Security which is labeled as ABS whose payments and values are primarily derived from a set of portfolio of fixed income with underline assets as in favor of the buyers with a fixed duration. CDOs are divided into different risk trenches or classes as like senior trenches which are considered as the safest securities for the investors. The principal payments and the interests are made in order of seniority as maximum with the senior trenches and the lowest with the junior trenches depending on the duration and maturity of the CDOs. The nature of transactions and the transfer of ownership of these CDOs are in a flexible and are regularly transfer from one owner to that of the other with a shifting of profit margin from the buyer towards the seller. The junior trenches are offering higher coupon payments along with the interest rates and the lowest prices to compensate for the additional default risks as are associated with these CDOs. The level of risks is always associated with the transactions and the ratings of the Collateralized Debt Obligations (CDOs) are in fluctuating model depending upon the size and the nature of the financial transactions as are accomplished with the sales and purchases of the CDOs. Many of the CDOs are valued on the basis of mark to market mechanism and thus, have witnessed substantial right-downs on the balance sheet of the investors as entirely based on their market value along with its collapsed status. The investment as made through the CDOs, therefore, is considered as a volatile and risky business transaction and the investors are investing in these financial instruments as on the basis of their face value and the maturity period and as on speculations(Dodd et al 1951)(2). However, the fear of their collapse is always attached with the investment as made through these transactions in the financial market. The establishment of the Collateralized Debt Obligations: The Collateralized Debt Obligations (CDOs) were issued initially in 1987 by the bankers Drexel Burnham Lambert Inc. for imperial savings association which was a saving institutes that later termed as insolvent and was taken over in 1990 by the Resolution Trust Corporation. In the subsequent years the CDOs has emerged as the fastest growing instrument of the assets-backed synthetic in the securities market for its capitalization. The growth in the CDOs is reflecting the increasing acceptance of these financial instruments with an objective to enhance the number of assets mangers and the investors. These investors include mutual fund companies, commercial banks, pension fund mangers, investment banks, unit trusts, private bank organization and the individual investors through the structural investment vehicles and other CDOs. The investors were investing in the set mode of financial investments as these were offering 2 to 3 percentage points higher than other financial opportunities as for example, corporate bonds with the same level of the credit ratings for the same fixed period of investment. The investors are executing their investments in the financial modes with the greater profit margins as the CDOs has provided to their potential investors and the manufactures. The CDOs has witnessed a period of their growth during the year 2001 with the introduction by David X. Li of Gaussian copula models which had offered a rapid pricing for the CDOs. The period of growth as witnessed by the CDOs was mainly driven by a high level of profit as compared to other financial arrangements as on future based financial transactions. The marketing of the CDOs: In the year 2005, the size of global CDO market was calculated at the level of 1.5 trillion US $ and was projected that the market will further grow during the subsequent years with high investment from the new investors in the market. The marketing of the CDOs was through the arrangements as in the shape of assets-backed security for the creation of a CDO corporate entity as is designed to hold assets in the shape of collateral and to sell the packages of cash flow to the investors with the following well designed and structured marketing mechanism as relating to the CDOs: 1) A special purpose in entity has acquired a portfolio of the underlined assets like mortgage-backed securities, corporate loans and the real estate bonds. 2) These special purpose entities have issued the bonds in the shape of CDOs as in different trenches and the proceeds were used to purchase the portfolios of the underlined assets as equities securities ,junior securities and the senior securities for making investments in the CDOs. The same can be reflected with the help of the following hypothetical diagram: The arrows are indicating the cash flows from the proceeds of one type of the assets and their financing in the clearance of the other types of the financial transactions as to benefit the investors and the investment corporations as are involved in the business. The proceeds of the different trenches are used to purchase the portfolio of the underlying assets for the enhancement of the profits as in favor of the investors. The ratings of the CDOs: The senior CDOs are disposed off with the cash flows as was received from the underlying assets prior to the junior securities and that of the equity securities for enhancing the rating of the CDOs at the level of AAA. The ratings were attained by the investment corporations as through the maturation of the senior CDOs and their successful disposal through the funds as received from the underlying assets. The successful completions of the cycles have resulted in the shape of better rating as AAA. These transactions have also the chances of risks in the returns from the proceeds of these CDOs to their investors depending directly on the mechanism that how these CDOs and their trenches have been defined in the shape of their direct and indirect mode of investments. CDOs like other asset-backed securities enable the originators of their underlying assets to transfer the credit risks to another individual or the investors for securing their losses at the minimum levels, therefore, the investors are always taking extra care while investing in the transactions as are associated with the CDOs. These CDOs are earning their profits or losses during the time of their transactions on the issues through their transfers. The managements are securing their fees during the whole life of the CDOs. These CDOs are generating substantial fees from the securitized loans as associated with the absence of any types of residual liability with the incentives as offered to the originators in the shape of loan volume rather than that of the loan quality. The marketing of the CDOs are earning a commission typically through an investment bank during the time of their issues as the management fee with a structural flaw and deficiency in the securitization market as in the shape of debts which has generated in the shape of credit bubbles of 2000 as will as the crisis relating to the credits as had observed in the form of baking crisis of 2008.The marketing of the CDOs in the shape of other CDOs has always created enormous problems for the accounting mechanism as have been allowed by the large financial institutes to off-load their book losses by pooling their collective debts with other financial organization and institutes to bring their debts back onto their books as in the shape of synthetic CDO assets(Mitchener & Eichengreen 2003(3). That is the arrangement that has allowed the financial institutes to hide their losses as are associated with the financial transactions as are made in the CDOs but has allowed them to enhance their earnings. The collective impact of all these unfortunate effects of potential losses is in the shape of doubling as losses in the book wise arrangements. The losses as are associated with the CDOs are clear and are indicating the mode of their marketing in the financial markets but with hidden shape of losses as booked by the financial institutes, the local councils and other similar bodies which have initially declared investments in the CDOs as safe but later on have realized that they had bought something very risky and unproductive assets with high levels of liabilities and the associated financial risks. The ratings as attained by the financial institutes and the organizations are short lived and artificially maintained for attracting further investments as through AAA ratings. These investments are having profound financial impacts on the financial institutes and the buyers of the CDOs. Their investments have proved to be worthless with quick and long term effects as in the shape of financial collapse as witnessed in many parts of the world like in Australia, UK and the Unites States of America. Fluctuations in the currency exchange rates and their impacts on the marketing of the CDOs: The investments in the CDOs are influenced by a set of external and internal factors including changes in the foreign currency rates on the volume and the nature of these investments. The changes in the foreign currency are having profound negative impacts on the level of investments as with any increase in the currency exchange rates will enhance in the estimated impairment losses through their impacts of settlement with a reduced exposure to CDOs. The fluctuations in the foreign currency exchange rates are having the potential to affect the investment levels in the CDOs as an adverse effect on the value of administration fees as earned by the financial institutes through their transactions and the value of the advisory charges as are received by the concerned financial institutes for the investments which are denominated in the form of foreign currencies. The currency exchange rates are influencing CDOs in the shape of their pace of transactions and other structured products as are linked with the financial sector and through the leveraged speculating community as a segment of the overall financial business including that of the CDOs. These exchange rates as in the shape of any fluctuation have triggered a set of readjustments and rearrangements in the portfolios with huge losses especially relating to the technology stocks, credit derivatives and the CDOs along with other structured vehicles. The illiquid CDO market is negatively influenced by the currency exchange rates as most of the players having no other option but to hold and hope for their recovery. These impacts lead to unprecedented levels of risks as have been noticed in the financial markets at the world over. These currency exchange fluctuations have created insurmountable problems as unprecedented risks during the past few years in the shape of reckless lending with long lasting negative impacts on the financial institutes and the individual investors. A set of allied negative influences are generated through the changes in the currency exchange rates as faltering system of liquidity as against the investors ,contagion effects of the changed exchange rates , and high rates of interests for making future investments. The Currency devaluation has the strength to influence the subordinated compartments of the investments as in the shape of liquidity crisis. A set of companies are influenced with the change in the currency exchange rates as are introduced by the national governments for adjusting their exchange rates at the global levels and to attract the flow of the capital in their respective jurisdiction. In such type of situations, the companies are seeking hedging protection for the maintenance of their respective financial disciplines and to mitigate the impacts of the changes as in the shape of the currency exchange rates. These companies are focusing in an articulated mechanism so as to avoid a default like situation for securing their financial credibility in the financial markets. The impact of the currency devaluation is especially problematic for the derivative companies which are mainly relying on the dynamic hedging programs as it initiates the possibility of a discontinuous market process with a decline trend in the market including that of the CDOs as through the currency exchanges and the currency devaluation which has influenced the marketing process of the financial instruments including that of the CDOs. The process gradually lead to the deterioration of the financial positions of the corporations and the companies who are dealing with the CDOs in a systematic and directional mechanism with a profound signal of the hedging program that has the capacity of entailing shorting securities as to establish position that would have the potential to generate cash flow to avoid devaluation process and ,therefore , to maintain the portfolio investment as made in the shape of investments as CDOs for the maintenance of their declining portfolios in the financial markets. The eventual outcome for the local Councils who had invested in the CDO’s: Many of the local councils who had invested in CDOs as with the concept that the investment is safe in the sense that they would achieve economic returns with maximum benefits will not be in a position to get their expected financial gains through these financial transactions. The investment has also been made by the charities and other institutions around Australia would be across the levels of huge financial losses as investment in the CDOs is not based on the financial performances of the corporations or the financial institutes rather than on speculations and expectations mainly through the underlying assets. The short fall ad the collapse would be witnessed when a certain number of companies with their investments in the CDOs go broke and the investment in the CDOs would definitely become worthless the position is rapidly approaching as the long term financial impacts at the global level have been witnessed in many parts of the world including Australia. Similarly, the bankruptcy as observed by general motors during the month of June 2009 was also a step towards the larger incident. The investors who had made investments in such type of financial instruments are joining legal actions against the position for the recollection of at least sum of their funds from those financial institutes and the advisor who had tendered an advice for buying CDOs at the initial stages. The position is forecasted on the basis of the financial results and the collapse of the various financial modes in many parts of the world as the mechanisms did not prove to be beneficial both to the individual as well as to the financial organizations who had made their investments in such type of so called safe investments as in the shape of CDOs. The local councils who had made their investments in the faltering market in CDOs are facing a dilemma as their financial resources and future investments are vanishing with a quick pace with each major collapse as leading towards a final collapse of the financial arrangements. These local councils and the charities are having a number of options to deal with the issue as in their collective as well as individual capacity. More appropriate option is to leave the market as on quick basis with the acceptance of the financial losses and reinvestments of the earnings as made through the CDOs. The other option as available with the local councils is to approach to the national government for seeking their timely intervention for the financial help as in the shape of donations and financial inputs as in favor of the local councils. These steps will help in the termination of the structures and release of local councils from the deadlocks and from the zones of uncertainties. All types of the CDOs including those backed primarily by leveraged bank loans, by the fixed income securities, by the credit derivatives and by the structured products for example, asset-backed securities and mortgage-backed securities would get benefit from the mechanism and the local councils would be in a position to regain their strength as in financial as well as administrative terms. The local councils need to re-fix their strategic directions for making investments as purely based on financial reviews and analysis of the companies who had performed well during their respective financial years with better dividends and bonuses to their shareholders. Key economic considerations by the local councils as under writer will bring a new deal to such type of the administrative units for making their presence as effective and on solid financial grounds (Frederic 2007) (4). In addition these local councils will work with the assistance of the financial managers for the determination of the post closing trading restrictions that would include the CDOs transactions and the related documents for their final disposals. The concluding step towards the disposal of the CDOs is to find the investors for taking the financial modes as from the local councils. The financial managers would receive a piece of the transaction and the local councils are accepted to be relieved from the cycle of investment as in the shape of the CDOs. The investment in CDOs as was made by the local councils, charity organizations and other individuals as in the shape of safe investments for maximum gains in favor of the investors did not yield the expected financial outcomes, however, their disposals would benefit the local councils as in the shape of their withdrawal with the acceptance of the financial losses would be covered in the subsequent years as by making investments in the established financial markets for the achievement of the financial gains as in favor of the local councils. The local councils are recommended to make their financial deals as on the basis of the financial analysis, reviews of the performances and on the ranking and rating of the corporations and the firms for financial gains. It is expected that the episodes of the investments would not be repeated by the local councils and other similar organizations as the same is in the best interest of such type of the organizations and the investment would be made on the basis of the financial performances but not on the expectations and speculations as were associated with the CDOs as was made by the local councils for the realization of their targets as through the CDOs. References: 1. Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 271. ISBN 0-13-063085-3. 2. Graham, Benjamin, and David Dodd (1951). Security Analysis. McGraw-Hill Book Company. ISBN 0071448209. 3. Barry Eichengreen and Kris Mitchener 2003 "The Great Depression as a credit boom gone wrong", Bank For International Settlements, Working Papers No. 137 (September 2003). Retrieved 2007-05-08. 4. Mishkin, Frederic S. (2007). The Economics of Money, Banking, and Financial Markets (Alternate Edition). Boston: Addison Wesley. p. 8. ISBN 0-321-42177-9.    Read More