Financial Risk Management of Insurance Enterprises Collateralized Debt Obligations (CDOs)

Overview Introduction History Fundamentals Attributes Parties Credit Ratings Synthetic CDOs Valuation models Current events

Introduction of CDOs Asset-backed security Structured credit product Portfolio of fixed-income assets Tranches

History First CDOs, 1987 –High yield bond portfolios Next CDOs, 1989 –Mortgage Backed Securities –John Meriwether, Salomon Brothers Liar’s Poker Long Term Capital Management Credit Risk Transfer (CRT) vehicles Loans Securitization CDOs Growth Synthetic CDOs

Fundamental Concepts behind CDOs Corporate entity raises capital Invests in financial assets Distributes cash flows

Four Key Attributes of CDOs Assets Liabilities Purposes Credit Structure

Assets Corporate bonds Residential Mortgage-Backed Securities Commercial Mortgage-Backed Securities Asset-backed Securities

Liabilities Senior debt Junior debt Subordinated debt Equity

Purposes Balance sheet –Shrink balance sheet –Reduce required regulatory capital –Lower funding costs Arbitrage –Asset manager increases fund size and fees Origination –Issuing securities to CDO as CDO issues liabilities

Structure Market value CDOs –Enhance returns through trading –Credit quality derives from the ability to liquidate assets and repay debt tranches Cash flow CDOs –Cash flows from assets pays the interest and principal of tranches

Cash Flow CDOs Distribution of cash flows: waterfall Coverage test –Overcollateralization –Interest coverage

Structural Matrix

Parties Asset managers Asset sellers Investment bankers and structurers Monoline bond insurers and financial guarantors

Credit Ratings Collateral diversification Likelihood of default Recovery rates

Synthetic CDOs Does not own assets on which it bears the credit risk Sells protection via Credit Default Swaps Buys protection via tranches issued

Valuation models Gaussian copula model –Default correlation Dynamic model –Hazard rates with deterministic drift with periodic impulses

CDOs on CDOs CDOs based on a tranche from a CDO Example: –CDO^2 based on a tranche (e.g. BBB) of a CDO –CDO^n based on a tranche of a CDO^(n-1) It gets very complicated very quickly

Current events Subprime mortgage crisis Counterparty credit risk Liquidity issues Prices drops –ABX index Rating agencies are blamed for inaccurate credit ratings

Concerns with CRT vehicles ‘Clean’ risk transfer Risk of failure of market participants to understand associated risk Potentially high concentration of risk Adverse selection