Slide 1: CDOS, CDS,THE SUBPRIME CRISIS AND IRELAND, 2007-2009
Dr Stephen Kinsella stephen.kinsella@ul.ie www.stephenkinsella.net
Slide 2: LAST TIME
Financial Fragility in Ireland Corporate Governance lacking, financial innovations disrupt normal running of markets.
Slide 3: MINSKY WAS RIGHT.
Slide 4: MOVING L17-L18
Slide 5: TODAY
CDO + CDS, Definitions & Examples. How do they relate to Ireland today?
Slide 6: Definition
Securitization… is the process of packaging (illiquid) liabilities and debt instruments, thus converting them into liquid tradable “asset-backed securities.”
Slide 7: BASIC STRUCTURE
The bank sells a portfolio of loans Bank Payment for loan portfolio Special Purpose Vehicle (SPV) The SPV issues bonds
Investors Proceeds from the issue
Slide 8: Central Bank policies (next week) Interest rate policies and regimes. Funding cost changes. Exchange Rate policies. Models, Pricing knowledge, fast and accurate calculation of ‘Greeks’, Hedging ability Leads to innovations in structured credit markets
Slide 9: What is a structured Credit asset ? Reasons for using structured assets Anatomy of a structured asset CLE CDO Examples -- Pricing and sensitivity
Slide 10: A structured asset is, at the end… an asset incorporating a derivative strategy. But this notion gets broader in Credit The notion of correlated events become central
Slide 11: Individual Credit Exposures
Credit Risk: by tranches
Portfolio of N Credit Exposures To Be Covered
T R A N C H I N G
Super Senior AAA Mezzanines Equity
Slide 12: A COLLATERALIZED DEBT OBLIGATION (CDO) IS A STRUCTURED PRODUCT WHERE A portfolio of securities is transferred to a SPV SPV issues tranches of notes with different seniority and there is also an equity stub The CDO tranches are rated based on portfolio credit quality, portfolio diversification, and subordination.
Single tranche…bespoke CDO/CDO-squared
Slide 13: LIABILITIES
ASSETS Reference Portfolio
Super Senior
+25 ABS – [83%] (3.32% each) +3 CDO Tranches – [17%] (5.6% each) ABS Bucket ♦RMBS [60.00%] ♦Credit Cards [12.00]% ♦? ABS [12.00]% ♦Consumer Credit [8.00]% ♦Auto Loans [4.00]% ♦Student Loans ABS [4.00]% CDO Bucket ♦Total number investment grade ♦Corporate Reference ? is 42% ♦100 names per CDO ♦Portfolio average rating: A/BBB+
Senior AAA [2.48]%
Junior AAA [0.99]%
AA [1.03]%
Equity [1.36]%
See sifma.org
Slide 14: By reallocating the default probability CDO tranches can generate returns of 15-20% from very small default probabilities…
But, more importantly… …they generate assets with different sensitivities to (default) correlation
Slide 15: Buy Equity tranche… …Sell Mezzanine tranche. The effects of default probability will cancel out. And the correlation effect can be isolated. This can be traded.
Slide 16: Innovation is essential to make money …and structured products are a major way of doing this.
Slide 17: CDS
Credit default swap (CDS) market is a large and fast-growing market that allows investors to trade credit risk. Credit default swap (CDS) is a contract between two parties, where a protection buyer pays a premium to the protection seller in exchange for a payment if a credit event occurs to a reference entity. CDS are customizable, over-the-counter products and can be written to trigger in the event of bankruptcy, default, failure to pay, restructuring, or any other credit event of the reference entity.
Slide 18: IRELAND & THE GLOBAL QUESTION
Slide 20: NEXT TIME
The European Central Bank & Investor Behaviour. Reading: Buiter, W: Why the United Kingdom Should Join the Eurozone.
