Talk:Collateralized debt obligation/Archives/2013

Backup of text removed by Chrerick

The following was text removed by User:Chrerick as part of a major rewrite. I wanted to keep a copy here so it doesn't get lost in the article's edit history. Finnancier (talk) 12:35, 12 February 2008 (UTC)

Rewrite

The manufacturer of this entity, typically an Investment Bank, takes a cut of the value of the inventory and obtains management fees. The bank also typically does not have to maintain the underlying assets on it's own accounting ledgers, a significant financial advantage. An investment in a CDO is therefore an investment in the cash flows of the assets, and the promises and mathematical models of this intermediary, rather than an a direct investment in the underlying collateral. This differentiates a CDO from a mortgage or a mortgage backed security (MBS).

Typically, the highest CDO tranche income rates are paid to those that will accept the highest credit default risks.

The "arbitrage" of a CDO involves the spread between the income generated from the higher-yielding assets the CDO holds in its portfolio and the lower-yielding liabilities the CDO issues. Since the CDO issues mostly high-rated debt, the cost of the debt is less than the before-default cash flow generated by the CDO's assets. The yield on the CDO's assets minus the cost of the CDO's liabilities and expenses is called "excess spread", i.e.,

excess spread = yield - $\sum$ interest payable to each tranche - management fees and expenses

Most of the excess spread is made available to equity investors in the CDO. The excess spread of the CDO must be sufficiently large to generate an attractive return for equityholders and this is a key consideration in the structuring of the CDO during the underwriting process. If losses on the CDO's assets are low, the spread can be substantial and lead to equity returns of 10% or higher but even a low number of defaults on the CDO's assets can eliminate the CDO's excess spread and cause equityholders to lose up to their entire investment. If losses exceed the size of the equity tranche, losses are next applied to the most junior debt tranche and so on in reverse order of seniority.

The distribution of cash flow from the CDO's assets to the CDO's tranches is modeled in cash flow waterfalls. There are separate waterfalls for interest and principal. Cash flow is first used to cover top-priority expenses such as administrative fees and hedge costs. Next, cash flow is distributed sequentially from the most senior tranche to the most junior tranche.

CDOs are subject to certain interest coverage or overcollateralization tests. For instance, an overcollateralization coverage test may require the CDO to maintain a minimum ratio of assets in portfolio to senior debt outstanding. If the ratio is not maintained, cash flow is diverted to pay principal on the senior tranche. Missed interest payments to mezzanine tranches that result may not lead to default as many mezzanine tranches include pay-in-kind features, in which missed cash interest payments are added to the principal of the tranche.

CDOs may include subordinate management fees and subordinate expenses.

"Blame"

From this article (and, notably, unsourced at the time of this writing): "Some news and media commentary blame the financial woes of the 2007 credit crunch on the complexity of CDO products."

Well, apparantly according to the chairman of the Financial Services Committee: A Liberal Wit Builds Bridges to the G.O.P., By DAVID M. HERSZENHORN,Published: May 13, 2008 (http://www.nytimes.com/2008/05/13/washington/13barney.html?th&emc=th). This should be revised and much better cited in the article. Shoreranger (talk) 15:43, 13 May 2008 (UTC)

ABS vs CDO

Can someone explain clearly what are the differences between these two? I understand it is assumed in this article that CDOs are a type of ABS but then it would be nice to state what differentiates them within the category. Other view is considering that ABS and CDOs are different things, both included in the category of long term securitization, this is the view I have found in some Bank of Spain articles [[1]] (spanish) . The difference given in this article is that ABS portfolios are highly granular and homogeneous in risk while CDO´s are not.Elartistamadridista (talk) 09:13, 10 July 2008 (UTC)

Transaction participants

For Chopstickkitty, do you have citations for any of the stuff you added today to the Transaction Participants section? It appears quite opinionated and I propose removing it unless you can provide objective citations. Bond Head (talk) 15:26, 15 September 2008 (UTC)

Seconded. In particular, the phrase "Now more often these participants were one and the same entity, and due-diligence underlying appraisals of mortgages was forsaken over the opportunity to rake in enormous fees." is rather partial, and makes no sense — if the participants are "one and the same entity", then who is paying the "enormous fees", and to whom?пан Бостон-Київський (talk) 12:25, 19 September 2008 (UTC)

For JMWester, two things. First, Phil Gramm didn't do anything on GLB single-handedly. GLB was passed by both houses of Congress and signed into law by the President. Second, the Barth paper you cite as a reference doesn't support any of the points you are making. I am going to tag those statements in the article. I am interested in your response. Bond Head (talk) 20:09, 8 October 2008 (UTC)

Removing a section just because it mentions Phil Gramm is a bit odd, especially since he authored the bill. I've placed request for comment at the Finance Wikiproject so someone with more knowledge about this subject than me can weigh in. NJGW (talk) 19:11, 9 October 2008 (UTC)

There are several problems with this part of the article. First, even if it were supported by references, it doesn't belong in the section on "Transaction Participants." Second, the statements are not supported by the reference provided. Third, there are at least three authors of GLB--Phil Gramm, Jim Leach and Tom Bliley--and in fact, many legislators, regulators, lawyers and lobbyists contributed to it; the article suggests that Gramm wrote and enacated the law single-handedly. Bond Head (talk) 02:26, 11 October 2008 (UTC)

I changed the wording to remove the emphasis on Phil Gramm and place it on the Gramm-Leach-Bliley Act. Now, what effect did the Gramm-Leach-Bliley Act have on CDO's? NJGW (talk) 02:32, 11 October 2008 (UTC)

Gaussian copula models???

Tha article states "A major factor in the growth of CDOs was the 2001 introduction by David X. Li of Gaussian copula models, which allowed for the rapid pricing of CDOs." The reference points to a paper that describes the application of these models to CDOs, but doesn't support the notion that this application was "a major factor in the growth of CDOs" or that it allowed "rapid pricing of CDOs." That the paper appears to be unpublished suggests that perhaps this work wasn't as influential as the article states.

Can the contributor provide an additional reference that better supports the statement? If not, I suggest it be deleted. Bond Head (talk) 10:23, 8 October 2008 (UTC)

In my opinion it's not credible. I would bet that 99% of professionals involved in such products neither knew of or cared to know of the paper. --216.165.95.70 (talk) 22:35, 9 October 2008 (UTC)

On the other hand it implies that traders were using systems fundamentally similar to the Black-Scholes options pricing method to evaluate the risk on these things (and fans of Long Term Capital Management will know how that story played out there. Edward Vielmetti (talk) 00:09, 10 October 2008 (UTC)

Someone added some links on the paper. Apparently it was a rough approximation of the risk, and people placed far too much faith in it. --216.165.95.70 (talk) 20:17, 16 October 2008 (UTC)

Note: if you follow the link to Gaussian copula models there is no mention of David Li, so without wishing to rob him of credit for this work, I suggest that the comment above that he may not have been that influential is probably correct.

Actually David X Li is pretty well known in academia, see: http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all His work seems to be influential. —Preceding unsigned comment added by 203.110.235.130 (talk) 00:52, 8 December 2010 (UTC)

History of these instruments

Along with Credit default swaps, this article could use a good history section, placing the invention of these instruments in the context of subsequent changes to the market. Edward Vielmetti (talk) 15:42, 9 October 2008 (UTC)

Thinking on the CDO market back in 2005, (Requires rewite) http://www.celent.net/PressReleases/20051031/CDOMarket.htm

The emergence of synthetic deals has clearly boosted the CDO market. The market is dominated by synthetic deals, and today 75% of CDOs issued are synthetic CDOs. This marks a clear evolution in the CDO market. In fact, the two most recent products, single tranche CDOs and ABS-backed CDOs, now account for, respectively, 66% and 25% of the synthetic CDO market. The market is moving toward "on demand" credit risk, where an investor can specify a product’s risk/return and the bank originates the "raw material" (bonds, ABS, etc.) and then distorts the risk/return ratio of its portfolio and delivers a new product to its client.

The development of the synthetic CDO market on the back of the CDS market is having a tremendous impact on the credit market, reorganizing the credit value chain. The development of the credit derivatives market and especially CDOs has had a tremendous impact in the positioning of banks in the risk management value chain," says Pierron. In the medium term, regional and smaller banks will concentrate on sourcing risk (especially via loans), while brokerage houses and investment banks will focus on deal structuring. The distribution will be shared between various players, from large banks to insurance companies, he adds. —Preceding unsigned comment added by 85.2.143.148 (talk) 12:45, 12 October 2008 (UTC)

Explanation of underrepresenting risks

The present article presents as obvious fact, written in parenthetically in various section, a single explanation for why CDOs encountered the problems they did -- that decoupling risk from the origination process degraded credit standards by removing incentives on originators to decline potentially risky loans. However there are other possible explanations. An additional example involves the assumptions the underlying risk models made -- they assumed that defaults are independent random variables -- that each debtor's risk of default doesn't depend on what any other debtor is doing or on global extrinsic factors. While in a rising economy this is a reasonable assumption, in an economic downturn everyone's risk increases at the same time, rendering these risk models invalid. The Gaussian copula approach is one example of models which make these types of assumptions. I would suggest removing parenthetical explanations presenting a particular view from the various sections of the article they're currently in, and have a section presenting a broader range of views on why the risk models on which these instruments were based didn't work. In particular, the reason originators degraded standards wasn't all due to corruption. The risk models themselves produced results which told originators they could degrade credit standards and the CDOs would still work. A key reason for the problems was that this conclusion was wrong because the models were faulty. --76.127.178.20 (talk) 13:57, 29 January 2009 (UTC)

You are absolutely right, 76.127... The cover story in latest issue of Wired magazine (not online yet) has the best explanation I have seen yet of the issues at play. There was a widespread misunderstanding of the correlation of risks in mortgage pools. The underlying assumptions that allowed huge volumes of CDOs and structured finance ABS to be sold with investment grade ratings were wholly wrong. Everybody had drunk David Li's Kool-Aid. While fraud, weak regulation, lax origination standards and other factors all played a part, none of that would have been possible without continued funding, which was accomplished based on a fundamental misunderastnding of risk correlation. Bond Head (talk) 15:13, 23 February 2009 (UTC)

Just to add to the story, the senior tranches, that were not supposed to default, did not default and have not defaulted. What happened is a bunch of people said "HOLY SHIT THE RATING AGENCIES GOT EVERYTHING WRONG", and they sold, and then a bunch more people sold, and some people were forced to sell, et cetera. The rating agencies, perhaps (it remains to be seen), did their job, which is to tell you how likely the instrument is to default if you hold on to it, and not whether the market price will crash temporarily due to a bunch of people freaking out.

concept of CDO

In the paragraph that 'defines' CDO's, the word "CDO" is used. Such a recursion is not helpful. The reader needs to know what a CDO is, in order to read the explanation of what a CDO is.

The explanation "Essentially a CDO is a corporate entity constructed to hold assets as collateral and to sell packages of cash flows to investors." is not compatible with a later part of this paragraph:"The SPE issues CDOs in different tranches and the proceeds are used to purchase the portfolio of underlying assets." You cannot issue a corporation (is a "corporate entity" a corporation?).

To remedy this, I changed the abbreviation "CDO" into "bond", and change the text where necessary to accomodate this change. I'm not sure whether the result is correct. I hope that someone who knows more about this can check it. --Roger Jeurissen (talk) 22:53, 29 March 2009 (UTC)

Certainly you can "issue" a corporation. That's what stock is... :) However, that's not a terribly good explanation, because CDOs aren't corporations, they're securities. They're more like a special type of bond, deriving payments from mortgages. Andrew Elgert (talk) 07:01, 7 June 2009 (UTC)

Credit card CDOs

As this 2003 working paper discusses, credit cards are a fair part of collateralized debt obligations. I find that strange, because credit cards are unsecured debt. That means that by definition they are not backed by collateral (finance). Has anyone heard about how this is resolved? Am I missing something? It also seems like using "security" to refer to something which is a package of unsecured debt could be a bit misleading. Of course, equities are securities and equity-holders are junior creditors who probably have no technical "lien" on collateral... II | (t - c) 00:00, 25 June 2009 (UTC)

Credit card CDOs are CDOs whose assets are comprised of credit card ABS. Credit card ABS use a variety of techniques and structures to provide some credit enhancement for investors. These can include internal structures like excess spread, spread accounts, overcollateralization and senior/subordinated structures. They can also use external credit enhancement like letters of credit or bond insurance, although with the demise of the bond insurers and the credit crisis, external credit enhancement is much harder to come by and much more expensive than it used to be. Hope this helps. Bond Head (talk) 23:18, 28 June 2009 (UTC)

proof of intractibility

Should we include a link to the proof of the impossibility of solving (assuming P≠NP) the problem of whether a given CDO is "good"? http://www.cs.princeton.edu/~rongge/derivative.pdf It seems relevant to this topic, but I'm not sure where in the article it should go.--WhiteDragon (talk) 20:12, 23 October 2009 (UTC)

Rating agencies and methodologies (Moody's, S&P & Fitch)

"The risk and return for a CDO investor depends directly on how the CDOs and their tranches are defined..." misses the mark. It might be useful to add a section to delve further into the rating agencies and their methodologies for rating the CDO. These ratings are one of the tools an investor should use when determining whether to invest. Just a thought...Cmentmixer (talk) 12:35, 2 March 2010 (UTC)cmentmixer