OF CDS & CDO

Hmmm... Its been a long long time since I posted the last one; which was around the time Bear Stearns had fallen; Now Wall Street has seen another biggie fall and Another taken over yet another nationalised. Reason enough for the newagegrotius to wake from his Slumber. The newagegrotius sadly notes the end of an era at Wall Street and let us hope some sanity is restored in this new ( hopefully more regulated! ) era.

As Always then the Big Bear Buffet has the last laugh. In his letter to the shareholders of Berkshire Hathaway, he had labelled financial Derivatives "Weapons Of Mass Destruction" and how true his words were! I am sure a lot of you might want to decode the info on CLOs and CDOs and CDS. But random Googling will only lead you to jargon and more jargon; Thenewagegrotius believes in Democratizing the World Of Structured Finance and so this attempt to explain the logic behind the jargon that CLO, CDO, CDS has become in plain English!
Let us take the simplest first:
CDS aka Credit Default Swap:-
This is innovation on the Standard Securitisation Structure with one diffrence in that the reference asset is not transferred from the books of the originator and the risk of the asset defaulting is transferred merely; the buyer of Protection pays a premium to the seller of the protection. ( A bit like Insurance, this solution is, with one major diffrence that is the buyer need not have any " insurable interest"in reference asset he is buying). The "Insurance" is brought on a notional principal and the premium is paid thereon. On Default ( the trigger event could be liquidation, reorganisation bankruptcy of the reference asset ( in plain English, the Borrower Co.). , the buyer sells the reference asset to the seller of Protection or the seller pays the loss to the buyer.
These Swaps are a good portfolio diversification device and also a way to work around regulatory capital requirements. This may be illustrated as follows:
Say Financial Institution has heavy exposure to Steel and wants to increase its exposure to another space, say retail loans ; it simply sells protection to the FI active in the retail loan Space and itself buys protection on its Steel heavy Portfolio. It transfers its risk on the Steel space and hence does not have to make provisioning for that space; Since it is selling protection on the retail loan space, its like synthetically creating exposure in the retail loan segment. Thus it has now to provide for the loan default on the retail loan segment. In effect therefore, the portfolio is no longer comprising merely of Steel Sector, it is inclusive of retail Space as well. Thus the FI has achieved portfolio diversification without actually lending to the retail Space. Also note that since the loans in the Steel sector are already provided for, ( the risk of default is transferred to the seller ofProtection), the provisioning for the same need not be done. this frees regulatory capital and allows the FI to create more assets. This is the way a vanilla CDS functions. more exotic versions exist; but this is the most used Credit Derivative.
CDO aka Collateralised Debt Obligations:-
A CDO issues securities to the investors and itself invests in a portfolio of assets. This portfolio is called the reference portfolio and may comprise of basket of reference assets like Loans, bonds; ( if the underlying is loan, it is termed "CLO");Sometimes the reference asset may be a CDS ( what this means is that the CDO will sell protection to the buyer for a receivable ; as we saw earlier this is the " Premium"). The receivables on the portfolio are used to redeem its own Securities and to pay coupon on them. So, a CDO is not unlike a bank that lends long , borrows Short and pockets the coupon Difference.
Generally, the Manager of CDO will slice the securities in different classes ( called " tranching"); Senior, First Class, Second Class and the last equity layer. the higher layer security holders are protected and get a correspondingly lower coupon and the later tranche holders carry a proportionately higher coupon to compensate for riskier exposure that they take. The reference asset(s) are a basket that should ideally have low Co relation ( Co relation signifies the probability that one reference asset will default given that one reference asset has defaulted; Obviously, if the reference basket has assets from same sector or related sectors, there is high probability that if one defaults, the other defaults; therefore Ideally, the reference basket should be diversified. It is clearly inferred however that the equity tranche holders will prefer high Co relation because of the higher coupon that it carries as High Co relation port folios are more volatile for obvious reasons and the senior tranche holders will prefer low Co relation).
More on CDOs will follow but for now the newagegrotius will take your leave!