Role of Collateralised Debt Obligation And Credit Default Swaps in American Crisis

1. PRESENTATION
ON CDO’s
By:
Manas Upadhyay

2. What is CDO?
• Collateralized Debt Obligation.
• Breaking up each we get:
• Collateralized : To secure (a loan) through use
of collateral.
• Debt: a liability to pay or render something.
• Obligation: an act or course of action to which
a person is morally or legally bound; a duty or
commitment.

3. Defining CDO
• According to Investopedia:
“A structured financial product that pools
together cash flow-generating assets and
repackages this asset pool into discrete tranches
that can be sold to investors.”

4. Tranches?
• Tranche is French word meaning slice.
• So, Tranches are pieces, portions or slices of a
deal or structured financing.
• This portion is one of several related securities
that are offered at the same time but have
different risks, rewards and/or maturities.

6. Types of Tranches
• Senior: Less risky, first payment in case of
default, less return and high ratings.
• Mezzanine: moderate risk, second payment in
case of default, moderate return, moderate
rating.
• Junior: high risk, last to receive payment in
case of default, low return, low rating.

7. History
• First created in 1983 by the investment banks
Salomon Brothers and First Boston for the U.S.
mortgage liquidity provider Freddie Mac.
• Problems before CDO’s?
1. Long tenure bonds traditionally
2. Prepayment risk
3. Reinvestment risk as repayment of principal on
loans.
4. Default risk

8. Problems Addressed by CDO’s
• CDO is formed by group of mortgages:
1. Keep some securities with long tenure and some
with short tenure.
2. A group of mortgages with high rating and other
with low.
3. A group of Principal only and another of Interest
only.
NOTE: Risk is increased or decreased is based on
structure of CDO formed.

9. Problem with CDO’s?
• Under collateralization is biggest and only
problem.
• When amount of default exceeds the value of
collateralized asset value.
• Happened during US sub prime crisis.
• Hence CDS ( Credit Default Swap) was
introduced.

10. Parties/Participants:
• Securities firms, who approve the selection of
collateral, structure the notes into tranches and
sell them to investors. Investment Banks like:
Morgan Stanley, Goldman are some of the
examples.
• CDO managers, select the collateral and often
manage the CDO portfolios;
• Financial guarantors, who promise to reimburse
investors for any losses on the CDO tranches in
exchange for premium payments, insurance
agencies using CDS;
• Investors such as pension funds and hedge funds.

11. CDS?
• A financial swap agreement
• The seller will compensate buyer in event of
loan default.
• Buyer pays a premium or fee to seller.
• In event of default buyer gets the face value of
loan and;
• Seller takes possession of defaulted loan.
• Naked CDS, without any interest in security

12. Not understood, don’t worry!
• As an example, imagine that an investor buys
a CDS from AAA-Bank, where the reference
entity is Risky Corp. The investor—the buyer
of protection—will make regular payments to
AAA-Bank—the seller of protection. If Risky
Corp defaults on its debt, the investor receives
a one-time payment from AAA-Bank, and the
CDS contract is terminated.

13. • As CDS provide a cover like insurance, to
CDO’s?

15. Well answer lies in Housing Crisis of
2008.
•Why comes the
question?

17. American Housing Crisis-
2008

18. Main reasons for crisis
• Deregulation
• Loans at higher rates without having proper
collateral. (Sub prime loans)
• Forming CDO’s of such risky securities.
• Rated AAA by rating agencies.
• Use of unregulated over the counter derivative
product such as CDS.
• Huge Compensation
• Fall in demand of housing, hence fall in prices

19. How we got here?
• Rise in financial sector in US since 1980.
• Deregulation of financial sector by
government, allowing saving and deposit
companies to make risky investment.
• Amending “glass steagall” act for merger of
Citi and travellers group. (Preventing
consumer deposit company to merge with
investment banking activity)

20. • Borrowers went to banks for loan, they sold
these loans to investment banks who then
sold it by combining it and making CDO’s.
• These CDO’s were sold to investors to all over
world.
• Rating agencies gave CDO’s AAA rating (even
to subprime loans CDO)
• Banks/ lender didn’t worried about repayment
so more riskier loans were given
• Investment banks didn’t worried too, more
CDO’s they sold higher profits they earned.

22. • Since loans were given easily, prices of houses sky
rocketed.
• Deregulation on leverage money.
ROLE OF CDS:
• AIG sold CDS of these CDO’s, which was bought
by speculators as naked CDO’s.
• Huge compensation paid to top executives out of
profits, no reserves were made.
• Goldman and Morgan Stanley started buying CDS
of CDO’s, they sold, they were betting against
CDO’s Sold by them .

23. CRISIS
• Now suddenly, default on loan rose; making
CDO’s worthless.
• House property value fall due to rise in
foreclosure.
• All the highly rated AAA CDO’s became
worthless.

24. Outcome of crisis
• Raised unemployment.
• Banks became bankrupt, Lehman Brothers
closure.
• Pension funds of various states vanished.
• Collapse of AIG.
• Huge loss to tax payer money.
• Prices of houses plunged.

25. CONCLUSION
• Going into depth of any security is important
specially of securities which has some
derivative products otherwise results would
be catastrophic.