Can you, in 500 words or less, list out everything relevant that we need to know for the exam on CDOs? This is a weak topic for many, and would help out all. - Cash flow CDO vs Synethic CDO vsl Market Value CDO - Junior vs Senior Tranche (risks and rewards) - Anything else of importance
haha, i spent 5 years structuring CDOs and i get all the CFA questions wrong! They do a poor job explaining what they want you to know (as opposed to what they actually are). If you have specific questions that are conceptual, please post.
Well ro424 i’m the exact opposite in terms of experience, but lets see what i can spit out from the memory Synthetic CDO. senior section doesn’t require funding shorter ramp up time only the junior section is funded Usually Sells a CDS and makes money from premium Cash flows CDO manage the bonds to obtain enough cash required for investors Market Value CDO Sells investments for cash required (disclaimer… this is how i have it remembered, not stating this is truth. if you don’t like tough, feel free explain, i’m not going to look in the book just because you don’t want to.)
Schweser is confusing because they say “The senior holders recieve a small premium in return for the obligation to fund any losses.” Then a few lines down they say “The bottom line is that the junior bondholders receive incomefrom the high quality debt securities as welll as the insurance premium on the credit default swap.” So who actually gets the CDS premium? Does the junior get more because they take on more risk?
i believe junior gets most of it. if its like 300 syn cdo. 50 junior section. Sell a CDS for 250 notational amount. Junior section would be liable for the first 50, so the senior holders wouldn’t be to at risk
i’m assuming this is a synthetic CDO? The junior portion (40% of the capital structure) is “funded” and the senior portion (60%) is “unfunded”. The CDO sells protection on a portfolio of assets, in return recieves premium income. When the jr. noteholder invests in the CDO, they provide cash to the CDO (just like any bond investor). The CDO invests in high-quality securities, that earn (let’s say) LIBOR. Income to the CDO = premium on 100% of the portfolio and LIBOR on the 40% of the high quality securities So now the CDO will pay out to its investors a small premium to the senior noteholders, and LIBOR + premium to the junior noteholders.
Based on my understanding, the junior section gets both the return from the high quality collateral and the premium of the CDS, so they are issued notes. Not sure what the senior sectioan actually gets, are they issued notes and share a portion of the premium with the junior notes?
yes, they receive premium for basically a promise to pay. The CDO has obligations under the CDS protection it has sold. If a default occurs, the CDO owes a protection payment. It will use the cash raised from the jr. noteholders to pay out those payments first. Once that’s exhausted as defaults increase, it will draw on the sr. noteholder for money to make its payment obligations.
Well, I have no experience in CDO. However, I’ll try my best to explain it. Correct me if I am wrong,pls + Cash flow CDO and Market CDO: Originators (banks) sell their assets (loans) to a trust to receive money. The trust issues CDO (in different tranches to investors) to receive money under promise to pay investor principal and interest on CDO => Trust owns the loan and exposes to credit risk Note: market CDO is very similar to cash flow CDO. The difference is that the portfolio manager has more flexibility (he can sell asset to generate cash flow) + Synthetic CDO: Originators buy CDS from trust => Trust doesn’t own loans (the asset) but they still suffer from credit risk. To protect itself, trust issue CDO to investor to receive money. They use received money to invest in high quality debt securities as collateral. Conclusion: Cash flow CDO and Synthetic CDO both fulfill one objective but in different manners. Why we need complicated synthetic CDO? Because of advantages attributed to synthetic CDO - No funding to senior section - shorter ramp up phase - Cheaper
BS Based: http://www.youtube.com/watch?v=WMwAyDnKjyk Synthetic: http://www.youtube.com/watch?v=0Q7ji-vPlP4 It is FRM focused, but helps in understanding.
I think some of you are a little mixed up with the jr/sr section concept. This is understandable, given that as far as I know, Fabozzi is the only one that uses this language; in practice people talk about the funded and unfunded portions. The funded portion (the “jr section”) is the only part that notes are issued for. To make matters more confusing, the jr section notes are tranched into more and less “sr notes.” There is no such thing as “holders of sr. section notes,” because by definition there are no sr. section notes. This means that if losses exceed the notional for the junior section, you have a problem. Therefore sometimes the issuing bank will get additional protection on the unfunded portion of the deal by entering into a super-senior swap, which is just a giant CDS done on the “sr. section” with a counterparty like a monoline insurer; this is typically done if regulators aren’t satisfied with the amount of protection afforded by the funded portion. Best seller hit some of the main motivations. Another big one is being able to remove credit exposure from you balance sheet without having to inform your clients. This is a big deal in Europe, where the law generally requires informing client when you have sold their loans, which isn’t necessarily good for client relations.
The main thing about Synthetic CDOs, I believe, is that they are ways to bet for or against a pool of debt, without either party actually holding that underlying debt. The “senior” or unfunded layer is essentially buying insurance (CDS) from the “junior” funded layer, for which he pays a premium, which together with the modest return from the treasury invested junior tranche equivalent makes up the junior’s return - unless things go wrong, when he has to pay out to the senior (that’s why his securities are safely tied up in the risk-free). So the senior is betting against the debt, the junior is taking a premium to insure the debt. You have a long and a short with no-one holding the relevant assets. It’s far away from the usual CDO, because in the usual CDO everyone wants the credit to hold, but in the synthetic it’s two sides of a bet.
You are correct that in a synthetic the assets are not transferred to the SPE that issues the notes. But in the simplest form of synthetic deal described in the book (believe me, in real life the deals were almost never that simple!), the SPE sells a CDS *to the bank* that does own the actual assets *on behalf of* the noteholders. It is this short CDS position that the SPE securitizes and sells to the noteholders. The deal as described in the book is not simply a bet, it is a real risk management tool. It is easy to get confused about this because 1) in many of the more complex real-world deals it wasn’t so clear who was managing what risk and 2) the media has generally done an extraordinarily bad job explaining this stuff.
LMB - that’s not correct the senior is not buying insurance from the junior debt. Its just tranching, losses affect junior noteholders and then senior.
photoguy, the book does focus on bank hedging, as you say, and the media is currently excited by the idea that two parties are gambling on an asset they’re not otherwise exposed to or hedging. I think the truth, applications aside, is that it can be either, but that the transaction itself is divorced from any direct asset positions/holdings, and in that sense, taken alone, represents a bet. ro424, it isn’t just tranching - the senior is only paying a premium, so he is not purchasing debt as such. I think that defaults are somehow linked to prepayments, and that is specifically what the junior is offering the senior protection against. Consider the outlay and payouts - the senior is paying a premium - his notional debt (for which he hasn’t paid, and for which he receives no interest or ultimate repayment) is guaranteed by the junior, whose job it is to absorb losses. That looks more like insurance/CDS to me than conventional tranching. I could be wrong, it’s a tricky area.
I am highly confident a CDO question will be one of the vignettes.
lmb, the “senior” (which I take to mean “senior section” - it gets confusing because of the relatively “senior” notes within the “jr section” as well) isn’t paying or doing anything, because the senior section isn’t a person or an entity, it is just a concept - namely the unfunded part of the deal. For the simplest-case synthetic deal described in the book, the entity paying the premium is the bank that has bought CDS protection from the SPE.