Saturday, July 11, 2009

Financial Disaster Part 2.

Welcome back folks and my fellow fans (if there is any)

Today I am going to talk about synethic CDOs which is the culprit behind the Lame man sister bibi bond and the give me a 5 notes saga. Now what i state here is not really most accurate reflect about the truth because there seem to be slight conflit in some areas and techicality.

Traditionally CDO are created to protect investor against credit risk. Ie investors whom brough credit related products would attempt to hedged their credit risk by buying a CDO. But today most CDO are actually use for the purpose of riding on the credit exposure, which mean selling the CDOs.

Lets use a simple CDO of 2 tranches Senior and Junior. Lets say the Senior is 800 m and junior is 200m. So what happen is a bank sell to a trust 1000m worth of loans, or debts, since it is syntheic the bank would retain ownership of the 1000m debt. The SPV then sell the tranches, some book would tell you the senior have 1000m worth, some book say is less than 1000m, i am not sure who is correct, please consult your university professor. Any way lets continue

The SPV would issue 200m of loans (same value as junior) to investors usually insitutional investors. The CFs from the 200m loans is invest in low risk assets. This action help to rise credit rating

  1. There is 200m of collectual
  2. Cfs generated is Rf or near Rf

The SPV will enter into a swap with the bank (usually a total return swap). please do not that most spv are acutally own and in fact most are run entirely by the bank. The bank would pay total return and receive some benchmark + a spread, benchmark can be sibor, libor, prime rate etc. The gain of the bank is LIBOR + spread - cost of funding. Cost of funding is how much the bank need to obtain money to originate the loans, usually the souces of money is from deposits so cost of deposit is the cost of fund, of cause today bank have many complex products and banks also borrow from the discount window and other banks so this make souce of fund calculation a bit more complex but the basic concept would not strive far.

Now do recall there is 200m bonds but 1000m of exposure. Now how is it possible to have 1000 exposure by selling just 200m bonds, the answer is CDOs. 1000m of CDO exposure is being sold. This allow investor to have 5x more return then they would if they just have 200m bonds. But this does not come without risk. The SPV maintain first loss position for the first 200m loss. The bank maintain the next 800. Due to the chances of loss exiting 200m being rare the senior tranches typically have high rating. But this also means 2 thing.

  1. the majority 800m risk lies with the bank
  2. first loss of 200m lies with SPV and SPV investors

CDOs are sold which mean the investor in the SPV assume credit risk. They do receive premium on top of their loan proceeds. Usually it is the junior issue the bond and senior issue the CDS, since the senior do not issue the bond many book tend to say that senior does not require funding. Should the loss exit that of Junior which is 200m, then senior whom issue CDS would start to pay for the losses. But in a good time the loss exiting 200m is rare. But in times of pollution the 200m barrier is easily broken. Do also note there are too many varification on the structure that is beyond my understanding, some have the junior issue CDS also, some have the Senior issue CDS while the junior issue call or put option on interest or bonds. I still trying to figure out why did the bibi bond structure with first to default credit derivatives but unfortunately i am still unable to get a solid conclusion.

Next Up part 3.

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