Invited Editorial CDOs cubed: The first-ever triple

Russ Ray College of Business, University of Louisville, Louisville, KY 40292, USA. Tel: þ 1 502 852 4832, Fax: þ 1 502 852 6072, E-mail: [email protected]

Russ Ray is a professor of at the University of Louisville, USA. Prior to entering academia, he worked for a Fortune 500 company and for the US Department of State as a financial economist. His research (over 90 journal articles, book sections, and conference papers) focuses primarily on risk management and derivatives. He holds a PhD in Finance from the University of Michigan, Ann Arbor, USA.

Abstract still other CDOs which, finally, contain This paper examines the newly created ‘CDOs investment assets of all types. Unlike traditional Cubed’, which are the first-ever triple derivative, that derivatives, which afford risk reduction and/or is, a derivative of a derivative of a derivative. Not leveraged speculation, CDOs literally create surprisingly, CDOs Cubed are often called, thousands of new assets covering the entire risk/ ‘derivatives on steroids’. Unlike traditional derivatives, return spectrum. Not surprisingly, CDOs cubed which are utilised for risk reduction and/or leveraged are frequently referred to as, ‘derivatives on speculation, this innovation has created thousands of steroids’. This paper examines this innovation, new investment assets, covering the entire spectrum of and its impact upon contemporary and return. This paper traces the evolution of this markets. The paper is organised as follows. innovation, and examines how this triple derivative is The next section of this paper traces the created, structured, and priced. evolution of CDOs from their inception in 1985 Derivatives Use, Trading & Regulation (2006) 12, (as single derivatives) to their highly evolved state 183–189. doi:10.1057/palgrave.dutr.1850038 of today. The section thereafter describes how CDOs cubed are created, structured, and priced. Keywords: derivatives; triple derivatives; The final section of this paper discusses the collateralised obligations; CDOs; derivative impact which CDOs cubed are having upon innovations world financial markets. A glossary of CDO terms is also appended to this paper. Some readers may find it helpful to INTRODUCTION read the glossary before reading the paper itself. In 2005, the first-ever triple derivative was Derivatives Use, issued, that is, a derivative of a derivative of a Trading & Regulation, Vol. 12 No. 3, 2006, derivative. ‘CDOs Cubed’ are Collateralised THE EVOLUTION OF CDOs pp. 183–189 r 2006 Palgrave Debt Obligations which, like a Russian shell CDOs trace their origin to the US S&L financial Macmillan Ltd 1357-0927/06 $30.00 doll, contain other CDOs which, in turn, shell crisis of the 1980s. A new instrument,

Derivatives Use, Trading & Regulation Volume 12 Number 3 2006 183 www.palgrave-journals.com/dutr Collateralised Mortgage Obligations (CMOs), In 1999, the for International was created during this period to remove Settlements held the Basel II conference at some of the assets — and their commensurate which it concluded that the risk of the balance risk — from the balance sheets of risky S&Ls, sheets of commercial in developed and thereafter package these assets as separate countries was dangerously high. Consequently, investment units (CMOs) which were then one of the accords issued by this conference was sold to individual investors, thus diversifying that central banks should encourage techniques the balance sheet risk of S&Ls throughout the and innovations to remove some of the debt US financial system. (For readers who are from the balance sheets of their commercial unfamiliar with CMOs, see Davidson.1) These banks and diversify such risk throughout their investment shells traded so smoothly and respective financial systems, analogous to the US efficiently in the US financial markets that it S&L financial solution of the 1980s. (For readers soon became apparent that such shells could unfamiliar with the Base II accords, see Bielski6 easily contain other assets, thus spawning and Rowe.7) Collateralised Obligations (CBOs) and Following the Basel II accords was a multi- Collateralised Obligations (CLOs), which year period of historically low interest rates. In still trade today. 2004, as a means of using CDOs to create In 1995, leading investment banks created pickups during this period, investment banks investment shells containing all types of rated began issuing CDOs cubed. (The Economist,8 and unrated securities — bonds, promissory Business Week,9 and U.S. News & World Report10 notes, project-finance , leases, etc — and subsequently reported the introduction of these investment shells (which were the first CDOs cubed in 2004 and 2005.) CDOs cubed CDOs) eventually became known as ‘unit-level created hundreds of new risk/return investment CDOs’ and, also, as ‘plain vanilla’ CDOs. (For combinations, and investors were willing to pay readers unfamiliar with unit-level CDOs, see premiums for these new and unique risk/return ‘CDO Guide: Understanding the Product.’2)A vehicles that exactly suited the unique needs of typical unit-level CDO is a derivative by virtue their portfolios. (For a discussion of the of obtaining its value from the underlying magnitude of these yield pickups (generally, securities comprising the CDO. A unit-level between 20 and 60 basis points), see Tett.11) CDO typically contains approximately A CDO cubed is a CDO that contains two or 100–1,000 individual securities of all types. more CDOs squared, or one CDO squared and In 1999, investment banks next created at least one unit-level CDO. A CDO cubed is a ‘CDOs squared’, which are CDOs containing triple derivative because it derives its value from two or more unit-level CDOs. A CDO squared other underlying derivatives (the CDOs squared) is a double derivative because its value is derived, that, in turn, derive their values from their first, from its underlying unit-level CDOs whose respective underlying CDOs (the unit-level values are, in turn, derived from its underlying CDOs) that, finally, derive their values from securities. (For readers unfamiliar with CDOs the securities comprising the unit-level CDOs. squared, see Batchvarov,3 Patel,4 and A CDO cubed typically contains several CDOs Watterson.5) squared.

184 Ray CREATING A CDO see Benkert12 and Meng and Gwylim.13) Also, In order to create a CDO, a ‘CDO dealer’ CDO dealers will occasionally include equity arranges a series of loans, called a ‘Special swaps in their CDOs, in lieu of outright Purchase Vehicle’, and uses such financing to buying the equities. (For readers unfamiliar with 14 buy securities of all types. These securities are equity default swaps, see Cluleyis. ) In both then bundled into a unit-level CDO. cases, the CDO dealer will price the swaps using The next step in the CDO creation process is their notional values, thus adding some leverage to rank-order all the securities, from the to the CDO. securities having the least risk of default to the Each of these three major is then securities having the greatest risk. The securities sliced further into subtranches, each of which is having the least risk comprise the senior then prioritised again with respect to risk, so that ‘’ of the CDO. (‘Tranche’ is the French a CDO is always prioritised from the least risky word for ‘slice’.) The securities in the senior subtranche to the most risky. Each subtranche is tranche are normally all rated by one or more of subordinate to the subtranche above it, meaning the ‘Big Three’ rating agencies (Moody’s, that the subtranche with the greatest risk is the Standard & Poor’s, and Fitch). first to absorb any CDO losses; then, the Equities comprise the CDO tranche with the subtranche with the second greatest risk is the greatest risk and, appropriately, are referred to as second to absorb CDO losses; and so on. the ‘equity tranche’ of the CDO. Being equities, Finally, almost all CDOs are ‘PFICs’ — none of these securities are rated by the Big Passive Foreign Investment Companies. PFICs Three. The CDO dealer (or his assistant, the are almost always headquartered outside of the ‘collateral manager’) will utilise standard country where the CDOs trade, usually in the measures of the risk/return trade-off (the Caribbean, in order to avoid security regulations Sharpe Performance Ratio, the Treynor Index, and, also, to minimise taxes. etc) in order to prioritise these equities with respect to risk. The middle tranche of a CDO is referred to as ASSIGNING LOSSES the ‘mezzanine tranche’ — or, more commonly, Before a subtranche is sold to an investor, the as simply ‘the mezzanine’. This tranche consists CDO dealer must assign ‘points’ to it. of a potpourri of lower-quality debt securities, Specifically, the ‘attachment point’ is the point in some of which are rated (such as project loans) the subtranche at which it begins to absorb a by the Big Three, and some of which are not CDO loss, and the ‘detachment point’ is the (such as leases). For unrated securities in the point at which the subtranche ceases to absorb mezzanine, the CDO dealer will again utilise the CDO loss. standard risk/return trade-off measures to assign A CDO dealer will set the attachment and a degree of risk to such securities. detachment points widely apart for the riskiest CDO dealers will also occasionally include subtraches, and progressively narrower for the default swaps in a CDO, in lieu of outright least risky tranches. In this manner, a CDO’s buying the securities from a commercial bank. losses are distributed across the entire CDO, (For readers unfamiliar with credit default swaps, with the riskiest subtranches absorbing the

CDOs cubed: The first-ever triple derivative 185 greatest losses, and the least risky tranches Table 1: Recent default probabilities for absorbing the smallest losses (if any). Setting rated securities these points is a combination of art and science, Obligor rating Five-year-default Ten-year default so that the price of a subtranche appropriately probability (%) probability (%) reflects its risk/return trade-off. AAA 0.38 1.29 AA (high) 0.44 1.55 PRICING TRANCHES AA 0.55 1.89 A subtranche’s price is essentially a function AA (low) 0.69 2.40 of four variables: (1) the market value of its A (high) 1.06 3.39 securities; (2) the default rates of these securities; A 1.26 4.04 (3) the default-rate correlations between and A (low) 1.48 4.87 among the CDO’s securities; and (4) the BBB (high) 2.06 6.48 recovery rates of the CDO’s securities subject to BBB 2.77 8.51 15 default. (See Credit Magazine. ) BBB (low) 4.15 12.00 In general, the lower the default rate of a sub- BB (high) 6.98 18.18 tranche’s securities, the higher will be its price, BB 11.09 26.10 and vice versa. (Table 1 shows typical default BB (low) 15.55 34.19 rates for rated securities.) Conversely, the higher B (high) 20.21 42.34 the default-rate correlations between and among B 31.14 54.96 a CDO’s securities, the less will be the value of B (low) 52.28 70.92 the tranche. And, finally, the higher the recovery rate of defaulted securities, the higher the value Source: Dominion Bank Bond Rating Service, Ltd. 16 of the subtranche. (Table 2 shows typical (Adams et al. ). recovery rates for defaulted securities.) In rating subtranches, Moody’s assumes an Table 2: Recent recovery rates for defaulted intra-industry default correlation of 0.25, and an debt inter-industry default correlation of zero. S&P Recovery rates assumes an intra-industry default correlation of 0.3, and an inter-industry default correlation of Minimum Maximum 0.1. Only Fitch actually calculates intra- and (%) (%) inter-industry correlations in setting their ratings. Senior secured bank loans 50 70 Although Moody’s does not calculate actual Senior unsecured banks loan 40 60 correlations, it does issue a ‘diversity score’ which Senior secured public debt 40 55 it issues in conjunction with its CDO ratings. Senior unsecured public debt 30 50 CDO subtranches are market priced. In Subordinated public debt 20 30 theory, the price is the discounted flow of Other 0 10 its projected cash flow streams, discounted at the required rate of return of the buyer of the Source: Dominion Bank Bond Rating Service, Ltd. subtranche. (Adams et al.16 ).

186 Ray INVESTORS IN TRANCHES whose underlying assets Typically, investors with fiduciary responsibilities contain only securities, (pension funds, etc) buy subtranches from the that is, no other CDOs. senior tranche of a CDO, while funds and CDO-squared A CDO whose under- other risk seekers buy from the equity tranche. lying assets contain one Buyers from the mezzanine constitute a varied or more unit-level clientele. CDOs. CDO cubed A CDO whose under- EFFECTS lying assets contain at The creation and selling of CDOs cubed least two CDOs effectively transfers a huge amount of risk from squared; or, one CDO the balance sheets of commercial banks, and squared and at least one thereafter diversifies this risk throughout the unit-level CDO. financial system. In the process of doing so, it Mother CDO A CDO which has at also creates thousands of new financial assets for least one other CDO as the investment community. one of its underlying assets. Baby CDO A CDO which is one SUMMARY AND CONCLUSION of the assets held by a CDOs cubed are the latest hierarchy of mother CDO. investment shells that literally create thousands of Cash CDO A CDO which does new investment assets, covering the entire risk/ not contain swap return spectrum, while simultaneously derivatives. diversifying risk throughout the financial Synthetic CDO A CDO which community. Conceivably, ‘CDOs quadrupled’ contains one or more could evolve in the next decade or so. swap derivatives. Meanwhile, this innovation continues to grow Static CDO A CDO whose under- and evolve as it facilitates and increases the lying portfolio of assets efficiency of financial markets worldwide. does not change during the CDO’s life. GLOSSARYof CDO TERMS Managed CDO A CDO whose CDO Collateralised Debt underlying assets are Obligation, a package occasionally changed. of securities which CDO dealer A dealer (normally are subdivided into associated with an smaller packages and investment bank) who then sold to individual raises money to buy investors. securities and then Unit-level CDO Also known as a ‘plain packages them into a vanilla’ CDO, a CDO CDO.

CDOs cubed: The first-ever triple derivative 187 SPV Special Purchase PFIC Passive Foreign Invest- Vehicle, the loans which ment Company, an a CDO dealer arranges investment company in order to buy the which is purposely securities for a CDO. headquartered offshore CDO manager Also known as the (such as in the Cayman ‘collateral manager,’ the Islands) in order to avoid person who manages security regulations and the day-to-day opera- minimise taxes; CDOs tions of the CDO; this are almost always PFICs person may or may not Obligor The issuer of a given be the CDO dealer. security in a CDO. Tranche The portion of a CDO Trustee The ‘watch dog’ of a which is sold to an CDO who issues individual investor; monthly reports to the ‘tranche’ is the French investors in a CDO word for ‘slice.’ regarding the status of Senior tranche The portion of a their particular CDO. CDO which is rated Risk prioritisation The process of rank investment grade ordering all of the (AAA, AA, A, BBB). securities in a CDO Equity tranche The portion of a CDO from least risk to which is comprised of greatest risk. equities. Loss subordination Refers to the manner in Mezzanine tranche The portion of a CDO which losses are assigned between the senior to a CDO; losses are first tranche and the equity absorbed by the riskiest tranche, composed of tranche, then by the various types of debt; this second riskiest tranche, tranche is commonly and so on. called ‘the mezzanine.’ Attachment point The point in a sub- Subtranche A ‘slice’ of securities tranche at which losses within one of the three begintooccur. major tranches (senior, Detachment point The point in a sub-tran mezzanine, and equity); che at which for example, the senior losses stop. tranche may be com- Thickness Refers to the monetary posed of four sub- size of a particular tranches (AAA, AA, A, tranche, typically BBB). expressed as the

188 Ray percentage it constitutes Equity default swap Essentially a put option of the CDO’s total on one or more of the monetary value. equity securities held in Default curve The probability distri- the equity tranche. bution of default for a given security in a References CDO over a given 1 Davidson S. (1997) ‘A Summary of CMO Structures’, America’s Community Banker, Vol. 6, No. 1, pp. 36–38. period of time. 2 ‘CDO Guide: Understanding the Product’, Credit Recovery rate The percentage of Magazine 6, 2005. the lost value of a 3 Batchvarov A., Davies W. and Daveletova A. (2004) ‘In the Search for Better CDO Yields, a CDO of CDO defaulted security Emerges’, Journal of Structured Finance, Vol. 10, No. 4, which is recovered pp. 28–31. via collateralisation. 4 Patel N. (2005) ‘The Challenge of CDO Squared’, Risk, Vol. 18, No. 3, p. 12. Credit migration The real or possible 5 Watterson P. (2005) ‘The Evolution of the CDO change in the credit Squared’, Journal of Structured Finance, Vol. 11, No. 1, rating of a security pp. 6–12. 6 Bielski L. (2003) ‘Basel II: A Guide to Operational while it’s being held in Risk Implications’, ABA Banking Journal, Vol. 95, a CDO. No. 11, p. 48. 7 Rowe D. and Reeves R. (2004) ‘Bank Capital Overlap The placing of the Management in the Light of Basel II’, Journal of same security in more Performance Management, Vol. 17, No. 1, pp. 15–25. than one CDO; for 8 Finance and Economics: Russian Doll; Credit Derivatives’, The Economist, 25 September, 2004, p. 105. example, a CDO 9 ‘Taking Risks to Extremes’, Business Week, 23rd May, squared may have the 2005, pp. 96–97. same security in each of 10 Roane K. (2005) ‘Dueling over Derivatives’, U.S. News and World Report, 25th July, pp. 32–34. its unit-level CDOs. 11 Tett G. Clouds Sighted Off CDO Asset Pool’, The CMO Collateralised Financial Times, April 18, 2005. Mortgage Obligations; 12 Benkert C. (2004) ‘Explaining Premia’, Journal of Futures Markets, Vol. 24, No. 1, p. 71. essentially, a CDO 13 Meng L. and Gwilym O. (2005) ‘Credit Default Swaps: consisting entirely of Theory and Empirical Evidence’, Journal of Fixed Income, Vol. 14, No. 1, pp. 17–27. mortgages. 14 Cluleyis P. (2004) The Rise of Equity Default Swaps’, Credit default swap Essentially a put option Derivatives Week, April 5, p. 1. on one or more of the 15 ‘Re-Securitizing CDOs’, Credit Magazine 6, 2004. 16 Adam M., Manroop I. and Jireh W. (2004) ‘CDO securities held in the Methodology’, Dominion Bank Rating Service Study, mezzanine tranche. Dominion Bank report, pp. 1–27.

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