Common Barriers to the Successful Functioning of High-Performing Teams
High-Performance Teams as we all know can be a blessing for an organization, as such teams play a crucial role in boosting organizational productivity and growth by meeting challenging outcomes. But, such teams are also faced with several barriers or challenges which act as impediments in their journey of excellence. These barriers are caused due […]
Solvency Regulations in the Insurance Industry
In the previous article, we have explained why regulation is important for the insurance industry. We have also understood how the focus of regulation has changed from merely restricting prices to protecting the rights of the consumer. In this article, we will have a closer look at the solvency regulations i.e. the rules regulators create […]
Impact of Using Poor Quality Data and Metrics to Measure Data Quality
In the previous article, we have understood why data quality is important in the field of risk management. We also had a closer look at the various characteristics which constitute data quality as well as the processes that need to be put in place in order to manage data quality. In this article, we will […]
Approaches to Public Administration
We have come across a number of times during our exploration of the topic, that it is somewhat difficult to define public administration in concrete terms. It has close association, interaction and influences from several fields of studies like law, political and social science administrative science and human relations and even behavioral science for that […]
Different Types of Virtual Teams
Many organizations turn to virtual teams to reduce operational costs, faster problem solving and innovate. Depending on the temporal distribution, lifespan, objective and role of members, virtual teams can be classified into the following 8 categories. This article looks at each type of virtual team in greater details. Examples are provided wherever possible to aid […]
Collateralized debt obligations (CDOs) are a very important and popular type of credit derivative. With the growth in structured finance, the origination and trading of collateralized debt obligations (CDOs) has seen a massive uptick. Their demand has increased multifold and as a result, newer products such as synthetic collateralized debt obligations (CDOs) are also being used widely in the marketplace.
In this article, we will explain the concept of collateralized debt obligations (CDOs) in detail. We will have a look at plain vanilla CDOs and synthetic CDOs and will try to understand the difference between them.
The term collateralized debt obligations (CDOs) was made famous during the 2008 credit crisis. These instruments are basically the result of what is called the "securitization" process. The securitization process is a mechanism to delink the credit risk of the originator from the credit risk of the underlying asset.
In simple words, this means that several loans are bundled together to create an asset pool. There are securities issued to investors wherein they purchase the cash flows which would emanate from this underlying cash pool. These securities are issued in tranches wherein the lower tranche securities have a higher chance of defaulting.
The end result of this process is that even if the bank originating the security goes bankrupt, it would have very little impact on the amount of cash flows being generated from these securities. Similarly, if the cash flow from these securities dries up, it would not impact the bank since they have already offloaded these assets from their books. Collateralized debt obligations provide a mechanism for banks to limit their exposure to debt by allowing the sale of debt that has already been originated.
In the above example, the securities being sold were backed by actual assets i.e. cash flows being generated by loans. This is the reason they were called plain vanilla collateralized debt obligations (CDOs).
Structured finance has made it possible to create collateralized debt obligations (CDOs) from derivative products instead of from underlying assets. Such instruments are called synthetic collateralized debt obligations (CDOs). Synthetic CDOs can be thought of as being a meta derivative. This means that they are a second-order derivative. Their value is dependent upon the value of another derivative which in turn is contingent upon the value of an underlying asset.
The credit default swap is the instrument most commonly used in the creation of synthetic collateralized debt obligations (CDOs). Normally, a group of investors comes together to create a fund pool. This fund works as an insurance company. It provides protection to other investors by selling credit default swaps. The working of the credit default swaps has already been explained in an earlier article. These credit default swaps require no initial cash outlay and generate money in the form of periodic premium payments.
The investment bankers bundle together these credit default swaps and sell them as securities. These securities are called synthetic collateralized debt obligations (CDOs). Just like plain vanilla CDOs, the tranching process takes place here as well. This means that buyers of lower tranches are exposed to more risk and return whereas buyers from higher classes are exposed to less risk and return. The only difference is that the asset being sold is not the bond but a credit default swap. Synthetic collateralized debt obligations (CDOs) have also become very popular because they create an extremely liquid market for credit default swaps.
If any of the credit event mentioned in the contract does take place, it becomes the legal responsibility of the collateralized debt obligation holder to compensate the sellers of credit default swap. Hence, in such cases, the trustees of the fund dip into the coffers and payout the amount based on what was agreed upon in the contract.
In case, the amount of money in the fund falls below a certain threshold, the fund calls for more money to be contributed. Synthetic CDOs are considered very risky since they sell protection worth several times the money that they have on hand. However, tranching has made the diversification of risk possible. The top two tranches are very secure and the chances of them facing a credit event are extremely less.
The problem with collateralized debt obligations is that they could expose the investors to a lot of risks. The liability of investors may not necessarily be restricted to the amount of money that they have put in the pool. This is because there could be multiple credit events that the credit default swaps would have to insure. This is the reason that in the 2008 crisis, the people holding CDOs were negatively impacted by the outcomes. The impact was so severe that several funds had to file for bankruptcy within a short span of time.
Just like all credit derivatives, collateralized debt obligations were created as a means to reduce risk. However, over time they have been used for speculative purposes which amplifies the risk on the balance sheet of the individual players as well as the system as a whole.
Your email address will not be published. Required fields are marked *
