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Re: Synthetic CDOs. Make or Break Time
I can relate to all your comments. The issue of CDOs etc seems very complex and not even understood by many who sold them or wrote the contracts, from what I can gather.
I have researched the net and found many contradictory explanations. Here is an explanation on Synthetic CDOs from, of all places... In Paulson We Trust. lol. But it seems to me, to explain it a bit better than most. Good luck.
Link to Full article - http://www.inpaulsonwetrust.com/2008...unfunded-cdos/
I have removed some parts to try and make it shorter (not that it did much good lol). I would understand that Bank XYZ would be the SPV and is the Underwriter, the seller of Protection and, to all intents and purposes is effectively the CDO. The Issuing Bank (Counter-party) is the Buyer of protection.
Bank XYZ (The SPV) is the underwriter on a Synthetic Unfunded ABS CDO and enters into CDS contracts. On these contracts, they are the seller of protection. The buyer of protection (the counterparty) will make the fixed monthly payments to the CDO.
These contracts are combined to form the one billion dollar CDO that gets marketed to investors. This one billion gets sliced into tranches. Tranche A (the most senior) is 600 million. Tranche B is 200 million, Tranche C is 150 Million, and the Equity (most risky) is 50 million.
It seems logical to assume that the Investors would then buy these tranches at par when the tranches are sold. The CDO would have 1 billion on deposit to cover the Credit Events that might emerge in the worst case scenario that every asset completely defaulted.
The problem here is that in many of these Synthetic ABS CDO’s, the most senior tranche was unfunded. This means that Tranche A puts no money upfront when the CDO is created. In return Tranche A (rated an implied AAA) receives something in the ballpark of 31 bps (0.31% per annum). The other classes are funded so Tranche B (rated AA) pays 200 million and gets 3 Month Libor + 150 bps. Tranche C (rated A) pays 150 million and gets 3 Month Libor plus 250 bps. Equity pays 50 million and gets an expected 8 to 12% per annum. So at issuance, you have a CDO that has sold protection on one billion in subprime asset backed securities that are rated AAA through BBB. This CDO, after getting the funding, now has 400 million on deposit in a GIC account. For ease of explanation, think of a GIC account as a safe place where the 400 million is placed that gets slightly less than 3 Month Libor each quarter. These interest proceeds from the GIC flow into the deal each quarter along with the monthly premiums received for selling protection on CDS contracts.
In theory, this financial wizardry seems to create a great opportunity for the Senior Tranche. They put up $0 and get their 31 bps each quarter. If there are few defaults, as is expected, then no big deal. You just take a portion of the 400 million from the GIC account and use it cover the credit events. What are the odds that over 40% of assets in a billion dollar portfolio made up of AAA through BBB default? The answer from the credit rating agencies was not only that it was improbable but impossible.
Well, the impossible happened. The subprime assets that the Synthetic Unfunded ABS CDO sold protection on got downgraded left and right. The GIC accounts got smaller and smaller as they were dipped into to settle credit events. This gradually wiped out principal on the lower tranches. The counterparty (the buyer of protection) then begins to worry that the seller of protection will be able to live up to their end. They place a call to the valuation agent. The valuation agent comes back and says the remaining assets that the CDS references are valued at 20 cents on the dollar. This valuation would typically happen before the GIC balance was zero but let’s assume the GIC balance is completely wiped out when this valuation is given. B, C, and Equity lose everything. (Remember, their 400 million was used to settle the first 400 million in credit events). You now have 600 million in CDS notional with a value of 20 cents on the dollar for the reference obligations. This means that if the CDO wanted to terminate all of it CDS positions today then it would have to put up $480 million (600mm *.20 = 120mm.. so 600mm – 120mm = 480mm). Where does it get this 480 million? The Senior Tranche. Ouch. The Senior Tranche goes from getting $450k per quarter on their 31bps for their unfunded 600mm to having to put up 480mm dollar to cover the losses.
I would suggest that because the CDOs were written whereby Defaults were against companies (rather than a default on a loan that the Bank might have had on its books), the Banks would benefit because they have lost nothing other than pay a premium for the protection. They need not have had any dealings at all with Fannie, AIG, Lehman etc. It seems to me that they just used these companies as default triggers because they knew they would fall, or at least had a good chance of failing.
As a side note, I understand that most, if not all of these contracts are denominated in USD and so must be settled in USD. In light of the fact that there has recently been a rather large increase in Currency Swaps between the Fed and foreign CBs, could these two issues be related ??
Cheers
Louie.
I can relate to all your comments. The issue of CDOs etc seems very complex and not even understood by many who sold them or wrote the contracts, from what I can gather.
I have researched the net and found many contradictory explanations. Here is an explanation on Synthetic CDOs from, of all places... In Paulson We Trust. lol. But it seems to me, to explain it a bit better than most. Good luck.
Link to Full article - http://www.inpaulsonwetrust.com/2008...unfunded-cdos/
I have removed some parts to try and make it shorter (not that it did much good lol). I would understand that Bank XYZ would be the SPV and is the Underwriter, the seller of Protection and, to all intents and purposes is effectively the CDO. The Issuing Bank (Counter-party) is the Buyer of protection.
Bank XYZ (The SPV) is the underwriter on a Synthetic Unfunded ABS CDO and enters into CDS contracts. On these contracts, they are the seller of protection. The buyer of protection (the counterparty) will make the fixed monthly payments to the CDO.
These contracts are combined to form the one billion dollar CDO that gets marketed to investors. This one billion gets sliced into tranches. Tranche A (the most senior) is 600 million. Tranche B is 200 million, Tranche C is 150 Million, and the Equity (most risky) is 50 million.
It seems logical to assume that the Investors would then buy these tranches at par when the tranches are sold. The CDO would have 1 billion on deposit to cover the Credit Events that might emerge in the worst case scenario that every asset completely defaulted.
The problem here is that in many of these Synthetic ABS CDO’s, the most senior tranche was unfunded. This means that Tranche A puts no money upfront when the CDO is created. In return Tranche A (rated an implied AAA) receives something in the ballpark of 31 bps (0.31% per annum). The other classes are funded so Tranche B (rated AA) pays 200 million and gets 3 Month Libor + 150 bps. Tranche C (rated A) pays 150 million and gets 3 Month Libor plus 250 bps. Equity pays 50 million and gets an expected 8 to 12% per annum. So at issuance, you have a CDO that has sold protection on one billion in subprime asset backed securities that are rated AAA through BBB. This CDO, after getting the funding, now has 400 million on deposit in a GIC account. For ease of explanation, think of a GIC account as a safe place where the 400 million is placed that gets slightly less than 3 Month Libor each quarter. These interest proceeds from the GIC flow into the deal each quarter along with the monthly premiums received for selling protection on CDS contracts.
In theory, this financial wizardry seems to create a great opportunity for the Senior Tranche. They put up $0 and get their 31 bps each quarter. If there are few defaults, as is expected, then no big deal. You just take a portion of the 400 million from the GIC account and use it cover the credit events. What are the odds that over 40% of assets in a billion dollar portfolio made up of AAA through BBB default? The answer from the credit rating agencies was not only that it was improbable but impossible.
Well, the impossible happened. The subprime assets that the Synthetic Unfunded ABS CDO sold protection on got downgraded left and right. The GIC accounts got smaller and smaller as they were dipped into to settle credit events. This gradually wiped out principal on the lower tranches. The counterparty (the buyer of protection) then begins to worry that the seller of protection will be able to live up to their end. They place a call to the valuation agent. The valuation agent comes back and says the remaining assets that the CDS references are valued at 20 cents on the dollar. This valuation would typically happen before the GIC balance was zero but let’s assume the GIC balance is completely wiped out when this valuation is given. B, C, and Equity lose everything. (Remember, their 400 million was used to settle the first 400 million in credit events). You now have 600 million in CDS notional with a value of 20 cents on the dollar for the reference obligations. This means that if the CDO wanted to terminate all of it CDS positions today then it would have to put up $480 million (600mm *.20 = 120mm.. so 600mm – 120mm = 480mm). Where does it get this 480 million? The Senior Tranche. Ouch. The Senior Tranche goes from getting $450k per quarter on their 31bps for their unfunded 600mm to having to put up 480mm dollar to cover the losses.
I would suggest that because the CDOs were written whereby Defaults were against companies (rather than a default on a loan that the Bank might have had on its books), the Banks would benefit because they have lost nothing other than pay a premium for the protection. They need not have had any dealings at all with Fannie, AIG, Lehman etc. It seems to me that they just used these companies as default triggers because they knew they would fall, or at least had a good chance of failing.
As a side note, I understand that most, if not all of these contracts are denominated in USD and so must be settled in USD. In light of the fact that there has recently been a rather large increase in Currency Swaps between the Fed and foreign CBs, could these two issues be related ??
Cheers
Louie.
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