Up until now we focused mainly on synthetic CDOs, well we haven't actually described yet what a synthetic CDO is, and we haven't compared it to what a cash CDO is. In this short module we're going to discuss first cash CDOs, and then we will discuss synthetic CDOs, and describe the differences between these two types of CDO. The first CDOs to be traded were all cash CDOs, where the reference portfolio actually existed, and consisted of corporate bonds that the CDO issuer, usually kept on it's balance sheet. Capital requirements then meant that these bonds required a substantial amount of capital to be set aside to cover any potential losses. Now sometimes the banks however often wanted to reduce these capital requirements. They didn't want to tie up capital with these bond portfolios. So, what they did instead was they converted the portfolio into a series of CDO tranches, and they sold most of these tranches to investors. They usually kept the equity tranche for themselves. And therefore they actually kept most of the economic risks and rewards of the portfolio. If you recall, the equity tranche is the riskiest tranche. It has a lower[UNKNOWN] .0 and it could have been 0 to 2% or 0 to 5% or some such number. And so, most of the time many of these tranches or CDOs, all of the losses would have occurred just in this equity tranche. So, effectively the equity tranche, incurred all of the economic risk and reward of the portfolio. However, by selling off these other tranches, the banks were able to reduce substantially the amount of capital they needed to set aside. And so, they're able to keep on the economic risk and reward, which is what they want to do, but they did not need to set aside an enormous amount of capital. And so, these first CDO deals were therefore motivated by what is called regulatory arbitrage considerations. The idea is that they are arbitraging the regulations. Which said they would need to hold a substantial amount of capital for this economic risk. But in fact what they did was, they just tranche the portfolio up, kept the riskiest tranche here, which meant they kept pretty much all of the economic risk in the portfolio. And they were able to substantially decrease the capital requirements with just holding this piece of the portfolio. So, that's what regulatory arbitrage refers to. The cash CDOs however, must be managed, and the legal documentation can be lengthy. You've got what are called waterfall structures to manage and design. You've got what's called credit enhancement and so on, an other important features. So, what for example is a waterfall structure? Well a waterfall structure, describes what happens to coupons prepayments for example, in the event of a loan pool or a mortgage loan pool underlying the CDO. you might have some derivatives securities inside the CDO in order to change some of the characteristics of the, the underlying cash flows. Maybe you've got some floating rate bonds in the underlying pool of bonds, and you want to convert them into fixed-rate bonds. Well you could use an interest rate swap to do that. So, you will often have extra factors inside a cash CDO that need to be managed. Credit enhancement, on the the hand, refers to many CDOs. The issuer of the CDOs may want the traunches to receive better credit ratings. a credit enhancement refers to methods for doing this. One common way of doing credit enhancement is to over-collateralized the CDO. What that means is, if the nominal notional of the CDO, say, let's say it's $100 million is the nominal notional of the CDO. Well the bank might actually put $101 million into it, so there's an extra million dollars. And that extra million dollars would be referred to as an overcollateralization amount. So, there is different ways to make the, the tranches seem a bit safer and therefore, to get higher ratings from the rating agencies. We don't have time here to go into how these ratings agencies actually rated these CDOs, but I think it's fair to say that they didn't do a very good job of this. these structures are very, very complicated, the waterfall structures make them even more complicated. And the idea that you could actually create models To actually understand the riskiness of the securities is, is, is somewhat, somewhat optimistic to say the least. But as I said we wont go into this issue any further. Once these cash CDOs came into the market place, it became clear. That there was an appetite in the market place for these products. Hedge funds, for example, were often very keen to buy the riskier tranches, the equity tranches. And that's because the equity tranches having the most risk, also have the greatest expected reward, or expected payoff in the future. So, hedge funds were often keen to buy the riskier tranches. Insurance companies and so on, often sought to purchase the triple-A rated senior and super-senior tranches. Remember, these senior and super-senior tranches are the safest tranches. So you rarely expect to see any losses entering into these tranches. And so they're considered very safe. They were typically triple-A rated products. But maybe by selling insurance, on these senior tranches. The insurance setters might get 10 or 15 basis points more than they would get from buying triple-A rated products out in the marketplace. Maybe by buying triple-A corporate bonds. Maybe the coupons on those triple-A corporate bonds, were just a little bit less than the premium they could earn by selling protection on triple-A rated senior and super-senior tranches. This appetite and explosion in the CDS market gave rise to so called synthetic tranches, where the underlying reference portfolio is no longer a physical portfolio of corporate bonds or loans. Instead, it was a fictitious portfolio consisting of a number of credits with an associated notional amount for each credit. If you were confused by the distinction between cash and synthetic CDOs, Imagine a series of football games for example. So, lets suppose Barcelona are playing, I don't know lets say Bayern Munich, Aresenal are playing AC Milan, Real Madrid are playing Manchester United. And let's say Juventus are playing Paris Saint-Germain. So, we've got four games here. Now, what we can do is, we can actually bet, or speculate or, if you like, invest or hedge on the outcomes of these four games. And we can do that without anyone actually owning these games. In fact, I'm not even sure what it means to own a game. But it certainly doesn't stop us from constructing a bet, or a payoff, or a security, whose cash flows depends on the outcomes of these four games. So, now you can imagine doing the exact same, but instead of having these four football games. We replace them with four credits, maybe General Motors, maybe Ford, maybe IBM, maybe Siemens. And now we can construct securities whose payoff depends on what happens to these securities. So, that's how a synthetic CDO works. We don't own the underlying bonds. We don't own, there isn't a reference portfolio of bonds on GM, Ford, IBM and Siemens and so on that the bank owns. We just refer to these credits, just like we don't own these football games, we can still bet on the outcome of these games. Likewise we can invest in traunches whose payoffs depends on what happens to General Motors, Ford, IBM and Siemens. And in particular whether these companies default or not over a specified period of time. And, so, that's what I mean by a fictitious portfolio. We, there doesn't have to be an underlining physical portfolio of bonds, of the GM bonds, Ford bonds, IBM bonds and Siemas bonds. We can just see these names out in the marketplace, we can see at any point whether they've defaulted or not. And we can construct securities who's payoffs depend on the default events of these underlying names, or this underlying fictitious portfolio. The mechanics of a synthetic tranche are precisely as we described earlier. When we introduced the Gasling-Coppler model, and we looked at that one period example, we were actually pricing synthetic tranches. We were computing the expected tranche loss, on such a synthetic CDO. there are at least two features that distinguish synthetic CDOs from cash CDOs. Number one, with a synthetic CDO, it is no longer necessary to tranche the entire portfolio and sell the entire deal. For example, a bank could sell protection or sell insurance, on a 3% to 7% tranche, and never have to worry about selling the other pieces of the reference portfolio. This is not the case with a cash CDO. In the case of a cash CDO, the bank would own all of the underlying bonds. If it's sold to the 3 to 7% tranche, let's say this one, it would still then be on the hook for the equity tranche and these tranches up above the 3 to 7% tranche. This is not the case with the synthetic CDO, because the underlying portfolio doesn't exist in the first place. The bank is just selling protection on a not, on a 3 to 7% tranche. And as I said it doesn't have to worry about selling the other pieces of the reference portfolio. But because of this we come to issue two. Because the bank no longer owns the underlying bond portfolio, it is no longer hedged against adverse price movements. It therefore needs to dynamically hedge its synthetic tranche position. Typically we might do this or would have done this in the past using the CDS markets. But hedging and risk managing CDO portfolios is very difficult in practice. And this is true regardless of whether or not you have a good pricing model. There are simply too many moving parts, there are too many names in the portfolio. There are too many individual default probabilities, you've got different industries and different correlations between securities and different industries and so on. These are very complicated securities and very difficult to hedge dynamically and risk manage.
