Collateral Debt Obligations. Thought of the Day 111.0

A CDO is a general term that describes securities backed by a pool of fixed-income assets. These assets can be bank loans (CLOs), bonds (CBOs), residential mortgages (residential- mortgage–backed securities, or RMBSs), and many others. A CDO is a subset of asset- backed securities (ABS), which is a general term for a security backed by assets such as mortgages, credit card receivables, auto loans, or other debt.

To create a CDO, a bank or other entity transfers the underlying assets (“the collateral”) to a special-purpose vehicle (SPV) that is a separate legal entity from the issuer. The SPV then issues securities backed with cash flows generated by assets in the collateral pool. This general process is called securitization. The securities are separated into tranches, which differ primarily in the priority of their rights to the cash flows coming from the asset pool. The senior tranche has first priority, the mezzanine second, and the equity third. Allocation of cash flows to specific securities is called a “waterfall”. A waterfall is specified in the CDO’s indenture and governs both principal and interest payments.

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1: If coverage tests are not met, and to the extent not corrected with principal proceeds, the remaining interest proceeds will be used to redeem the most senior notes to bring the structure back into compliance with the coverage tests. Interest on the mezzanine securities may be deferred and compounded if cash flow is not available to pay current interest due.

One may observe that the creation of a CDO is a complex and costly process. Professionals such as bankers, lawyers, rating agencies, accountants, trustees, fund managers, and insurers all charge considerable fees to create and manage a CDO. In other words, the cash coming from the collateral is greater than the sum of the cash paid to all security holders. Professional fees to create and manage the CDO make up the difference.

CDOs are designed to offer asset exposure precisely tailored to the risk that investors desire, and they provide liquidity because they trade daily on the secondary market. This liquidity enables, for example, a finance minister from the Chinese government to gain exposure to the U.S. mortgage market and to buy or sell that exposure at will. However, because CDOs are more complex securities than corporate bonds, they are designed to pay slightly higher interest rates than correspondingly rated corporate bonds.

CDOs enable a bank that specializes in making loans to homeowners to make more loans than its capital would otherwise allow, because the bank can sell its loans to a third party. The bank can therefore originate more loans and take in more origination fees. As a result, consumers have more access to capital, banks can make more loans, and investors a world away can not only access the consumer loan market but also invest with precisely the level of risk they desire.

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1: To the extent not paid by interest proceeds.

2: To the extent senior note coverage tests are met and to the extent not already paid by interest proceeds. If coverage tests are not met, the remaining principal proceeds will be used to redeem the most senior notes to bring the structure back into compliance with the coverage tests. Interest on the mezzanine securities may be deferred and compounded if cash flow is not available to pay current interest due.

The Structured Credit Handbook provides an explanation of investors’ nearly insatiable appetite for CDOs:

Demand for [fixed income] assets is heavily bifurcated, with the demand concentrated at the two ends of the safety spectrum . . . Prior to the securitization boom, the universe of fixed-income instruments issued tended to cluster around the BBB rating, offering neither complete safety nor sizzling returns. For example, the number of AA and AAA-rated companies is quite small, as is debt issuance of companies rated B or lower. Structured credit technology has evolved essentially in order to match investors’ demands with the available profile of fixed-income assets. By issuing CDOs from portfolios of bonds or loans rated A, BBB, or BB, financial intermediaries can create a larger pool of AAA-rated securities and a small unrated or low-rated bucket where almost all the risk is concentrated.

CDOs have been around for more than twenty years, but their popularity skyrocketed during the late 1990s. CDO issuance nearly doubled in 2005 and then again in 2006, when it topped $500 billion for the first time. “Structured finance” groups at large investment banks (the division responsible for issuing and managing CDOs) became one of the fastest-growing areas on Wall Street. These divisions, along with the investment banking trading desks that made markets in CDOs, contributed to highly successful results for the banking sector during the 2003–2007 boom. Many CDOs became quite liquid because of their size, investor breadth, and rating agency coverage.

Rating agencies helped bring liquidity to the CDO market. They analyzed each tranche of a CDO and assigned ratings accordingly. Equity tranches were often unrated. The rating agencies had limited manpower and needed to gauge the risk on literally thousands of new CDO securities. The agencies also specialized in using historical models to predict risk. Although CDOs had been around for a long time, they did not exist in a significant number until recently. Historical models therefore couldn’t possibly capture the full picture. Still, the underlying collateral could be assessed with a strong degree of confidence. After all, banks have been making home loans for hundreds of years. The rating agencies simply had to allocate risk to the appropriate tranche and understand how the loans in the collateral base were correlated with each other – an easy task in theory perhaps, but not in practice.

The most difficult part of valuing a CDO tranche is determining correlation. If loans are uncorrelated, defaults will occur evenly over time and asset diversification can solve most problems. With low correlation, an AAA-rated senior tranche should be safe and the interest rate attached to this tranche should be close to the rate for AAA-rated corporate bonds. High correlation, however, creates nondiversifiable risk, in which case the senior tranche has a reasonable likelihood of becoming impaired. Correlation does not affect the price of the CDO in total because the expected value of each individual loan remains the same. Correlation does, however, affect the relative price of each tranche: Any increase in the yield of a senior tranche (to compensate for additional correlation) will be offset by a decrease in the yield of the junior tranches.

Why Do Sovereign Borrowers Seek to Avoid Default? A Case of Self-Compliance With Contractual Terms.

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Every form of debt is typically a contractual agreement between a lender and a borrower. The former initially pays a money amount to the latter, the latter promises regular interest payments in the future (ct) for a certain time period (n years) and then return of the whole nominal value of the contract (C). This practically means that the owner of the contract (creditor) acquires a right on a future stream of payments and the contract a present value for the same reason. In a general case, the present value of the contract is given by the following formula (r is the discounting rate):

PV = ∑t=1n ct/(1 + r)t + C/(1 + r)n

Put simply, the equation gives the present value of the liability discounting all future anticipated payments. Default is by definition any ex post change in the stream of current and future payments on the debt contract. This change makes the contract less valuable to the creditor, reducing its present value for non-execution of the agreed payments.

In the case that the borrower is a private firm (or a household), law and related third party enforcers (including but not limited to the courts) guarantee the execution of the contractual terms. If the borrower in the international financial markets is a sovereign state, things are quite different as the third-party enforcement is typically futile. Sovereign borrowers may voluntarily choose to self-comply to the contractual terms; nevertheless, if not, there is no typical third-party enforcement on the international level. Even in the case that the debt contracts are subject to foreign law, the enforcement powers of the foreign courts are limited. The case of Argentina is indicative enough. As it is now well known and widely discussed, the court judgment of Thomas P. Griesa determined that the Argentine government should pay the holdouts pari passu despite the fact that the great majority of creditors had agreed to a restructuring. The decision had its results and triggered a new mini-default, but by no means could typically enforce a policy change to Argentina. In the relevant literature, this is usually called fundamental asymmetry of the sovereign debt market. In the mainstream misleading analytical context (where states, firms, and households are treated as coherent agents acting on a cost/benefit basis and pursuing the optimum position) the key question is the following: why do sovereign borrowers comply with the contractual terms much more often than expected?

Sovereign borrowers avoid default and self-comply with the contractual terms because the strategic benefits from a default do not exceed the anticipated losses. There is truth in this argument. For instance, a sovereign default would heavily affect the domestic financial system, which is usually not only exposed to domestic sovereign debt but would also face serious impediments in its organic connection to the international markets (in the case of a developed capitalist economy, this implies extra financial costs for the private sector and thus serious macroeconomic consequences for employment and growth). One should also take into consideration the economic and political consequences of a default, since negotiations with the creditors take considerable time. The list of cost/benefit analysis can be quite long, but this train of thought misses the crucial factor: the very nature of contemporary capitalist power.

Cost-benefit analysis takes a concrete form only within the contemporary context of capitalist power. International financial markets do not curtail the range of state sovereignty – they reshape the contour of capitalist power. Contemporary capitalism (the term “neoliberalism” is too restrictive to capture all its aspects) amounts to a recomposition or reshaping of the relations between capitalist states (as uneven links in the context of the global imperialist chain), individual capitals (which are constituted as such only in relation to a particular national social capital), and “liberalized” financial markets. This recomposition presupposes a proper reforming of all components involved, in a way that secures the reproduction of the dominant (neoliberal) capitalist paradigm. From this point of view, contemporary capitalism comprises a historical specific form of organization of capitalist power on a social-wide scale, wherein governmentality through financial markets acquires a crucial role. The new condition of governmentality (reproduction of capitalist rule) thus takes the form of a “state-and-market” type of connection. Regardless of the results of cost-benefit calculus, the organic inclusion of the economy in the international markets is a critical premise for the organization of capitalist rule. On the other hand, it is also clear that a recomposition of the relation to international markets (national self-sufficiency) can easily incite the most regressive and authoritarian forms of state governance, if it is not accompanied by a radical shift in the class relations of power.