Synthetic CDOs, Ratings, And Super Senior Tranches: Part 3

Prescience and Precedent

In the previous articles (part 1 and part 2), we discussed both the modeling and rating of  CDOs and their tranches. In this article, we will discuss the rating of synthetic CDOs and those fabled “super senior” tranches. As mentioned in the previous articles, I highly recommend that you read my article on Synthetic CDOs and my article on tranches.

Funded And Unfunded Synthetic CDOs

As explained here, the asset underlying a synthetic CDO is a portfolio of the long positions of credit default swaps. That is, investors in synthetic CDOs have basically sold protection on various entities to the CDS market through the synthetic CDO structure. Although most CDS agreements will require collateral to be posted based on who is in the money (and may also require an upfront payment), as a matter of market practice, the protection seller does not fund the long position. That is, if A sold $1 million worth of protection to B, A would not post the $1 million to B or a custodian. (Note that this is a market convention and could change organically or by fiat at any moment given the current market context). Thus, B is exposed to the risk that A will not payout upon a default.

Because the long position of a CDS is usually unfunded, Synthetic CDOs can be funded, unfunded, or partially funded. If the investors post the full notional amount of protection sold by the SPV, then the transaction is called a fully funded synthetic CDO. For example, if the SPV sold $100 million worth of protection to the swap market, the investors could put up $100 million in cash at the outset of the synthetic CDO transaction. In this case, the investors would receive some basis rate, usually LIBOR, plus a spread. Because the market practice does not require a CDS to be funded, the investors could hang on to their cash and simply promise to payout in the event that a default occurs in one of the CDSs entered into by the SPV. This is called an unfunded synthetic CDO. In this case, the investors would receive only the spread over the basis rate. If the investors put up some amount less than the full notional amount of protection sold by the SPV, then the transaction is called a partially funded synthetic CDO. Note that the investors’ exposure to default risk does not change whether the transaction is funded or unfunded. Rather, the SPV’s counterparties are exposed to counterparty risk in the case of an unfunded transaction. That is, the investors could fail to payout upon a default and therefore the SPV would not have the money to payout on the protection it sold to the swap market. Again, this is not a risk borne by the investors, but by the SPV’s counterparties.

Analyzing The Risks Of Synthetic CDOs

As mentioned above, whether a synthetic CDO is funded, unfunded or partially funded does not affect the default risks that investors are exposed to. That said, investors in synthetic CDOs are exposed to counterparty risk. That is, if a counterparty fails to make a swap fee payment to the SPV, the investors will lose money. Thus, a synthetic CDO exposes investors to an added layer of risk that is not present in an ordinary CDO transaction. So, in addition to being exposed to the risk that a default will occur in any of the underlying CDSs, synthetic CDO investors are exposed to the risk that one of the SPV’s counterparties will fail to pay. Additionally, there could be correlation between these two risks. For example, the counterparty to one CDS could be a reference entity in another CDS. Although such obvious examples of correlation may not exist in a given synthetic CDO, counterparty risk and default risk could interact in much more subtle and complex ways. Full examination of this topic is beyond the scope of this article.

In a synthetic CDO, the investors are the protection sellers and the SPV’s counterparties are the protection buyers. As such, the payments owed by the SPV’s counterparties could be much smaller than the total notional amount of protection sold by the SPV. Additionally, any perceived counterparty risk could be mitigated through the use of collateral. That is, those counterparties that have or are downgraded to low credit ratings could be required to post collateral. As a result, we might choose to ignore counterparty risk altogether as a practical matter and focus only on default risk. This would allow us to more easily compare synthetic and ordinary CDOs and would allow us to use essentially the same model to rate both. Full examination of this topic is also beyond the scope of this article. For more on this topic and and others, go here.

Synthetic CDO Ratings And Super Senior Tranches

After we have decided upon a model and run some simulations, we will produce a chart that provides the probability that losses will exceed X. We will now compare two synthetic CDOs with identical underlying assets but different tranches. Assume that the tranches are broken down by color in the charts below. Additionally, assume that in our rating system (Joe’s Rating System), a tranche is AAA rated if the probability of full repayment of principle and interest is at least 99%.

default-model-tranched-sidebyside2

Note that our first synthetic CDO has only 3 tranches, whereas the second has 4, since in in the second chart, we have subdivided the 99th percentile. The probability that losses will reach into the green tranche is lower than the probability that losses will reach into the yellow tranches of either chart. Because the yellow tranches are AAA rated in both charts, certain market participants refer to the green tranche as super senior. That is, the green tranche is senior to a AAA rated tranche. This is a bit of a misnomer. Credit ratings and seniority levels are distinct concepts and the term “super senior” conflates the two. A bond can be senior to all others yet have a low credit rating. For example, the most senior obligations of ABC corporation, which has been in financial turmoil since incorporation, could be junk-rated. And a bond can be subordinate to all others but still have a high credit rating. So, we must treat each concept independently. That said, there is a connection between the two concepts. At some point, subordination will erode credit quality. That is, if we took the same set of cash flows and kept subdividing and subordinating rights in that set of cash flows, eventually the lower tranches will have a credit rating that is inferior to the higher tranches. It seems that the two concepts have been commingled in the mental real estate of certain market participants as a result of this connection.

Blessed Are The Forgetful

So is there a difference between AAA notes subordinated to some “super senior” tranche and plain old senior AAA rated notes? Yes, there is, but that shouldn’t surprise you if you distinguish between credit ratings and seniority. You should notice that the former note is subordinated while the latter isn’t. And bells should go off in your mind once you notice this. The rating “AAA” describes the probability of full payment of interest and principle. Under Joe’s Ratings, it tells you that the probability that losses will reach the AAA tranche is less than 1%. The AAA rating makes no other statements about the notes. If losses reach the point X = L*, investors in the subordinated AAA notes (the second chart, yellow tranche) will receive nothing while investors in the senior AAA notes (the first chart, yellow tranche) will not be fully paid, but will receive a share of the remaining cash flows. This difference in behavior is due to a difference in seniority, not credit rating. If we treat these concepts as distinct, we should anticipate such differences in behavior and plan accordingly.

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Synthetic CDOs, Ratings, And Super Senior Tranches: Part 2

Bait And Switch

My apologies, but this is going to be a three part article.  I have come to the conclusion that each topic warrants separate treatment. In this article, I will discuss the rating of CDO tranches. In the next, I will discuss the rating of Synthetic CDOs and those illusive “Super Senior” tranches.

Portfolio Loss Versus Tranche Loss

In the previous article, we discussed how rating agencies model the expected losses on the portfolio of bonds underlying a CDO. The end result was a chart that plotted losses against a scale of probabilities. This chart purports to answer the question, “how likely is it that the portfolio will lose more than X?” So if our CDO has a single tranche, that is if the payment waterfall simply passes the cash flows onto investors, then this chart would presumably contain all the information we need about the default risks associated with the CDO. But payment waterfalls can be used to distribute default risk differently among different tranches. So, if our CDO has multiple tranches, then we need to know the payment priorities of each tranche before we can make any statements about the expected losses of any tranche. After we know the payment priorities, we will return to our chart and rate the tranches.

Subordination And Default Risk

Payment waterfalls can be used to distribute default risk among different tranches by imposing payment priorities on cash flows. But in the absence of payment priorities, cash flows are shared equally among investors. For example, if each of 10 investors had equal claims on an investment that generated $500, each investor would receive $50. Assuming each made the same initial investment, each would have equal gains/losses. However, by subordinating the rights of certain investors to others, we can insulate the senior investors. For example, continuing with our 10 investors, assume there are 2 tranches, A and B, where the A notes are paid only the first $500 generated by the investment and the B notes are paid the remainder. Assume that 5 investors hold A notes and that 5 investors hold B notes. If the investment generates only $500, the A investors will receive $100 each while the B investors will receive nothing. If however the investment generates $1,500 the A investors will receive $100 each and the B investors will receive $200 each. This is just one example. In reality, the payment waterfall can assign cash flows under any set of rules that the investors will agree to.

If the investment in the previous example is a portfolio of bonds with an expected total return of $1,000, then the payment waterfall insulates the A investors against the first $500 of loss. That is, even if the portfolio loses $500, the A investors will be fully paid. So, the net effect of the payment waterfall is to shift a fixed amount of default risk to the B investors.

Rating CDO Tranches

As a general rule, rating agencies define their various gradations of quality according to the probability of full payment of principal and interest as promised under the bonds. Assume that Joe’s Rating Agency defines their rating system as follows:

AAA rated bonds have at least a 99% probability of full payment of principal and interest;

AA rated bonds have at least a 95% probability of full payment of principal and interest;

A rated bonds have at least a 90% probability of full payment of principal and interest; and

Any bonds with less than a 90% probability of principal and interest are “Sub Investment Grade (SIG).”

Assume that the bonds underlying our CDO collectively promise to pay a total of $100 million in principal and interest over the life of the bonds. For simplicity’s sake, assume that the CDO investors will receive only one payment at maturity. Further, assume that we have conducted several hundred thousand simulations for our CDO and constructed the chart below:

default-model-tranched1

It follows from the data in the chart that the probability that losses on the CDO will be less than or equal to: $35 million is 90%; $40 million is 95%; $65 million is 99%. We define the tranches as follows: tranche A is paid the lesser of (i) $35 million and (ii) the total return on the CDO pool (the green tranche);  tranche B is paid the lesser of (i) $25 million and (ii) the total return on the CDO pool less any amounts paid to tranche A (the yellow tranche); tranche C is paid the lesser of (i) $5 million and (ii) the total return on the CDO pool less any amounts paid to tranches A and B (the blue tranche); and tranche D is paid the lesser of (i) $35 million and (ii) the total return on the CDO pool less any amounts paid to tranches A, B, and C (the red tranche).

After some thought, you should realize that, according to Joe’s Ratings, tranche A is AAA; tranche B is AA; tranche C is A; and tranche D is SIG.

Securitization Demystified

What Is Securitization?

Securitization is a process that allows the cash flows of an asset to be isolated from the cash flows of that asset’s original owner. There are countless variations on this theme, and since our purpose here at derivative dribble is to foster clarity and simplicity, we will discuss only the main theme, and will avoid the Glen Gould variations.

Cui Bono?

We will explain how securitization works by first exploring the most basic motivation for isolating assets: access to cheaper financing. Assume B is a local bank that focuses primarily on taking deposits and earning money through very low risk investments of those deposits. Further, assume that B is a stable and solvent bank, but that it lacks the credit quality of some of the larger national banks and as such it has a higher cost of financing. This higher cost of financing means that it can’t lend at the same low rates as national banks. B’s local community is one in which home values are high and stable, and as a result the rate of default on mortgages is extremely low. As such, B would like to be able to compete in the local mortgage market, but is struggling to do so because its rates are higher than the national banks. What B would really like to do is borrow money for the limited purpose of issuing mortgages in its local community. That is, B wants to separate its credit quality from the credit quality of the mortgages it issues in its community. Securitization is the process that facilitates this isolation.

The Nuts And Bolts

The overall process is quite simple and reasonable, despite its portrayal in the popular press. We know that so long as B owns the mortgages, B’s creditors will still consider B’s credit as an institution when lending to it, even if that lending is for the limited purpose of issuing local mortgages. The solution to that problem is simple: B sells the mortgages off shortly after issuing them. But to whom? Well, common sense tells us that investors are not going to be too excited about buying mortgages piecemeal. So, B will wait until it has issued a pool of mortgages large enough to attract the attention of investors. Then, it will set up a special purpose vehicle (SPV) where that SPV’s special purpose is to buy the mortgages from B, using money from the investors, and issue notes to those same investors.

So, the SPV owns the mortgages since B is completely bought out by the cash from the investors. And the notes issued to the investors are basically bonds issued by the SPV with the mortgages as collateral. As a result, B is out of the picture from an investor’s perspective. In reality, B might still service the mortgages (i.e., sending bills to borrowers, maintaining address information on borrowers, etc.) but because the mortgages have been sold to the SPV, the notes issued by the trust have no credit risk exposure to B. So if B goes bust, the assets in the SPV are safe and will continue to pay.

So What Does That Accomplish?

B wanted to enter the local mortgage market but was struggling to do so because it couldn’t lend at the same rates as national banks. This was due to B’s inferior credit standing relative to large national banks. But the securitization process above allows B to isolate the credit quality of the mortgages it issues from its own credit quality as an institution. Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage. As such, B will be able to issue mortgages to its local community at the market rate and profit from this by servicing the mortgages for a fee.