In this module, we're going to go beyond CDOs and discuss more complicated products such as CDO squared's and CDO cubed, and maybe even a little bit about ABSCDOs as well. That point we're going to try and make here is that the risk management of these products is incredibly difficult. And it is difficult indeed to see any economic justification for introducing these products. Nonetheless, they were traded in the marketplace in the lead up to the financial crisis. And it is worthwhile seeing what they were and how they actually work. It should already be clear that structured credit portfolios consisting of CDO tranches can be difficult to risk manage. But at least there is a solid risk sharing motivation for the creation of CDO's, and this is true for securitization in general. We mentioned earlier that the idea behind securitization is to package a series of underlying bonds or loans or whatever, into a set of new securities each of which may have a different risk profile and which may appeal to a different audience or investor class if you like. And so, by spreading risk that way we can actually make the, the financial markets more efficient and so this is the theory that justifies securitization in general. But the structured credit market quickly ran amok with the creation and treating of ever more complex securities. For example, products such as CDO squareds were soon developed. They were difficult to justify economically. they provided great examples of product risk whereby people didn't really understand the product that they were buying and model risk, and that really models were completely inadequate for pricing these securities. Legal risk and so on. Why legal risk? Well, the actual contracts underlying these CDOs ran to maybe many thousands of pages and so it's hard to believe that anybody fully understood what exactly they were purchasing when they invested in CDO squared's and so on. Before discussing these classes of securities, these CDO-squared's, recall first how a CDO is constructed. So, we've got an underlying pool of bonds, say 125 bonds. we might have what's called as we mentioned earlier, a special purpose vehicle. Which is a legal entity into which we would place these bonds. And then from these bonds, we can construct the CDO. So the bonds form the underlying collateral for the CDO. And then the CDO is tranched up into an equity mezzanine and so on. Tranches and people can invest in these different tranches and get very different risk profiles as a result. So, that's how a CDO is constructed. How about a CDO squared? Well here's an example of a CDO squared. We're going to assume that a hundred CDOs, CDO number one up to CDO number 100. We're going to take the mezzanine piece of each of these CDOs. So we're going to assume the mezzanine piece corresponds to attachment point of 3% up to 7%. And then we are actually going to construct a CDO square using these mezzanine pieces. So the CDO squared is constructed from mezzanine tranches of underlying CDOs. So basically, you can think of these mezzanine pieces as now corresponding to the bonds underlying the CDOs. So basically a loss will only occur in say the equity tranche here. When there is at least some loss in the mezzanine tranche of one of these underlying CDOs. If none of these underlying CDOs ever experience a loss in their mezzanine tranches then there will never be a loss anywhere in the CDO squared and in particular in the equity tranche here. On the other hand if all of these mezzanine tranches experience losses. In fact, if all of them are blown out, in other words maybe losses go right through the mezzanine tranches in all of these tranches, well then this CDO squared will face complete wipe out as well. All the way up through the[UNKNOWN] mezzanine and senior tranches. Remember the mezzanine tranches are the underlying bonds, if you will, for this CDO squared. It's also worth pointing out that many bonds act as collateral for multiple CDOs. So behind this, remember there are bonds behind each of these CDOs. And in many cases what you'll have is, you'll have a bond being in the reference portfolio for this CDO, but it might also be in the reference portfolio down here for this CDO. So there would be a lot of overlaps of names, of bonds going into these different CDOs. So this is just repeating in words what we showed visually on the previous slide. There's not much else to say here, so let's move on. Here's a question. How would you price and risk manage a CDO squared? Here are some considerations. And by the way a discussion of CDO squared can also be found on the paper by[UNKNOWN] that I referred to in an earlier module. They discuss some of these issues there as well. So here's some considerations. The legal contract governing each of the mezzanine tranches in the underlying portfolio of CDO's could be on the order of 150 pages long. So, therefore, if you really want to do your due diligence, really understand the legal details underlying a CDO squared, you would need to read approximately 100 time 150, which is 15,000 pages of legal documents. To just say good luck. You should also of course read the contract governing CDO squared. How do you keep track of the CDO squared's performance? Just to keep track of the performance of the CDO squared, remember you're going to have to keep track of the performance of all of these underlying bonds. You're going to have to feed the performance of these underlying bonds into each of these 100 CDOs and figure out what's going on in each of these CDOs. And then based on that, you're going to have to figure out what's going on in the CDO-squared. In order to do that, you're probably going to have to write several thousand lines of computer code, and that is just to keep track of the actual performance. It is not to actually price the CDO-squared. Or to, risk manage the CDO squared. You might need a model to price it. In fact, it's hard to say that any model really could ever possibly price that CDO squared correctly or give you a good sense of how much a fair value is for a CDO squared. So these are very difficult securities to manage. How would you perform scenario analysis? how would you estimate the value at risk? Or the conditional value at risk of a portfolio of CDO-squared's? It's it seems very difficult to even imagine doing such analysis. But why stop there? There are also ABS CDO's. An ABS CDO is an a, is a CDO where the underlying securities, the underlying bonds are themselves acid backed securities. So going back to our CDO squared instead of having a CDO number 1 up to CDO number 100 this could be ABS number 1 up to ABS number 100. And these ABSs could in fact be mortgage back securities. So there would be underlying pools of loans feeding into these ABSs. Which then feed into the CDO itself. Uhhh you can have CDO-cubes uhhhm. And why stop there? So here's how a CDO-cube would work. You got your n CDOs and a couple of slides ago we had n is equal to a 100. Now we've got n CDO's. From that we construct say 100 CDO-squared. So imagining here that the n, number n is greater than 100, so we can construct CDO-squared out of these n CDO'S maybe using the mezzanine tranches from these CDOS. Now we have our CDO squares. Let's take the mezzanine tranches of these CDO-squared and construct another CDO that would give us a CDO-cubed. So, if your head is spinning at this point, it's not surprising. And yet, there were trades apparently on CDO-cubed in the marketplace leading up to the financial crisis. So, one other point I'll make about the financial crisis and the subprime crisis before, before ending this module is the following. So there were securities, I mentioned in the previous slide, called ABS CDOs. And very often, actually, it was sub-prime mortgage ABS's that were feeding into these CDOs. And so you can imagine this being the CDO, maybe there's equity mezzanine and so on. So, maybe this is the zero to 3% tranche. Maybe this is, I don't know, a 6 and 9% tranche. And maybe the underlying pool of securities that feeds into this CDO. Are some mortgage backed securities. So we've got a bunch of mortgage backed securities feeding in here. Well, an interesting antidote about the financial crisis is that the sub prime crisis actually didn't come suddenly to many people. There were several money marketers, including banks and so on who had a good sense that the subprime crisis was coming down the line. And one way to profit from that belief was to actually buy protection on the 0 to 3% tranche of an ABS CDO. So if you buy protection here, what will happen is that you're going to get paid off. You're going to make money. If you see lots of defaults in the 0 to 3% piece, or lots of losses in the 0 to 3% piece of this CDO. And if you expect the subprime crisis to come down the line, then you're going to assume that the underlying mortgage backed securities are indeed going to see a lot of losses. Because people are defaulting on their loans and so on. And if they're defaulting on their loans and you're seeing losses in the underlying mortgage pool, then you expect to see losses inside this tranche as well. And so you could profit from that by buying insurance on this tranche. And so thats what some players did. They bought insurance on this tranche. But, when you buy insurance you've got to pay an insurance premium. And the insurance premium which you have to pay quarterly could be quite substantial. So rather than having to pay out this amount of money every quarter, some of these players or banks got clever and said, you know what, instead of paying out money every quarter on this tranche, why don't we sell protection or sell insurance up here? On this tranche, say. and if you sell insurance on this tranche, well then you are going to be taking in a premium. And you could use the premium you take in here to fund the insurance premium you have to pay out for your protection here. The only problem with that is because this tranche is much riskier than this tranche, you have to sell a lot more insurance up here to cover your payments down here and that's what some players did. They thought that the sub prime crisis might blow through these tranches up to here say, but that the higher tranches would be safe and that they would never incur losses and so on. And so they thought it would be a good idea to sell protection on these more senior tranches and use the premium to fund protection on the equity tranche. And so that was a good idea. It, it meant you didn't have to spend any money net on your position. The premium here was funded by the premium you're taking in up here. The problem was, that the subprime, crisis came along, and was much more severe than anybody anticipated. And in fact, the losses didn't stop at this point, or at least the mark-, market losses didn't stop at this point. The mark to market losses went like this, and blew out these tranches as well. And so the players who actually put on the straight, ended up losing an awful lot of money. Because they were selling protection on a much larger notional up here than the notional they were buying protection on down here. So this is just an aside. And the reason I wanted to mention it is, number one, many players actually did see the sub prime crisis coming along and they used these ABS CDOs in order to make plays on what was happening, or what might happen with the sub prime, with the sub prime crisis. But also it emphasizes how even if your opinion is correct, and their opinion was correct. The sub prime crisis was coming and it did occur. It can still be very difficult to execute a trade properly. So they executed the trade by buying protection down here, selling protection up here but their execution didn't work. In fact, the sub prime crisis was worse than what they anticipated. And some of these players ended up losing an awful lot of money as a result.
