Case Study Cdos

Case Study CDO CREATIVE residuum SHEET RISK MANAGEMENT determine CREATION? 1) What is a CDO? Who procures CDOs? CDOs ar a type of asset dressinged warranter composed of bonds ventd by special swirl fomites (a corpo send entity that consents the assets as collateral, packages them and stags the resulting notes to investors). Normally, the bonds issued be dual-lane into tranches with different peril characteristics and debt rating. Each tranche carries a different rating which determines the interest and specie f kickoff for each layer. There argon several types of primal assets that the special vehicle can buy.The most typical be corporate bonds, corporate brings, trust favourite(a) stocks, mortgage-backed securities and commercial real estate bonds. Those exposit above are conventional CDOs. Banks in any case created unreal CDOs. The main characteristic is that the denotation put on the line is transferred by a differential ( trust default on alternate, ordinarily) still the originating bank retains the underlying crime syndicate of assets in the balance sheet. Nevertheless, with semisynthetic CDOs reliance peril is transferred and the originating bank incurs an grievous relief in capital requirements.There are several investors interested in purchasing CDOs. The motivations for those investors are different depending on the tranches they buy. In general, investors buy CDO assets with certain rating that offer a soaring return than more than(prenominal) traditional securities and benefit from the theoretical variegation buying a CDO portfolio. Risk contrary investors such as mutual cash in hand and pension pedigrees pull up stakes buy the senior tranches in order to obtain a higher return than buying treasury bonds.Senior tranches pay a circularize above LIBOR scour if they are rate AAA. Other investors, such as ring bloods, banks or private banking organizations can some cartridge holders prefer junior tranches such as mezzanine notes and rightfulness notes, tranches offering yields normally not available in other fixed income products. 2) Who sell CDO and why? CDO is a form of securitization. When securitizing, banks manage to transfer their loans forbidden of their balance sheets, transferring similarly the opinion risk of these loans. The main CDOs issuers are investment banks.Transferring computer address risk, banks require less capital to implement Basel II capital requirements. Moreover, banks will employment capital excess and the cash they get under 1s skin from the loan transfer to lend over again money to more winive lenders, generating supernumerary fees, returning higher incomes and improving RoAA and RoAE. This naturalized the principal objective for Richard Mason for effect CDOs in RBS. The second important indicate for banks to issue CDOs are the commissions and the fees they earn during the CDO life.Thus, CDOs are in theory a in truth attractive product for originating banks which explain their discipline in the last decade reaching a volume of $520 billion in 2006. In practice, issuer banks transfer their loans to special subroutine vehicle (SPV) that will package these loans and sell notes with interest and principal payments to the interested investors. 3) What are the main characteristics of the SEQUIL/MINCS jalopy described in the case? SEQUILS/MINCS is a specific social organisation that combines both plain vanilla and synthetic CDO constructions and uses two separated SPVs.In the case, RBS sells a portfolio of loans to the SPV SEQUILS. SEQUILS will issue notes from this portfolio and sell them to investors. SEQUILS will also buy a recognise default swap from Morgan Guarantee, paying a uninterrupted fee and transferring in theory the credit risk to JP Morgan. As JP Morgan will hold the risk, SEQUILS will be able to issue some notes with AAA rates even if the underlying loans were rated BB- to B+. Then, JP Morgan will bac k the loans with its own credit default swap while at the same time transferring the CDS to investors through a separate SPV (MINCS).By doing this it separates the living and the credit risk on the loan portfolio into two separate pools of investors. 4) From a pool of loans below investment vagabond (BBB) , the deal promise the creation of investment grade securities (some AAA and the worst is a BBB). idle How is this possible? The main objective of this structure is to transform low rating loans into higher rating notes in order to attract more investors. It also eliminates or minimizes the equity tranche, therefore, transferring the risk from the bank to a tertiary party.The structure starts with the originating bank (RBS) owning a portfolio of loans worth(predicate)(predicate) $852. 5 million of low-rated loans from BB- to B+. Because RBS wants to repair its capital requirement ratios it will transplant them from its balance sheet. The bank creates the first SPV, SEQUILS that is consisted of a traditional CDO structure. SEQUILS would issue low rated BB- to B+ notes to sell to investors. To achieve an investment-grade rating, SEQUILS insures its notes by a credit default swap provided by Morgan Guarantee corporate trust.SEQUILS would pay Morgan Guarantee a percentage of the $852. 5 million as a periodic fee victimisation the spread. Being backed up by a highly rated entity boosts the ratings of the tranches issued by SEQUILS to AAA, AA and BBB loans. This repackaging of loans attracts more investors and minimizes the risk on RBS. The second pure tone is to create a separate SPV, MINCS that uses a synthetic CDO structure. Morgan Guarantee sureness buys credit swaps from MINCS the second SPV. MINCS would issue notes worth $ receipts million based on the pilot light 852. 5 million-loan amounts.MINCS would provide Morgan Guarantee Trust insurance through a credit default swap 6 propagation its capital of $gross million (6 x revenuem = 864). Theref ore, investors in MINCS would be receiving higher yields, 6 times the credit swap, on the $144 million, yet they are uncovered to the total risk. To boost the ratings MINCS would invest the proceeds of the $144 million into a AAA security. 5) figure to be a portfolio manager of a large pension fund, would you buy Mincs securities (the BBB ones)? What are the risks from the perspective of the investor?What are the risks from the perspective of RBS? A portfolio manager of a pension fund should invest in financial instruments with low risk since a pension fund is a scheme which provides retirement income. buy MINCS notes means receiving higher yield but also being exposed to the to the full risk. In reality Morgan Guarantee Trust did not fully insure SEQUILS in case of the default of investors. It only ensure 16% to 17% of this SPV (144/852. 5). If it has fully see SEQUILS, then all the tranches created by SEQUILS could eat up a triple-A rating.MINCS only issued notes that are worth $144 million, which is almost 16% on the original loan portfolio. However, regardless of whether SEQUILS was part or fully insured by Morgan Guarantee Trust, this structure keeps transferring the risk from one party to another. From RBSs perspective, it is a impregnable deal because the bank is not exposed to the risk anymore, the equity tranche was minimized or even eliminated and the bank obtained a snap off rating for its portfolio of loans.In practice, pension fund managers certain(p) the ratings that MINCS notes received by the rating agencies and were not fully aware the risk they were prop by buying those notes. This kind of interlocking structure helped to transfer the credit risk from company to another. Additionally, it was another important risk factor that was not almost interpreted into consideration by investors. Loans had a high default correlation with themselves. When one mortgage defaulted, many would, which would trigger many credit defaults at the same time.