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What is a CDO? | Collateralized Debt Obligation | Credit Derivatives - YouTube
Channel: Patrick Boyle
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Hello and welcome back to my YouTube
channel where I upload tutorials on
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quantitative finance and derivatives,
usually in bite-size format to help
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people better understand important
financial topics. Today we're going to
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learn all about CDOs or collateralized
debt obligations why they exist what
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they are used for and how they are
structured. This is video 4 in my series
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on credit derivatives if you want to
watch the whole series check out the
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credit derivatives playlist I've created.
There'll be a link to it above ok so
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firstly let's answer the question what
are collateralized debt obligations
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collateralized debt obligations or CDOs
are a type of asset-backed security (ABS)
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where the underlying assets are bonds or
other financial assets. A portfolio of
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bonds is assembled and the risk of
losses on the entire portfolio are
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carved up and sold to different investor
classes. The first CDO was issued in 1987
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by Drexel Burnham Lambert. CDOs can be
thought of as a pool of bonds that
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promises to deliver cash flows to
investors in a prescribed sequence. This
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sequence is based on the cash flow the
CDO collects from the pool of bonds or
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other assets that it owns. A CDO is made
up of tranches or slices which delivered
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the cash flow from interest and
principal payments from the pool of
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bonds in sequence based upon seniority
if some bonds default and the cash
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collected by the CDO is not sufficient
to pay all of its investors those in the
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lowest most junior tranches are
allocated losses first the last tranche
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to suffer losses from defaults are the
safest most senior tranches of the CDO
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as a consequence of these different
treatments credit ratings and interest
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rates vary by tranche with the safest
most senior tranches paying the lowest
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rate and the riskiest tranches paying
the highest rate to compensate these
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investors for the higher default risk
and hopefully that makes sense too it's
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just a risk return trade-off where the
riskier bonds
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are paying a higher coupon but of course
there is a greater risk that you won't
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receive your principal by a CDO might be
made up of the following tranches in
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order of security senior triple-a junior
triple-a double-a a triple B and
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residual a residual tranche is sometimes
referred to as the equity tranche and is
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often retained by the issuer of the CDO
as it can be very difficult to find a
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buyer for it the triple-a rated senior
tranche is generally the first to
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receive cash flows and the last to
absorb mortgage to false or missed
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payments but such it has the most
predictable cash flow and is usually
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deemed to carry the lowest risk on the
other hand the lowest rated tranches
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usually only receive principal and
interest payments after all other
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tranches are paid furthermore they're
also first in line to absorb defaults
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and late payments. Depending on how
spread out the entire CDO structure is
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and depending on what the loan
composition is the equity tranche can
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generally become the toxic-waste portion
of the issue it's worth noting that this
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is the most basic model of how CDOs are
structured CDOs can actually be
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structured in almost any manner so
investors can't presume that they are
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all the same
early CDOs were diversified and were
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made up of a mix of loans and debt
securities from a variety of industries
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and of a variety of types including
mortgages student loans aircraft leases
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and credit card debt this
diversification was a selling point as
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it implied that if there was a downturn
in one sector and those loans defaulted
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other types of debt would be less
affected the biggest selling point of
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CDOs was that they offered returns that
were sometimes two to three percentage
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points higher than similarly rated
corporate bonds now hopefully that
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should give you guys at home a bit of a
hint that often when something is said
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to be of similar risk to something else
it should surprise you if it's paying
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significantly better any
how CDO issuance grew from 69 billion
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dollars in 2000 to around 500 billion in
2006 much of this growth was due to the
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demand for yield in a low interest rate
environment in practice the pooling of a
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series of low-quality
or more speculative credit risk assets
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can result in the creation of some
higher ranked credit products due to the
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tranching of the derivatives CDOs are
usually structured such that the highest
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tranche would receive a triple-a credit
rating and that's just that would be a
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specific goal starting out because
essentially you're taking average
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quality bonds and you're making some
really good ones and some really bad
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ones out of them and the reason that you
would want to do that is simply that
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there's much more demand for really good
for triple-a rated bonds than there is
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for the average quality bonds that you
started out with by 2003 as the CDO
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market grew rapidly subprime mortgages
began to replace diversified portfolios
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of loans as collateral and in a few
minutes when we start talking about
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correlation you'll see how that might
matter the global search for yield
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caused so many investors to purchase
CEOs trusting the credit rating without
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fully understanding the risks and
intrude without really understanding
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what a CDO was by 2004 mortgage-backed
securities or MBS accounted for more
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than half of the collateral in CDOs and
the demand for new CEOs began to drive
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the market for mortgage origination in
particular for lower credit quality
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loans towards the peak of the credit
boom there was so much more demand for
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CDOs than supply of loans but CDOs were
being created by packaging up the low
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rated tranches of mortgage-backed
securities and CDOs
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synthetic CDOs became a popular product
in the mid 2000s where the underlying
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was a pool of CDs a type of credit
derivative described in my last video
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not a
jewelle bonds CDO squared was a term
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used to describe collateralized debt
obligations backed primarily by the
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lower rated tranches of other CDOs now
hopefully you can see that it's becoming
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more and more of a problem because if
you start out with a bunch of average
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bonds and make some good bonds and some
bad bonds out of that then if you take
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those bad bonds and put them back
through the Machine and try and make
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more good bonds from it it's it's quite
a problematic idea because quite simply
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they're already the dregs of the last
process that you went through so anyhow
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who buys CDOs or who bought CDOs when
they were popular generally speaking
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it's rare for retail investors to
directly own a CDO insurance companies
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banks pension funds and investment
managers and hedge funds are the typical
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buyers of these products these
institutions look to outperform Treasury
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yields and we'll take what the hope is
appropriate risk to outperform added
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risk yields higher return when the
investment environment is healthy and
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when the economy is normal or strong
when things slow or when defaults rise
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the opposite will happen and greater
losses occur CDO issuance fell
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dramatically after the financial crisis
of 2007 2008 as you can see by the chart
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on screen right now because so many
investors experienced large losses in
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these products and they got such a bad
name that no one really wanted anything
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to do with them afterwards
CDOs like everything else do suffer from
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the garbage in garbage out problem in
essence you cannot assemble a fillet
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steak from low quality hamburger meat
however there is value in the overall
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idea of taking a pool of assets and
allocating the different risks and
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returns to investors with different risk
profiles so let's talk about CDOs and
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default correlation something I
mentioned a little bit earlier a pool of
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loans might be expected to experience a
certain level of individual borrower
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defaults
they should under normal circumstances
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not all happen at the same time during
times of financial crisis however
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defaults do become more highly
correlated this is particularly the case
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for the most stressed borrowers whose
loans increasingly made up the pools
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underlying CDOs the default correlation
assumed in pricing CDOs is key it's a
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really important factor if the
correlation is low meaning that there's
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not a strong relationship between the
various loans in the portfolio the
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senior tranches are then very safe and
the junior tranches would be expected to
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be extremely risky as the correlation
gets higher the junior tranches become
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less risky relatively speaking and the
senior tranche has become more risky if
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the correlation is worn meaning the
perfect correlation then the junior and
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senior tranches are equally risky so as
you can see in their diversification
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really matters and because
diversification of course plays out as
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low correlation leading up to the
financial crisis of 2007 2008 masses of
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CEOs and other similar instruments were
created CDOs embed within their pricing
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and in particular embed within their
ratings various default assumptions
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these were calculated by large numbers
of credit and mortgage performance
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experts using complex models the models
were often built and run by physicists
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and in the end the real world
correlations and default probabilities
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varied significantly from the models
designed by banks insurance companies
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and asset managers in 2013 the Press
reported on Deutsche Bank launching an
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eight point seven billion dollar CDO
with two tranches with interest rates
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ranging from 8 percent to 14 point 6
percent in the low interest rate
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environment of 2013 investors in these
products might at least be getting paid
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an interest rate that could come
take them for the risk that they were
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taking CEOs most likely won't go away
since in principle they have powerful
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risk management capabilities products
like these allow for risk
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diversification that otherwise might be
quite concentrated both banks and credit
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rating agencies share significant
responsibility for the CDO growth
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explosion often when the issuers and
rating agencies gnudi assets to be of
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poor underlying quality in the mid-2000s
along with investors who were investing
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in products that they did not understand
in the hopes of getting a free lunch so
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that's it for today on CDOs all of these
videos are based on my book trading and
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pricing financial derivatives which is
linked to in the description below don't
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forget to click on the like button if
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great day see you later bye
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you
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