A Classroom Demonstration of a Colleteralized Debt Obligation Valuation William C. Hudson Professor of Finance St. Cloud State University Department of Finance, Insurance and Real Estate G.R. Herberger Business School St. Cloud State University 720 Fourth Avenue South St. Cloud, MN 56301 1
INTRODUCTION In the capital markets courses that we teach, there are opportunities to take concepts from the financial headlines and bring them into our courses. The sub-prime housing crisis of 2008 has presented us with a wealth of such examples. This paper will discuss the Collateralized Debt Obligation (CDO). We will discuss the origins of the CDO, how they were used to rid banks of the lesser credit tranches of Mortgage Backed Securities (MBS), and how eventually the creation of Super Senior Tranches resulted in much of the risk returning to the originating bank s balance sheet. Finally, a simple valuation model is provided which would be appropriate in an undergraduate capital markets or investment course. MORTGAGE BACKED SECURITIES To begin our paper, a discussion of Mortgage Backed Securities (MBS) is useful. MBSs began as a rather innocuous security designed to provide a more certain maturity for pass-through securities backed by pools of individual home mortgages. The maturity of these pass-through securities was uncertain as borrowers were allowed to pre-pay any or all principal at any time over the life of the mortgage and without penalty. The MBS sliced the pool of loans into tranches with respect to principal repayment and interest. The first tranche would receive principal repayment from the entire pool of mortgages during which time higher tranches would receive only payments of interest. As such, the first tranche would be repaid in short order and the process would begin anew with tranche number two now receiving principal payments from the pool of mortgages. This process continues until all tranches are retired. This so called 2
maturity-tranching transformed a pool of mortgages with uncertain maturity into a series of tranches with more certain maturities. APPLYING TRANCHING TECHNOLOGY TO POOLS OF SUB-PRIME MORTGAGES: CREDIT TRANCHING. As Wall Street began to focus more on the sub-prime mortgage market, tranching technology was utilized once again. The problem was one of how to make a MBS backed by subprime mortgages appealing to investors with a preference or requirement of holding only AAA rated debt securities. Instead of slicing a pool of mortgages by principal payment and prepayment, pools were sliced by defaults. The first tranche would absorb the first defaults collectively from a pool of underlying subprime mortgages. If defaults were sufficient to destroy the entire value of the first tranche, the next tranche would begin to absorb subsequent defaults. These lower tranches contained the highest level of default risk and therefore paid yields above those of higher up safer tranches. It was hoped that through this financial slight of hand or alchemy higher tranches (the last to absorb default) could receive a AAA rating by the rating agencies. The rating agencies granted this wish and as it turned out much more. THE COLLATERALIZED DEBT OBLIGATION The investment grade tranches were easily sold to investors who sought AAA rated debt securities. However, it was the BBB and BBB- tranches that were difficult to sell (McLean and Nocera Page 122). What to do with these scraps of MBSs for which there was no demand? Wall Street found a solution; the CDO. 3
CDOs were developed in the late 1980 s and subsequently became popular in the 2000 s. McLean and Nocera (pages 120-121) describe the assets which can make up a CDO as A collection of just about anything that generates a yield bank loans, junk bonds, emerging market debt. Depending upon the type of assets loaded into it, the CDO could be as described a kind of asset backed security on steroids. Wall Street used the CDO to package the unwanted BBB and BBB- tranches of MBS s into a CDO structure with the hopes of at least a portion of the CDO receiving an investment grade rating. CDO managers soon became the dominant buyer of BBB and BBB- tranches, 85 95% at the peak. (McLean and Nocera, Page 123) As with credit tranching of MBSs, CDOs sought to employ a similar structure. The unwanted BBB and BBB- tranches of several MBS structures were purchased and loaded into a CDO. The CDO was then sliced into tranches by default seniority. That is, the lowest tranches of the CDO absorbed the first defaults from the underlying MBS s. As with the MBS tranches, the higher tranches received investment grade ratings. Astonishingly, 75-90% of the value of these CDOs received a AAA rating by the rating agencies. (Smith, page 249). Yves Smith (2010, page 247) summed up this concoction well: CDOs were originally devised as a way to dress up these junior layers to make them palatable to a wider range of investors, just as unwanted piggie bits get ground with a little bit of the better cuts and a lot of spices and turned into sausage. Interestingly enough (or perhaps obviously) these AAA rated tranches paid an attractive rate as summarized in the following words: 4
Remember, in finance, if something is too good to be true, it is. The idea that an instrument could pay more interest than other AAA bonds and still legitimately be as safe was questionable from the outset. But a lot of investors had good reason to delude themselves. (Smith, page 246) In the end it was too good to be true. In the case of Merrill Lynch, Standard & Poor s rating agency estimated the probability of default in the next five years of one of their AAA tranches as 0.12%. In the end, these tranches experienced a default rate of 28%, or 233 times higher than estimated. (Geithner, pages 133 134). Why did Standard & Poor s so grossly underestimate the probability of default? First, CDO s are very difficult to rate; much more so than plain vanilla bonds. Secondly, there were strong incentives for rating agencies to assign inflated ratings in order to earn repeat business, a blatant conflict of interest. (Deckant 2010-2011). TYPES OF CDOs 1 CDOs may be categorized based upon source of assets; Arbitrage CDOs and Balance Sheet CDOs. With an Arbitrage CDO, the originator acquires the assets from which the CDO is constructed elsewhere. Profit for the CDO originator is generated from the difference between the funding costs of the acquired assets and the return on the CDO. With a Balance Sheet CDO, the assets from which the CDO is created already exist on the originator s balance sheet. Such a CDO creates an incentive for an originator to removed assets they might consider to be bearish and place them in a CDO. The originator earns an origination fee as they were the initial provider of the assets. The originator may choose to overcollateralize 1 This section draws heavily on Note: Criticisms of Colleteralized Debt Obligations in the Wake of the Goldman Sachs Scandal. 5
the CDO by retaining an equity interest which absorb the first losses in the event of default. Such a position boosts investor confidence in the remaining tranches. CDOs may also be categorized with respect to how funds are generated within the CDO in order to satisfy tranche payment obligations. With a Cash Flow CDO, the assets have an expected cash flow sufficient to satisfy repayment obligations of all tranches. As such, minimal management is required aside from allocating asset generated cash flow among the various tranches. The inner workings of a Market Value CDO are far different. Assets within the CDO may or may not be able to generate sufficient cash flow to satisfy payment of all tranches. The CDO manager must actively determine on an ongoing basis the underlying asset s market value using marked-to-market accounting. It is incumbent upon the CDO manager to periodically sell off assets in order to satisfy the cash flow requirement of the various tranches. A synthetic CDO is designed to synthetically replicate the funding structure of a Cash Flow CDO without the need to actually purchase assets. (Jobst 2007) These structures are quite sophisticated and beyond the scope of this paper, but remain fertile ground for future papers by the authors. A Hybrid CDO is a blend of both Cash CDOs and Synthetic CDOs. (Jobst 2007). RISK OUT THE FRONT DOOR AND IN TROUGHT THE BACK DOOR: The question then arises. If banks were removing the BBB and BBB- MBS tranches from their balance sheet by piling this toxic waste into CDOs, then why did Merrill Lynch and Citigroup book tens of billions of losses on their CDOs? The answer is the Super Senior Tranche. By 6
2006 and 2007 investors in AAA CDOs became dissatisfied with their yields which at this time were as low as 20 basis points above Treasury Bonds with the same duration. Keeping the buyers of the AAA tranches satisfied allowed the banks to keep generating CDOs and of course continue to collect handsome fees. Banks created the so-called Super Senior Tranche by dividing the risk within the AAA tranche. Banks would retain the Super Senior Tranche which would pay a lower yield than the remaining AAA tranches which are then sold to investors. In holding the lower yielding Super Senior Tranches, banks could still make a profit as their cost of capital was sufficiently low. Also, by holding the Super Senior Tranches, the remaining AAA CDO tranches could be sold while generating handsome fees. The danger in retaining Super Senior Tranches of CDOs and CDO squared s is that the banks ended up owning as much as 90% of the original CDO dollar amount. To hedge this risk, banks purchased Credit Default Swaps, but by 2006 even AIG would not insure these Super Senior Tranches. CLOSING COMMENTS Warren Buffet summed up the CDO as follows: If you take on the lower tranches of the CDO and take 50 of those and create a CDO squared, you re now up to 750,000 pages to read and to understand one security. I mean, it can t be done. When you start buying tranches of other instruments, nobody knows what the hell they re doing. Faber (2009, page 96)) was perhaps even more forthright in his comments. The Collateralized Debt Obligation (CDO) may well go down in history as the worst thing anyone on Wall Street has ever thought up. But like so many other financial 7
products invented by people who really liked math in school, the CDO was a harmless three-lettered security when it made its debut in 1987. THE REMAINDER OF THIS PAPER Our completed paper will include an example of CDO valuation using the CDO Cash Flow Waterfall Valuation Model. Finally, a numerical example illustrating how a substantial amount of sub-prime MBS risk returned to the balance sheets of banks which in part led to their failures. 8
REFERENCES Deckant, Neal. Criticism of Collateralized Debt Obligations in the Wake of the Goldman Sachs Scandal. (2010-2011). Review of Banking and Financial Law, Volume 30, pp 407-442. Faber, David. (2009). And Then the Roof Caved In. Hoboken, New Jersey. John Wiley & Sons. Geithner, Timothy. (2014). Stress Test, Reflections on Financial Crises. New York, New York: Crown Publishing. Jobst, Andreas. A Primer on Structured Finance. (2007). Journal of Derivatives & Hedge Funds, Volume 13, No. 3. McLean, Bethany and Joe Nocera. (2010). All the Devils are Here: The Hidden History of the Financial Crisis. New York: Penguin Group. Riddix, Mark. Down the Rabbit Hold: Deciphering CDOs. (May 17, 2010). Forbes. Smith, Yves. (2010). Econned, How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. New York, New York. Palgrave Macmillan. Sorkin, Andrew Ross. (2009) Too Big to Fail. New York, New York. Viking Press. 9