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Collateralized Debt Obligation and Credit Derivative Research Paper

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Updated: Sep 12th, 2021

Background

Traditional financing schemes in firms include the issuance of stock, bonds, and the use of retained earnings. Through these mechanisms, companies have managed to boost their financial capabilities and eventually continue their planned expansions. Although these financing schemes remain as the logical options for firms, changes in the business environment have pointed to various alterations. As firms evolve, several of their assets and liabilities have useful tools in offsetting the financial incapacities of companies. Indeed, these valuable components gradually turned into valuable parts of corporate financing.

The development of collateralized debt obligations and credit derivatives is motivated by the growing risk associated with conventional methods of financing. The issuance of stocks has decreased because of ownership issues and other regulatory barriers. Bonds, on the other hand, have proven to become risky in the long term. In addition, retained earnings are hard to realize given the competitive markets today. All these scenarios suggest that ways have to be done in order to make firms independent from these financing mechanisms.

It is undeniable that collateralized debt obligations and credit derivatives have developed significantly. But these are situations wherein credit has been misevaluated. The imbalanced assessment of credit poses both positive and negative effects. Basically, the succeeding discussions will focus on connecting such misjudgment to the economy. Both advantages and drawbacks of such practice will be comprehensively touched. As vital as firms are to the economy, these financial instruments also play important roles.

Collateralized Debt Obligation

Collateralized Debt Obligation (CDO) is asset-backed security and structured credit product. A CDO acquires exposure to the credit of a portfolio of fixed income assets and divides the credit risks among various tranches. These tranches include senior tranches, mezzanine tranches, and equity tranches. The losses are determined through reverse order of seniority so that junior tranches provide higher coupons to compensate for the augmented risks. Moreover, the development of CDO technology has transformed these high-risk tranches into seemingly low-risk senior debt (Schorin and Weinreich, 1998).

A CDO cash flow structure distributes interest income and principal repayments from a collateral pool of debt instruments to a prioritized set of CDO securities. In addition, a cash-flow CDO indicates that the collateral portfolios are not allowed to be publicly traded (Duffie and Garleanu, 2001). The rationale of this CDO attribute is supported by the uncertainty related to interests and principal repayments to the CDO tranches, which are purely determined by the number and timing of defaults of the collateral securities.

Market value CDO will necessitate equity more than cash flow CDO. In order for the trading to commence, the capital structure of the market value CDO has to include a significant revolving credit facility to allow collateral managers to efficiently monitor the capital of the CDO and to trade the CDO hassle-free. Another important aspect that has to be recognized pertains to the legal requirements related to CDO securitization. The US government for instance has drafted several regulations to ensure that parity and legality are practiced.

Credit Derivatives

Credit derivatives are financial instruments with value and price that depend on the creditworthiness of the third party, which is removed and traded. Usually, credit derivatives are connected with financial guarantees. Credit derivatives are commonly traded and credit default products are the normally traded derivatives (Morrison, 2005). In addition, unfunded products such as credit default swaps and funded products such as CDO are traded. A bilateral contract forged by buyers and sellers in which the seller sells credit protection to a third party is the simplest form of credit derivative.

Most financial institutions consider credit derivatives as a mechanism that de-couples several aspects of the credit process. The most compelling part of this transaction can be compared to credit risk transfer arrangement wherein credit derivatives separate credit risk from funding and origin. Moreover, credit derivatives allow the guarantor to assume credit risk related to a borrower or group of borrowers from the beneficiary. Risk transfers include contingent payment from guarantors to the beneficiary.

Another important characteristic of a credit derivative is that it allows credit risk transfers within a financial system and such also include transfer between different financial intermediaries (Instefjord, 2005). Such a process is considered a stabilizing aspect of the financial system. It lessens the concentration of exposures in several banks and disseminating the credit risks to all institutions that have the capacity to handle the risk. This innovation has become a popular option among financial institutions that value rewards to risks.

Situational Overview

Several institutional private equity investors have substantial equity portfolios. The creation of CDO will give investors the opportunity to realign the portfolios and subsequently providing the leverage for additional investments. It is noticeable that CDOs have become powerful mechanisms that affect pre-existing markets of CDO-related assets. Moreover, CDO has an effect on the current private equity markets and provides significant liquidity, transparency, and discipline. Furthermore, CDOs will expand the capacity of investors to increase the level of returns through renewed structures.

At present, there are two kinds of CDOs that are prominently used by investors. The balance-sheet CDO is described as a collateralized loan obligation. This is created to eliminate the loans from the balance sheet of financial intermediaries to achieve capital relief. In addition, collateralized loan obligation improves the value of the assets because of the increased liquidity. Second, the arbitrage CDO functions to capture the difference between the total cost of acquiring collateral assets in the secondary market and returns obtained from management fees and the sale of the CDO structure (Weithers, 2007).

Aside from the mentioned CDOs, there are other forms that are being used by investors. CDOs are sometimes being supported by real estate and other properties. Other companies have used bonds as collateral to create the CDO. Although these are the most common, there are other CDOs that appear to be complicated but provide the same level of results that are preferred by the investors.

It is evident that the market for credit derivatives has developed these past years. Approximately $17.1 trillion of credit derivatives have been realized from 2001 to 2005. Indeed, it is hard to determine the actual size of the credit derivative market. This is because transactions are done privately and the assets involved are usual eliminated from the balance sheet. This reality, however, does not imply that the impact of credit derivatives is unquantifiable. In addition, the market size is also dependent on the fluidity of the assets involved. There are several aspects that need to be understood before drafting the entire picture that reflects credit derivatives.

Analysts predict that the growth of credit derivatives in financial institutions will be significant. In fact, such projection was deemed as low because actual figures suggest growth rates doubling and tripling. Banks have experienced tremendous improvement in acquiring credit derivatives which have an estimated value of $10 billion in just one year. In Rabobank, for instance, it was reported that the credit derivatives transactions amounted to $5 billion despite it being new in the market (Tavakoli, 2001).

One major concern that the market needs to be aware of is the risks involving credit derivatives. Regulators most especially are puzzled about the process in which the risk varies from time to time. The US Federal Reserve provided its view of credit derivatives and emphasized the increasing backlog of confirmation associated with trades. Another barrier that has to be eliminated is the lack of concern from individuals with the knowledge of credit derivatives to help in reducing the risks.

Although it was predicted, the subprime meltdown became an ultimate test of the value of CDOs. From 2003 until 2006, new CDOs supported by asset-back and mortgage-backed securities were constantly exposed to subprime mortgage bonds. In 2006 alone, $200 ABS CDOs were issued having an average exposure to subprime loans of about 70%. The majority of the staked CDOs were mezzanine and are backed by lower-rated trenches of mortgage bonds (Dodd, 2007). The negative aspect of this over-exposure is that defaults and deficiencies on subprime loans continue to increase. Logically, it is expected that the rating on the CDOs will go down and future losses are looming.

Indeed, the decline in the value of CDOs has made it difficult for banks and investment institutions to price their respective CDOs. The recording of the CDOs was made at par because the pricing was usually based on its market value. Basically, CDOs are not actively traded. The prolonged time and the continuous decline will lead to the loss. Several banks have experienced collateral calls from lenders who have accepted CDOs backed by sub-prime loans. It is forecasted that more losses will be experienced as subprime lending continues to plummet.

The new issue pipeline for CDOs supported by and is expected to stall significantly in the second half of 2007 because of the weakness in subprime collateral. The resulting reassessment by the market of pricing of CDOs backed by mortgage bonds has also been weak. This in turn has the capacity to limit the availability of mortgage credit that is available to real estate owners. CDOs purchased with riskier part of mortgage bonds lead to the issuance of nearly $1 trillion in mortgage bonds.

Impact of CDOs and Credit Derivatives

Before tackling the entire economy, it is best to discuss the impact of developments in CDOs and credit derivatives to various stakeholders. In an economy, there are several players that contribute to its success and failure. As expected, the issues that occur in the credit market will both provide positive and negative results. Although the exact impact is difficult to fully understand, it is still necessary to have a glimpse at the effects of such development. Credit is a primary tool for progress in an economy. Its misjudgment can lead to various negative impacts that can economic outlook.

For investors, the presence of CDOs provides leverage to improve their finances. Unlike before, being part of a company requires a significant amount of shares through stocks. Through CDOs, investors indirectly become part of these companies. Using credit is a major advantage because it is backed by securities and assets. Most importantly, these assets and securities are valued well above their market value. Indeed, this is a win-win solution for investments. Using credit as a tool can expand the capacity of investors to venture into several activities.

Misevaluation of credit has a consequence that no investor is willing to absorb. When credit aspects are disregarded, investors become more exposed to risks. Risk is a valuable consideration that investors evaluate before entering into deals. The most challenging aspect of risk in credit is that it is hard to predict. The best option for investors to take is to be conservative. Indeed, the risks on credit pose a high threat for investors. In situations involving credit, high risks may not always lead to high rewards.

Lenders become the middle man in CDO-related transactions. This shows that lenders are freed from the burden of risks associated with CDO. Even at a small rate of return, lenders will be more than willing to facilitate the trade of CDOs backed by loans and securities. Usually, the lenders are the best resource speakers when it comes to risks on CDOs. Banks and financial intermediaries are fully knowledgeable of possible trends in the market. This, however, has never been reflected in recent situations when CDO values decreased. Definitely, lenders have interests that prevent them from informing investors on the possible drawbacks of CDO transactions.

On the other hand, lenders are also aware that misjudgment of credit has some negative implications. The most important perhaps is related to their ratings provided by rating agencies. Once banks fail to disclose the real score on CDOs, then investigations will become a likely destination for these institutions. Lenders believe that reputation is as important as providing the best options for their clients. Losing that edge will eventually make the banks lose prospects and future clients.

Through credit, the government becomes a vital participant in the economy. Usually, the government has the capacity to provide other credit instruments to boost its own finances. CDOs allow the government to partake in private transactions and become part of private institutions. Although such practice is discouraged, it is possible that the government will take the opportunity. In addition, CDOs improve the revenues of banks and investors, which are eventually translated to taxes.

When credit is misjudged, the government is given the most important role to ensure that credit remains a valuable financial tool. The government has the power to create regulations through legislation that can prevent lenders and investors from manipulating the system. Moreover, the government can request knowledgeable individuals and groups to help in formulating the best approaches in credit evaluation. Overall, the government can shape the market and alter the negative aspects surrounding it. But it is also important for the government to allow economic phenomena to take their toll. Sound political and economic policies will make credit a better financial tool.

The impact of credit misjudgment on the economy is larger than what most individuals tend to believe. On the positive side, the government becomes aware of the necessary regulations needed to be imposed. When credit starts to slow down, the government needs to convene its financial experts to improve credit rates and rewards. The government becomes more dynamic in dealing with financial issues. As important as revenue is, the government has to positively advocate for the use of credit to finance projects in the private sector resulting in an economic boom.

It is a known fact that credit is an obligation. Once credit becomes unavailable, investors will seek other modes of financing. Credit is associated with risks and such aspect needs to be reduced. Misevaluation of credit makes it less appealing and left out. This may sound negative, but investors are more willing to venture into less risky activities. Without the credits, risks can also be eliminated from the financing equation.

Undeniably, the drawbacks of misjudging credit are far more noticeable. For a mature economy such as the US, credit is a valuable option for all players in the economic sphere. Once a credit is given the wrong assessment, chances are firms will never be able to make their non-performing assets more liquid. Moreover, lenders will just stick to the usual process and credit products will never evolve. In financing, firms are given a wide range of options to boost their financial standing. Losing credit as an alternative means losing half of the options given to investors. Credit is the most dynamic form of financial instrument and its promotion needs to be solidified.

Once companies fail to acquire credit, there are limited opportunities given for expansion. As a result, employees will be losing their jobs and the government will be deprived of additional income. Individuals at the same time are unable to improve their plight as credit is unavailable for their disposal. The same situation can be applicable to the government, which will be limited in terms of creating projects and job opportunities. When such events happen, a recession of the economy is a likely end result. Worse, the lack of financing options will eventually lead to economic depression.

As discussed, the effects of dislodging credit can threaten the growth of the economy. Assets become nothing but mere possessions of companies. Some liabilities remain as obligations that have to be settled. These reasons are justifying the growth of the credit market. Without such innovation, it is hard to fathom that most of the industries standing today can survive the complex and competitive business environments.

Conclusion

Throughout the discussion, it was evident that credit is highly valued more than what has generally perceived. It is easy to state that credit financing has to be the last resort because it is risky. In addition, credit provides several intricacies that average investors fail to understand. Given the limitations that credit has, it is still considered a powerful financial instrument. In the current economic setting, it is even more prominent than other forms of financing. Indeed, access to credit has improved considerably and credit products have become more risk-free.

The evolution of CDOs and other credit derivatives is inspired by the growing demand for credit. CDOs are vital especially in an ever-changing economy. Other credit products are also as important. The availability of these instruments ensures that credit will be continuously promoted even in varying circumstances. With CDOs and credit derivatives, the credit market has revolutionized and has been moving towards its peak. This is expected to improve as more credit commodities associated with CDOs will be created as the need arises.

According to the earlier hypothesis, misjudging credit has some positive and negative implications. Based on the discussion such is indeed true. Although further testing is necessary, the elements that are needed to justify such a claim have been sufficiently provided. Indeed, the effect of credit misjudgment can change the economy in the long run. This discounts the effect of such a scenario on the other financing tools.

The impact of misjudging credit presents a seemingly domino effect among the stakeholders of an economy. From the lenders to the investors, to the government, and the beneficiaries, such miscalculations can lead to damaging implications. It is inevitable that these components will be affected because their exposure to credit is high. In fact, most of these entities are dependent on the performance of the credit market. Because of this, their role in ensuring equity in credit processes remains an utmost priority. Today, the credit market is flooded by credit products and market regulations. These are vital aspects that make credit a crucial financial instrument.

Holistically, the lack of credit will push investors to use their stocks and earnings in order to expand. Lenders will lose their purpose because credit is a primary source of revenue. The government as well is about to lose tax income from these investors and lenders. Without that financial leverage, the economy will have a hard time surviving the current market setup. The financial aspect is needed to fuel other activities that facilitate economic growth. Losing credit as a viable instrument will lead to an economic collapse.

As stated, the discussion has sufficiently touched on all aspects needed to prove the hypothesis. On the other hand, further enhancements will make the study more substantial. One suggestion that can be manifested is the comparison made on the credit and securities market. Another feasible option is to determine the effect of misjudging credit in different industries. Although the suggestions are considered ambitious, these will allow all concerned entities to have a clearer picture of the importance of credit.

References

  1. Dodd, C. (2007). Hearing on Mortgage Market Turmoil: Causes and Consequences. Washington, DC: US Senate Committee on Banking, Housing, and Urban Affairs.
  2. Duffie, D. and Garleanu, N. (2001). Risk and Valuation of Collateralized Debt Obligation. Stanford, CA: Stanford University.
  3. Instefjord, N. (2005). Journal of Banking and Finance. “Risk hedging: Do credit derivatives increase bank risk?”
  4. Morrison, A. (2005). Journal of Business. “Credit derivatives, disintermediation, and investment decisions.”
  5. Schorin, C. and Weinreich, S. (1998). Collateralized Debt Obligation Handbook. Working Paper, Morgan Stanley, Dean Witter, Fixed Income Research.
  6. Tavakoli, J. (2001). Credit Derivatives & Synthetic Structures: A Guide to Instruments and Applications. New York: Wiley Finance.
  7. Weithers, T. (2007). Credit Derivatives: Macro-Economic Issues. “Credit derivatives, macro risks, and systemic risks.”
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IvyPanda. 2021. "Collateralized Debt Obligation and Credit Derivative." September 12, 2021. https://ivypanda.com/essays/collateralized-debt-obligation-and-credit-derivative/.

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