Can the same asset be in multiple CDO tranches?

[sridhar]

I refer to page 38 of your Credit Risk C screencast -- where you talk about CDO-squared.

From the picture, it appears that the same asset can be part of multiple tranches? Is this physically possible? Looked at from the point of view of the tranched investors -- if Asset B is part of a junior tranche as well as that of a mezzanine one -- and if asset B defaults will investors in both tranches be exposed to this?

Not sure, if I am phrasing this correctly -- but curious to know if a single asset (e.g. mortgage loan) can be part of two different tranches? If not, how do I interpret the "green lines" in slide 38 and similar graphics I've seen elsewhere?

--sridhar

 

[David Harper CFA FRM]

Hi sridhar,

That's a really keen observation, I admit i've treated that CDO^2 graphic superficially. Luckily, it is acceptable because in practice (at least before the crunch, it will be interesting to see what is working now and going forward), the *synthetic* CDOs were more common than cash CDOs.

So, the double lines are indeed possible where the inner CDO is a synthetic CDO: it (the inner CDO) sells credit protection by selling credit default swaps (CDS) on the reference assets. So, you would be correct that physical references cannot be "in two places at once." But I can be a manager of an inner CDO and construct my CDO by writing a CDS on, say, IBM; you can manage a different CDO and similarly write a CDS on IBM. (notional on IBM CDS = 2x phyical). The outer CDO may include pieces (e.g., mezzanine) of *each* of our respective CDOs. That's called credit overlap; the outer CDO is doubly impacted by an IBM default.

This relates to a thread (from yesterday?). It is easier to see this when you realize that CDS are merely "notional" derivatives that reference the credit - there can be many multiples of CDS written on a single-name. Or as Meissner says, the CDS writer (who sells credit protection) is "synthetically long" the reference which is not the same thing as owning the underlying.

So, to your question, I suppose the physical mortgage loan cannot be in two places at once, but multiple CDS can be written on the mortgage loan. And to your point, per 'credit overlap', CDO^2 investors may be doubly hurt by a default on the single-name.

David

 

[sridhar]

Thanks for the usual clarity David....One lingering thought...

<<....but multiple CDS can be written on the mortgage loan....>>

I've read through your IBM example...You and I independently sell a CDS on an underlying asset such as IBM...I am trying to relate this in a common-sensical way. If I think about it from the asset-owner point of view, this means he's buying credit protection from two different CDS sellers...Does this really happen? After all, I don't buy insurance for my car from State Farm as well as All State... Can a (financial) asset-owner really buy insurance from two different CDS dealers?

--sridhar

 

[David Harper CFA FRM]

Hi sridhar,

I don't disagree from the perspective of the asset owner. I mean to say: the asset owner does not need to be in the picture. The CDS is a contract between two parties, the protection buyer does not need to own the asset. (we started with the question, how can the CDO^2 be doubly exposed?).

In your example (metaphor), you may own the a car and insure by purchasing a CDS, so to speak, from All State. That is analogous to the "first generation" balance sheet CDOs that, to your point, are/were MOTIVATED by the balance sheet ("I have assets with credit risk, I would like to transfer the credit risk to willing investors"). Some would argue this is the healthy part of credit securitization. This is securitization as insurance.

But then I come along, say i am a CDO manager and I am more like the second generation (synthetic arbitrage CDO). I am not balance sheet motivated. I found investors and now i am building a portfolio and i think you will not default. So I find a different counterparty and I write a CDS on your car (or car loan) to a counterparty (Joe Smith). Neither I nor Joe own your car loan; we have a contract that just happens to use your situation for a trigger. This shifts from balance sheet to arbitrage and synthetic CDOs where the motivation is not from the owner's perspective but from the investor's/speculator's perspective.

So yes there is only one car loan and probably the owner (you) only buys protection once, but there can be abstract layers of counterparties making derivative bets that reference your loan. Like the credit indices (CDX, iTraxx, John Hull), these are "bets" on pools but the buyers/sellers do not own the underlying names, they are "expressing views" via the derivatives.

David