[Risk Analysis in Correlation Products: Using CDO's as Evidence]

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ACKNOWLEDGEMENT

I would take this opportunity to thank my research supervisor, family and friends for their support and guidance without which this research would not have been possible.

DECLARATION

I, [type your full first names and surname here], declare that the contents of this dissertation/thesis represent my own unaided work, and that the dissertation/thesis has not previously been submitted for academic examination towards any qualification. Furthermore, it represents my own opinions and not necessarily those of the University (Agarwal, 2000,, 739).

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ABSTRACT

Collateralized debt obligations (CDOs) have been responsible for $542 billion in write-downs at financial institutions since the beginning of the credit crisis. In this paper, I conduct an empirical investigation into the causes of this adverse performance, looking specifically at asset-backed CDO's (ABS CDO's). Using novel, hand-collected data from 735 ABS CDO's, I document several main findings. First, poor CDO performance was primarily a result of the inclusion of low quality collateral originated in 2006 and 2007 with exposure to the U.S. residential housing market. Second, CDO underwriters played an important role in determining CDO performance. Lastly, the failure of the credit ratings agencies to accurately assess the risk of CDO securities stemmed from an overreliance on computer models with imprecise inputs. Overall, my findings suggest that the problems in the CDO market were caused by a combination of poorly constructed CDOs, irresponsible underwriting practices, and flawed credit rating procedures.

Table of Contents

ABSTRACTIV

CHAPTER 1: INTRODUCTION1

CHAPTER 2: LITERATURE REVIEW3

Collateralized Debt Obligations3

The Evolution of Collateralized Debt Obligations5

Credit Rating Agencies (CRAs)10

Investment Banks15

CHAPTER 3: METHODOLOGY19

Questions and Hypothesis Development19

General CDO characteristics20

Hypothesis 1A: “The Housing Effect”21

Hypothesis 1B: “The Vintage Effect”22

Hypothesis 1C: “The Complexity Effect”22

Underwriters and Originators23

Hypothesis 2A: “The Underwriter Effect”23

Hypothesis 2B: “The Size Effect”24

Hypothesis 2C: “The Originator Effect”24

Hypothesis 2D: “The Asymmetric Information Effect”25

Credit Ratings26

Hypothesis 3A: “Recycled Ratings Effect”27

Hypothesis 3B: “Peer Pressure Effect”27

Regression Analysis28

Data Description28

The Effects of Asset and Liability Characteristics on CDO Performance29

CHAPTER 4: RESULTS AND ANALYSIS31

The Effects of CDO Underwriters and Collateral Originators34

CDO Credit Ratings40

Determinants of CDO Tranche Downgrades44

CHAPTER 5: CONCLUSION46

REFERENCES48

APPENDIX51



CHAPTER 1: INTRODUCTION

A Collateralized Debt Obligation (CDO) is a credit derivative1 that creates fixed income securities with widely different risk characteristics from a pool of risky assets. The coupon and principal payments of these securities are linked to the performance of the underlying pool. These fixed income securities are known as tranches and divided into senior, mezzanine and subordinated/equity tranches. Each of these tranches has a different level of seniority relative to the others in the sense that a senior tranche has coupon and principal payment priority over a mezzanine tranche, while a mezzanine tranche has coupon and principal payment priority over an equity tranche. It is important to note that a CDO only redistributes the total risk associated with the underlying pool of assets to the priority ordered tranches. It neither reduces nor increases the total risk associated with the pool. A CDO is called a synthetic CDO if the risky assets in the underlying pool are credit default swaps ...