8/14/2019 In Relevance to the Current Global Crisis

1/12

1

I n r e l e v a n c e t o t h e c u r r e n t g l o b a l c r i s i s

CDS & CDO

8/14/2019 In Relevance to the Current Global Crisis

2/12

2

Credit default swap (CDS) market is a large andfast-growing market that allows investors to tradecredit risk.Credit default swap (CDS) is a contract between twoparties, where a protection buyer pays a premium tothe protection seller in exchange for a payment if acredit event occurs to a reference entity. CDS arecustomizable, over-the-counter products and can bewritten to trigger in the event of bankruptcy, default,failure to pay, restructuring, or any other credit event of the

reference entity.

8/14/2019 In Relevance to the Current Global Crisis

3/12

3

Example

Suppose Bank A buys a bond which issued by a SteelCompany.

To hedge the default of Steel Company: Bank A buys a credit default swap from Insurance

Company C.

Bank A pays a fixed periodic payments to C, inexchange for default protection.

8/14/2019 In Relevance to the Current Global Crisis

4/12

4

Exhibit Credit Default Swap

Bank A Buyer

Insurance Company

CSeller

Steel companyReference Asset

ContingentPayment OnCredit Event

Premium Fee

8/14/2019 In Relevance to the Current Global Crisis

5/12

5

What is a CDO?

Debt Securitization Pool of Diversified Debt Obligations is Packaged and Sold to theCapital Markets

The CDO Issues Multiple Layers/Tranches of Securities: Senior,Mezzanine, Equity (First Loss)

Payments to CDO Tranches depend on the performance of theUnderlying Portfolio of Assets

Underlying Portfolio can be - Real or Synthetic; Actively Managed orPassive

8/14/2019 In Relevance to the Current Global Crisis

6/12

6

Types of CDOs

Arbitrage & Off-Balance Sheet Arbitrage CDO

Weighted Average Coupon of Underlying Securities > WeightedAverage Coupon of Repackaged Securities

Off-Balance Sheet CDO Financial Institutions can achieve Capital Relief by securitizing

balance sheet assets

8/14/2019 In Relevance to the Current Global Crisis

7/12

7

Types of CDO Collateral

CDOs Have Been Issued For: Commercial Loans

Corporate Bonds

ABS

Mortgage Backed Securities Emerging Market Debt

CDOs of CDOs

8/14/2019 In Relevance to the Current Global Crisis

8/12

8

Generic CDO Structure

CDOSpecial PurposeVehicle (SPV)

Subordinated NotesEquity

MezzanineFixed or Floating

RateNotes

Senior Fixed orFloating Rate

Notes

Diversified Pool ofUnderlying Assets

(Collateral)

CollateralManager

8/14/2019 In Relevance to the Current Global Crisis

9/12

8/14/2019 In Relevance to the Current Global Crisis

10/12

10

8/14/2019 In Relevance to the Current Global Crisis

11/12

11

8/14/2019 In Relevance to the Current Global Crisis

12/12

Higher defaults

Financial failure

Lower interest rates

Inflation

Higher cost

Contraction in consumer spending

Recession