Derivatives

CHAPTER 43Securitisation, ABSs and CDOs

Aims

• To analyse the process of securitisation.
• To show how structured products such as asset backed securities (ABSs), collateralised debt obligations (CDOs) and ABS-CDOs give rise to credit enhancement.
• To outline the importance of ABS-CDOs in the 2008–9 credit crisis.
• To examine single tranche trading, synthetic CDOs, and total return swaps.

Banks can reduce the credit risk on their ‘banking book’ by securitisation. They ‘bundle up’ a portfolio of loans and sell securities which entitle the investor (e.g. a hedge fund or pension fund) to the promised future cash flows from these loans – so the credit risk is transferred from banks to the holders of the securitised assets. Often the cash flows from securitised assets are paid out in order of priority, known as tranches or a waterfall. Senior tranches get paid first and are the least risky and the equity tranche gets paid last and is the most risky. These securitised assets are known as asset backed securities (ABSs) and collateralised debt obligations (CDOs). They are multi-name credit derivatives since the loans in the securitised assets originate from many different companies (or individuals in the case of home mortgages or car loans). In this chapter we discuss how ABSs and ABS-CDOs are constructed, how they provide ‘credit enhancement’, and the risks posed by these securities particularly in the 2008–9 credit crunch.

43.1 ABS AND ABS-CDO

Securitisation is the term used when issuing ...