Introduction to Securitization

KEY POINTS OF THE CHAPTER

• Balance sheet CDOs apply the securitization technology to parcel out a portfolio of loans, usually low-rated loans or emerging market credits and below investment-grade bonds, held by large banks.

• Balance sheet CDOs may be either cash CDOs or synthetic CDOs.

• In cash flow balance sheet CDO transactions, the structure used is a true sale structure (i.e., the seller makes a legally perfected sale of the asset to the SPV).

• Correlation risk can be fatal to a CDO because the concept of creating different bond classes with varying probabilities of default is based on the diversification of the asset pool and, as a result, one of the important objectives of both balance sheet and arbitrage CDOs is to achieve diversification.

• Diversification is easier to attain in an arbitrage CDO transaction because the CDO manager selects assets to suit the objective of the transaction; in balance sheet transactions, the assets are being parcelled out of the balance sheet of the bank and, therefore, rating agencies and investors are more concerned about portfolio diversity.

• A CDO’s enhancement structure will be based on the probability of default curve, with the default curve estimated using proprietary models of rating agencies.

• Cash CDOs are intended for raising liquidity; synthetic CDOs are intended for risk transfers.

• The advantages of synthetic CDOs over cash CDOs are related to the purpose of the originator.

• Synthetic CDOs have the following advantages ...