COLLATERAL AND STRUCTURAL RISKS IN CDO INVESTING
The collateral and structural risks when investing in CDOs include:
• Correlation risk
• Interest rate and basis mismatch
• Cross currency risk
• Ramp-up risks
• Reinvestment risks during the revolving period
• Lack of granularity:
• Asset risks
We discuss each risk next.
The quintessential risk in any CDO structure is the risk of correlation. CDOs are essentially correlation products; they create seemingly diversified asset pools and try to take advantage of minimal correlation by stretching the leverage. Needless to say, high degrees of leverage can never be sustained in the presence of high correlation. So, if high correlation is present in the CDO, the structure becomes extremely fragile.
Armed with CDO evaluation models of the rating agencies, CDO structurers have the advantage of doing a mix and match of assets to try and contrive a structure that under rating agencies’ assumptions, has minimal asset correlation. For example, if obligors from different industry clusters are selected as per the rating agencies’ definitions, the correlation is presumed to be either zero or minimal.62
In situations of economic downturn, most often there are widespread intersector disturbances that cause generic losses to several segments. In adverse business cycles, the absence of correlations among industries will not hold, leading to a basic assumption being questioned.
Interest Rate and Basis Mismatch
One of the ...