Subprime Mortgage Credit Derivatives

CHAPTER 9

Credit Default Swaps on CDOs

In June 2006, the International Swap and Derivatives Association (ISDA) released a template that sellers and buyers of credit protection can use to negotiate the terms of credit default swaps (CDS) on collateralized debt obligations (CDOs). Standardized documentation improved the liquidity of CDO CDS, which was important to CDO investors for four reasons.

First, selling protection on a CDO CDS provided a new way to access CDO risk, and opened up investment opportunities to a broader range of CDOs than those available in the cash market. Second, CDO CDS allowed one to efficiently short CDOs for the first time. Applications ranged from simply providing another way to get out of long cash CDO positions to the execution of various long-short strategies. These long-short strategies could involve tranches within the same CDO, tranches from different CDOs, or CDO tranches and underlying CDO assets. Third, supply and demand technicals across cash and synthetic CDO markets almost guaranteed price misalignments and, therefore, profitable trading opportunities. Finally, trading levels of CDO CDS enlightened one's view of the cash CDO market. Price distinctions among vintages and managers are often more apparent, or apparent sooner, in the synthetic market than in the cash market. Even if CDO CDS levels do not affect one's view of the quality and value of cash CDOs, CDS levels will impact the views of other cash market participants. One needs to understand ...