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September 27, 2006

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James

If banks hold the lowest tranche of debt, they will have an incentive to monitor only over a certain range, right? In other words, once enough loans go bad, they will be out of the money and won't get anything by monitoring. I suppose in theory the holders of the next tranche would step up, but there might be some free-riding if ownership isn't concentrated. Also, won't banks make more and larger loans now that they can offload them quickly into these debt securities? If that's the case, won't it simply become harder to monitor? A bank may end up holding the same amount of debt, but that debt is owed by more debtors, so the burden is higher.

Finally, debtors don't need to know if their debt has been securitized, right? They will simply alter their expectations (and behavior) to match the probabilities. In any case, isn't most debt securitized these days?

Ben

James is correct about the bank's moral hazard. The equity tranche is a high-risk, high-return asset, while the senior tranches are low-risk, low-return. Also, since the equity tranche is high return, the bank/equity-holder can make an economic profit faster than the senior tranche holders. The transaction doesn't even need to suffer any deterioration for this hazard to begin to pop up, especially in "managed" transactions where the bank can trade assets in and out of the underlying collateral pool.

In light of this, perhaps it would make more sense for the CDO originator to take a vertical slice of the pool (at least up to a relatively senior point), rather than the equity layer? Why isn't this isn't more common? It'd allow the banks to offload more risk, while avoiding the moral hazard James identified. It's hard to believe there isn't enough investor appetite for more equity risk.

Also, in regards to reputational risk, many of these CDO transactions are private and can also be governed by confidentiality agreements. If a private, confidential transaction goes bad, the wider market may not find out about it. Even if a deal tanks and there is no confidentiality agreement, the bank may choose to make a deal with the aggrieved investor to keep them quiet, keeping the wider market in the dark. This mitigates the threat to reputational risk that the banks fear, and slows the buildup of market knowledge. I suspect that this is fairly common.

Separately, another, and possibly much larger, moral hazard associated with CDO's is the fact that the rating agencies have drastically overrated CDO risk relative to corporate or municipal risk. This is one of the reasons that the CDO market grew so quickly. Rating agencies provide a similar monitoring function to pensions and other investors that banks provide to borrowers, and rating agencies simply guessed wrong when they created their models to assess these transactions (generally, their models attempt to provide a corporate-equivalent rating).

In the CDO market, it's not uncommon to see AAA ratings assigned to CDO tranches that trade as wide A or BBB corporate single-name CDSs (occasionally even worse). The difference with muni's is even larger. This is also apparent from rating transition and default data, even though the market is relatively young. The rating agencies have updated their models in part to address this, but the differences persist.

BobRasmussen

There is an implicit assumption about the banks' business model here -- it is that its profits come in large part from a return on its loan, in particular the tranche that it holds. But this is only part of the story. It is my understanding that the lead bank often gets the lion's share of its profits from fees. Sure, it collects some of these on the front end, but it collects a lot during the course of the loan as well. For example, the debtor will often have to a pay substantial fee in order to procure a waiver of a default. So, even if the bank is out of the money as James points out, it may still have an incentive to monitor to the extent that that monitoring will bring in revenues on the fee side.

ToddHenderson

These are great comments! Thank you. This is obviously an area that is greatly in flux, so the answers are not at all obvious. This discussion is already helping me think deeper about these issues.

On the reputation point made by "Ben", I don't think the "private" or over-the-counter (OTC) nature of these transactions mitigates the reputational penalities for selling lemons. About 95% of the transactions are handled by several huge banks (JP Morgan, Citi, etc.), and this is a very tight community. If a deal is deliberately designed in a way that the protection buyer scams the seller or shirks in a way that destroys value, the word gets around. The ISDA, who has written the form contacts and set the industry standards, has already responded quickly in cases where opportunism has been revealed -- e.g., in the Conseco case. I think we can rely pretty strongly, but obviously not completely, on reputation here.

Bob Rasmussen makes a nice point about the role of fees in the story. Fees after all are what cause the bank to want to shed risk in the first place. The bank gets fees from originating the loan but has to "pay" to hold the loan. Since it has the relationship with the borrower, what it wants is fees and more fees, either in origination or in renegotiation, which is just the flip side of monitoring. So I think there is something to this good point.

I'll have to think more about the point made by "James" and "Ben" on the limits to monitoring inherent in holding only, say, the first-loss position. It might be that once this position is out of the money, the nature of the ownership stakes changes in a way that brings in another set of monitors, say distressed debt investors or the bank arranging for workout or DIP financing. With respect to Ben's question about why we don't see more banks taking vertical ownership stakes, my knee jerk answer is that the buyers don't think this is needed. Perhaps because of Bob's point; perhaps because of my point. A third possibility, which is related to Ben's observation about the credit rating agencies, is that we are in a period of learning and are truly out of equilibrium. This is possible, I guess, but I have reason to doubt that the buyers of CDO tranches are so misinformed.

Jake

This also illustrates a larger point about legal scholarship in financial markets: by the time the academic looks at the problem, it has already been examined by somebody with millions (or tens or hundreds of millions) of dollars on the line. It seems unlikely that the academic is often going to be able to point out a way that investors might get scammed that the investors have not already thought of and dealt with.

Jamie

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One thing to note re: "trillions." That's notational value - it grossly exagerates the amount of $$$ really at play, which is still considerable.

Tom Vega-Byrnes

All very interesting comments. Especially about the difficulties of academics studying aspects of new financial products. By way of analogy and detour, I represented a fairly aggressive team at a NY bank (which will remain anonymous) who did a lot of synthetic lease deals in the late 1990's and into early 2000-2001. This group developed new products based on close study of the accounting rules, and jealously guarded the terms of new structured financing products from their competitors, much less share them with academics. Those familiar will know that the synthetic lease structure is an arbitrage between the US federal tax treatment of ownership of an asset during construction of a real estate project, versus the accounting treatment. The tax rules and accounting rules gave different answers as to who was the owner, and thus got the tax benefits during construction, and later during the operating lease life, this could be followed by another structure. All a long intro to the example of Enron, and how it really got the whole synthetic lease market into trouble. The structure is one of the several types of off balance sheet structures that effectively hides debt on a corporation's balance sheet. Congress has allowed this for 20-30 years; the tax code is full of moral hazards known to financial industry insiders and tax jocks, that the general public would be appalled at if they understood what was going on. After Enron, the FASB was forced by all the pressure to revise their rules to prevent the greatest abuses, but only after a huge amount of damage was done (e.g., Enron losing $68 billion in market cap value). Enron basically did way too many off-balance sheet deals. In many cases, each deal was probably in and of itself legal and supported by accounting rules and signed off by a big 4 accounting firm. The problem was that taking 1% or 5% or so of your developing projects off balance sheet creates a minor distortion to the picture created by your financial statements. For Enron, I can't say what the % was, but it was much greater, to the point of an abuse that had no effective monitor. The accounting firms were the worst, in the sense of continuing to sign off on Enron's audits even when so large a part of the firm had been financed off balance sheet. The lame justification made was that these deals were sometimes acknowledged in the footnotes to the financial statements, thus allowing Wall St analysts to back the deals into their numbers. But in the late 90's, every major corporation I advised or heard of was looking for aggressive means to manipulate their earnings, and everyone on Wall St knew this was the trend. In the heady atmosphere of dotcom's that had never made a profit trading at ridiculous share prices or being bought out for billions, there was a overwhelming level of "moral hazard" in all the financial markets. Everyone was simply making gobs of money, and lots lost their compass. Jeff Skilling may be today's poster child, but he was simply the tip of an enormous iceberg of people who are very glad they never got caught out like he did. Enron melted as fast as it did in late summer of 2001, precisely because everyone on the Street knew how aggressive the Enron guys were at "financial engineering", and deal-making, thus once the first blood was in the water, most traders assumed the worst and wanted to avoid being the last guy in the pool stuck with Enron shares. The day after Enron filed for BK I was in Rio helping my client figure out how to repo a Brazilian powerplant Enron had just finished building with my client's money. Those who want to study financial markets should watch the movie "Boiler Room", just for starters, and maybe spend some time on the open outcry trading floors at the Board of Trade before they get rid of them for screen trading.

smancy

Do you have any other articles or info on credit derivatives pricing or trading? I found some interesting information on the following sites:

http://www.axiomglobal.com

http://cdsaxiom.com

Charlie Mann

Do you have any other articles or info on credit derivatives pricing or trading? Been looking to find out more info on the player in the market... I've some interesting information on the following sites:
http://www.cdscawley.com
http://cdsaxiom.com

Know where I can find any additional info on the other players?

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