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Questions and Answers
What happens to banks' behavior when there is a high demand for collateralized debt obligations (CDOs)?
What is a potential outcome if mortgage owners default on their loans?
Which entities are primarily responsible for structuring and selling CDOs?
What is a typical management fee that large asset management companies might charge for managing a $1 billion CDO?
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What role do rating agencies play in the CDO market?
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How does pooling multiple mortgage loans into one tranche affect overall credit risk?
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How do financial guarantors enhance the CDO market?
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What is the primary purpose of securitization?
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What is a special purpose vehicle (SPV) primarily used for in the securitization process?
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What is the function of ratings agencies in the securitization process?
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In the context of Asset-Backed Securities (ABS), what role do the underlying assets serve?
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What characterizes the different tranches created by Collateralized Debt Obligations (CDOs)?
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How does an investor profit from a CDO?
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What is the primary characteristic of the assets that SPVs typically acquire?
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What is an example of an underlying asset of an Asset-Backed Security (ABS)?
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Study Notes
Structured Products
- A structured product allows investors to buy a single instrument with exposure to multiple underlying assets.
- Investors customize investments to reduce market declines while maintaining return potential or maximize flat or rising market benefits.
Securitization
- Creates a liquid market for illiquid assets like mortgages and credit card loans.
Securitization Process
- Managers create a special purpose vehicle (SPV).
- The SPV purchases a pool of assets from a financial institution.
- Assets should be homogeneous (good quality, fixed-term, fixed rate) for steady income.
- The SPV borrows money from its parent/associate company, financed by investment banks.
- The SPV issues debt securities to repay borrowings and acquire more assets.
- SPVs hire rating agencies to assess credit risk and maximize marketability.
- Separate asset pools back each security issue.
Asset-Backed Security (ABS)
- A debt security whose principal and interest payments come from an underlying asset pool's revenue.
- The pool can include mortgages, credit receivables, commercial loans, derivatives, or combinations of these.
- Collateral: Underlying assets guarantee payment to security holders. For example, mortgages have houses as collateral.
- Defaults: Borrowers unable to repay interest/principal face losing their collateral (e.g., house).
Collateralized Debt Obligations (CDOs)
- A pool of fixed-income assets like mortgages, corporate bonds, or credit card loan debts.
- CDOs or security companies purchase this asset pool.
- They create tranches representing different risk levels and returns.
- Investors choose tranches according to their risk tolerance and return expectations.
- Each tranche can be sold to various investors.
- Revenue: CDO investors receive revenue from the interest paid by mortgage holders.
- CDOs and Housing Prices: CDO investors benefit from rising housing prices as higher loan values mean greater interest payments for borrowers.
- Housing Crisis: A housing crisis increases CDO investment demand because many homeowners may default on their loans, leading to increased demand for CDOs.
- Mortgage Loan Issuance: Increased CDO demand encourages banks to issue more mortgage loans.
- Lowered Criteria: To meet this demand, banks lower loan issuance criteria, accepting higher credit risks from borrowers.
- Refinance or Sell: When high-risk homeowners struggle to meet mortgage payments, they may refinance (revaluing the house for a lower interest payment) or sell the house. Refinancing is often impractical during a housing crisis.
Mortgage Default
- Mortgage owners default on their loan agreement when they fail to meet its terms.
- Defaults lead to a decrease in mortgage-backed security demand.
- Banks, facing many defaults, become reluctant to lend to borrowers, increasing illiquidity.
- This decreases housing demand.
- CDOs and Debt REITs: If a CDO pool contains mortgage loans, it's similar to a Debt REIT structure.
CDO Diversification
- Credit Risk: Combining individual mortgage loans into a pool (or tranche) leads to lower credit risk, as diversification benefits reduce overall risk.
CDO Players
- Securities Firms (Underwriters): Approve collateral, structure tranches, and sell CDOs. Major players include Merrill Lynch, Goldman Sachs, Citigroup, and others. They profit from issue fees.
- CDO Managers: Select collateral like mortgage-backed securities. They can be large asset management companies (PIMCO, Blackrock) or smaller independent firms. They charge fees based on assets or performance.
- Rating Agencies: Provide guidelines on the size and returns of tranches. They need at least two ratings from agencies (e.g., Moody's, S&P, Fitch), which charge fees for their services.
- Investors: Select the desired tranches based on their risk tolerance and expected returns.
- Financial Guarantors: Issue credit default swaps.
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Description
This quiz explores the concepts of structured products and the securitization process. You'll learn about how investors can leverage structured investments and the creation of asset-backed securities through special purpose vehicles. Test your understanding of these complex financial instruments and their implications in the market.
