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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Tue, 09 Oct 2007

Similarities and Differences between Banks and CDOs

In February 2006, I posted a blog entry about how banks and CDOs are very similar in their economic function. I received a couple of comments on that entry and then in August 2007, Francisco Casanova from Madrid began a long email conversation with me on the subject. All this forced to me think carefully about the issues and helped clarify my thoughts on the similarities and differences between banks and CDOs. So I decided to pull the comments and my responses into one long blog entry.

Comment Response

A CDO is a leveraged play on the underlying, banks forget that the ‘deltas’ of the underlying portfolio can be quite large and mean substantial MtM volatility.

I think a good test of the market is around the corner when the credit cycle turns and we see a number of downgrades on existing tranches making them economically unviable. (Mrinal Sharma)

A bank is also a leveraged play on the underlying loan book. But banks do not M2M their loan book and when the credit cycle turns, the impact is gradual. When there is no M2M, downgrades do not matter only defaults do.

‘Correlation risk’ and how it affects pricing is also a term misunderstood by banks and frequently ignored. (Mrinal Sharma)

Most of the risk of a bank’s loan book is also correlation risk though it is more commonly called concentration risk.

Tranching creates a slicing of risk whereby the 0-3% (in 5 years CDOs) is labeled as an equity investor. By receiving this name it would equate to the equity investor in any business, i.e., a bank. Nevertheless the actual risk/return characteristics of a non tranched equity stakeholder (i.e., a bank equity holder) are very different to those of a 0-3% holder in a CDO, aren’t they? (Francisco Casanova)

In a bank also, there are actually many tranches – demand deposits, time deposits, subordinated debt, hybrid capital and equity. If there were no central bank to bail out the bank, this would behave much like a CDO. When things start getting bad, the demand deposits will pull out quickly and will be paid out in full – this is like the AAA tranche. Time deposits might involve some loss if pulled out but the loss might be very small – an A or AA tranche. Some of the subordinated debt and hybrid capital would be like the BB tranche. Equity would be like the equity tranche.

The precise attachment points of the tranches in the CDO reflect three things – the quality of the underlying pool, the lack of central bank bail out and the rating errors of the rating agencies.

The big difference between banks and CDOs is the lender of last resort (the central bank)

Also, this permanent presence of the idiosyncratic vs systemic signals debate arising from the correlation movements in trading (which I do not know how accurately could be extrapolated to a bank), or the fact that, ceteris paribus (collateral spreads unchanged), a change in correlation reallocate expected losses among tranches in a zero sum game (i.e., an increase in default correlation expectations shifts risk allocation from junior to senior CDO tranche holders)... Or the mere fact that you can trade pure correlation views if you take delta hedged positions... (I guess you could do the same if all stakeholdings in a bank were securities form...). (Francisco Casanova)

It is interesting to note that the Basle II formula for corporate exposures is based on the same one-factor Gaussian copula models that are often used to price CDS index tranches. It is also useful to look at the following paragraphs from the second consultative package (Jan 2001) on Basle II that introduced the formula:

424. Credit risk in a portfolio arises from two sources, systematic and idiosyncratic. Systematic risk represents the effect of unexpected changes in macroeconomic and financial market conditions on the performance of borrowers. Borrowers may differ in their degree of sensitivity to systematic risk, but few firms are completely indifferent to the wider economic conditions in which they operate. Therefore, the systematic component of portfolio risk is unavoidable and undiversifiable. Idiosyncratic risk represents the effects of risks that are peculiar to individual firms, such as uncertain investments in R&D, new marketing strategies, or managerial changes. Decomposition of risk into systematic and idiosyncratic sources is useful because of the large-portfolio properties of idiosyncratic risk. As a portfolio becomes more and more fine-grained, in the sense that the largest individual exposures account for a smaller and smaller share of total portfolio exposure, idiosyncratic risk is diversified away at the portfolio level. In the limit, when a portfolio becomes “infinitely fine-grained,” idiosyncratic risk vanishes at the portfolio level, and only systematic risk remains.

425. The design and calibration of the IRB approach to regulatory capital relies on decomposing risk in this manner. Under an IRB system, the risk weight on an exposure does not depend on the bank portfolio in which the exposure is held. That is, while capital charged on a given loan reflects its own risk characteristics, such as the credit rating of the obligor and the strength of the collateral, it is not permitted to depend on the characteristics of the rest of the bank’s portfolio. To get this property of portfolio-independence, we must calibrate risk weights under the assumption of infinite granularity. Without this assumption, the appropriate capital charge for a facility would depend partly on its contribution to the aggregate idiosyncratic risk in the portfolio, and therefore would depend on what else was in the portfolio. With the assumption of infinite granularity, idiosyncratic risk can be ignored, so the appropriate capital charge for a facility depends only on the systematic component of its credit risk.

426. Of course, no real-world portfolio is infinitely fine-grained. Thus, there is always some idiosyncratic risk that has not been fully diversified away. If this residual risk is ignored, then a bank just satisfying IRB capital requirements will in fact be undercapitalised with respect to the intended regulatory soundness standard. To avoid such under-capitalisation, IRB risk weights have been scale upwards by a constant factor from the infinite granularity standard. The constant factor was chosen to approximate the effect of granularity on economic capital for a typical large bank. In order to capture variation across banks in granularity, we furthermore introduce a portfolio-level “granularity adjustment.” This additive adjustment to risk-weighted assets is negative for banks with relatively fine-grained portfolios, and positive for banks with more coarse-grained portfolios.

If the concepts of CDO and Bank are so fundamentally close, why are CDOs facing this acute lack of consensus in the valuation methodologies which is not present in the valuation of banks by equity and debt analysts? (Francisco Casanova)

  1. Banks are well diversified as compared to many CDOs. The few banks like Northern Rock that are not so diversified have seen huge valuation volatilities similar to CDOs. In the past, banks that have faced deterioration of a major part of their portfolio have seen values go down to zero very quickly. For example, think of what happened to some of the largest East Asian banks during the Asian Crisis. In the late 80s/early 90s, some analysts had a target price of zero for Citi stock before it clawed its way back from the brink.
  2. This leads to the interesting question as to why CDO investors did not apply the lessons of centuries of bank management and regulation to CDOs. Why did they accept sector concentrations that would have raised eyebrows in banking?
    • One possible answer is that this was a new field and investors were learning the lessons the hard way.
    • The other answer is that the investors were diversifying across CDOs and so risk concentration in any one CDO did not matter. If this is so, then big value changes in individual CDOs do not matter; what matter is value changes of diversified portfolios of CDOs. These latter changes have been much less dramatic.
  3. The attachment points for AAA and AA tranches in many CDOs seem to have been badly off. A well run AA rated bank probably has a capital of 10% and a price to book ratio of 1.5 implying a cushion of 15% on a globally diversified asset pool with very little sector concentration. If we apply this benchmark to a CDO, the AA attachment point was I think badly off the mark. If the rating agencies had thought of CDOs as mini banks, would they have given these ratings? I think the answer is clearly no.
  4. Bank valuations have not suffered much because they had huge liquidity support. If the central banks had gone to sleep, what would have been the volatility in the valuations of the big banks? The CDOs have had no liquidity support.
  5. It would be interesting to compare the actual default rate in investment grade CDO tranches during this crisis with the default rate of banks during the days before central banking became so widespread. I suspect the default rates have actually been lower so far, but it will take a year or so to find out.
  6. If CDOs can survive this crisis without any central bank bailout, they may emerge stronger with better risk management, better valuation models, better rating practices, greater transparency and less moral hazard. In the long run, this crisis might be the best thing that ever happened to CDOs!

Posted at 21:48 on Tue, 09 Oct 2007     View/Post Comments (1)     permanent link