Tranched Portfolio Default Swaps [Credit C, slides 34-35]

[mikey10011]

I went through Credit C slides 34 & 35 and it appears that the super-senior tranche relates to the tranched portfolio default swap (TPDS). I’ve read Meissner (p. 49) and saw

http://www.bionicturtle.com/learn/article/tranched_portfolio_default_swap/

To be honest I still don’t understand TPDS and I am still puzzled why “super senior” tranches at the top of the totem pole caused so much trouble to Merrill’s massive write-offs?

http://www.ml.com/index.asp?id=7695_7696_8149_88278_101366_103431

Also I don’t know if you saw this but Janet Tavakoli’s article “The Elusive Income of Synthetic CDOs”

http://www.sec.gov/comments/s7-04-07/s70407-1.pdf

(pp. 6-21) might provide some insight. Or put more bluntly, could you give a screencast of what Takevoli is saying (to be honest I can’t decipher it).

 

[David Harper CFA FRM]

Mikey,

Sorry for delay responding, I hadn't had a chance until today to read Janet Tavakoli's article, I had not seen it, but it's a gripping read! Thank you for copying me. Here my takeaway: she is saying that the super senior tranches were dubious in the first place. As in,

in a conventional CDO (her figure 2, left), the 85% senior tranche (i.e., not necessarily TPDS, this is the "right hand" side, the liabilities issued to investors) is AAA rated and pays LIBOR + 50 bps. It has low risk but still costs the securitization 50 bps. But that's too much cost. So they break off the LOWEST piece of the formerly AAA rated senior trance, the 5%, and call it the new AAA tranche and the other 80% above it the super senior tranche. But the fallacy, the mistake is, they managed to get teh super senior tranche viewed as virtually riskless. The fallacy is 85% costing +50 bps (i.e, reflects some risk) is parsed into 80% costing only +6 bps and the other 5% which (being now the "first loss" of the senior tranche) is significantly riskier than its AAA rating. So, getting the 50 bps that would have been paid to investors down to 6 bps (note: she says often times the i bank retains this super senior tranche and hedged it with a monoline CDS. So, the CDS premium may have only cost 6 bps. In this case, the i bank is holding the super senior plus protection which cost very little. Put another way, the top 80% of the original 80% might have cost 50 bps as coupon paid to investors. But under this alchemy, the arrangers retain the top 80% and hedge with CDS protection that only costs 6 bps.). So, that's the "free cash" arbitrage she's taking about, but it's really a mis-pricing of risk.

in order for this to work, the ratings have to be utterly wrong. In this case, the new AAA is not senior, it is subordinate to fully 80% of the super senior. The other key aspect, in regard to Merill's write-down is that it is not necessarily about defaults reaching the super senior (after all, it takes a lot of defaults to breach 20%). It's a write-down in value. As de Servigny says, there are three types of losses with these credit derivatives: defaults, credit deterioration (downgrades) and loss in market value (interest rates). And if a super senior (or junior super senior; i.e., the tranche below the super senior) tranche is initially mis-priced with too low a spread, it's value is ripe for a ripe down plus it is effectively leveraged on top of the subordination, so it only takes modest defaults to send their value down (credit deterioration). It brings us back to the fair value debate, b/c i don't know the Merril details there, but the critics of fair value are saying: temporary illiquidity is beating down the mark-to-market value but it's "only paper" they could be worth more in the longer run.

Yes, absolutely, I'll screencast on this. Thank you for the interesting piece, please let me know if you find more good stuff!

David

 

[mikey10011]

Just FYI but Tavakoli has a new book out " Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization (2nd Edition) that was released in September 2008.

http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470288949.html

Looking forward to your screencast.

p.s., Is the CDO "Norma" in the following WSJ article (12-29-2007) an example of a TPDS?
http://blogs.wsj.com/marketbeat/2007/12/27/reading-a-cdo-called-norma/

There is a graphic on the "Rise & Fall of a CDO"
http://bp1.blogger.com/_MHNeK53cJto/R3avZStc5yI/AAAAAAAAANk/Jatu_7MAlh0/s1600-h/20071228-ng2.gif

Yup, you sure are right about credit deterioration!

 

[Yun chiang Tai]

Hello David:
I am a little confused...As we know that CDS can not be used for the credit deterioration, right?? Therefore, it is
used for default..... how can we use CDS for the credit deterioration indirectily or synthetically?? Maybe I ask the wrong question...
Thanks....
Chris

 

[David Harper CFA FRM]

Hi Chris,

Agree, CDS hedges default.
But, in regard to credit deterioration, following de Servingy Chapter 2, we say:
If CDS is marked-to-market (e.g., held in trading book), then CDS does hedge deterioration.
If not, CDS does not hedge deterioration.

Because, if credit deteriorates, spread and CDS premium will increase (i.e., M2M value of CDS increases) and buyer of protection is getting a hedge.

(to round out the three risks, CDS does not ever hedge market risk; i.e., shift in interest rates will not tend to impact spread).

David

 

[Yun chiang Tai]

Hello David:
I am so sorry about the question I ask...Yes, you have mention the point in the lecture...
BUT I FORGOT.......I have to reread that one AGAIN....
Thank you so much....
Chris