Special forms of asset-backed securities, which were briefly introduced in Chapter One, Section 1.2.4 are collateralised debt obligations. These instruments are created to reallocate credit risks (Bodie et al. 2009:474). They are backed by portfolios that not only consist of a single type of loans (assets), but of multiple types of assets, such as bonds, loans, asset-backed securities or other tranches of collateralised debt obligations (Tavakoli 2003:23).
Collateralised debt obligations were first seen in the financial markets in 1987 but only gained momentum after 1998. They were the fastest growing investment vehicle of the last decade. Figure 3.4 shows the development of collateralised debt obligations over the past ten years (Lucas et al. 2006:3).
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FIGURE 3.4: Development of collateralised debt obligations
Source: Adapted from Securities Industry and Financial Markets Association (2010b)
Figure 3.4 shows that the number of collateralised debt obligations traded reached its peak in 2006 and 2007 with the advent of the global financial crisis. In 2008, new instruments issued and traded declined steeply by 87.14 percent and even further in 2009 by 93.54 percent (Securities Industry and Financial Markets Association 2010b). This indicates that financial institutions no longer used such products as markets were illiquid and buyers no longer available. Furthermore, risk tolerance, played a central role. Investors became more risk-averse and pulled out of markets with extensive risk bearing products.
Latest figures show that the global market for collateralised debt obligations is experiencing an increase in volumes issued and traded. In the first three quarters of 2010, volumes increased by 98.97 percent compared to the same period in the previous year (Securities Industry and Financial Markets Association 2010b). Although this steep increase is mainly due the fact that volumes traded in 2009 were marginally, it also shows that investors gain confidence in credit derivative products and markets again.
As with ordinary asset-backed securities, collateralised debt obligations are created by a financial institution, such as a bank. The bank establishes a special purpose
95 vehicle which first purchases and later resells a portfolio of bonds or loans. The special purpose vehicle obtains the necessary funds to purchase the bonds and loans by issuing money market instruments, such as commercial papers. The loans obtained, which can be housing, credit card or student loans are pooled and then divided into several, usually four, classes known as ‘tranches’. The interest payments received from debtors are used by financial institutions to satisfy the interest investors receive for each tranche (Bodie et al. 2009:474).
The pooled tranches represent individual securities which can be sold to other institutions. Each tranche has an individual level of seniority, which represents the liquidity and creditworthiness of the loans pooled in each tranche. The senior tranche includes the loans with high liquidity ratings, such as AAA (Bodie et al. 2009:475). The next (two) tranches often represent mezzanine capital. Mezzanine capital is a mixture of equity and debt capital and carries a higher risk than the loans pooled in the senior tranche (Wirtschaftslexikon 2010b).
The first mezzanine tranche includes all the loans with an investment-grade rating, whereas the second mezzanine tranche has the higher-quality junk rated loans with the greatest risk of default. The last tranche usually includes equity. Thus, the second mezzanine and equity tranche are the most risky tranches that offer the greatest returns for investors (Bodie et al. 2009:475).
Collateralised debt obligations are created for three main reasons, namely to make profits from arbitrage opportunities that arise due to different seniorities of the collateralised debt obligation tranches bought by investors, to create equity capital by securitising and selling the illiquid loans to other financial institutions in the market and to restructure a company’s balance sheet. With collateralised debt obligations corporate and financial institutions can shrink their balance sheets, obtain cheaper funding or reduce required regulatory capital (Lucas et al. 2006:9).
Other reasons why collateralised debt obligations became so popular over the last decade are because they have a low correlation to equity or fixed income securities. Furthermore, equity and other markets did not offer attractive returns and financial institutions did not want to lose any of their market shares, even though they might
96 have seen the risks involved in such products (Conley n.d.; DiMaggio 2009; Evans 2008).
Structured products, such as asset-backed securities and collateralised debt obligations, offered high returns thus making them more appealing to investors, especially financial institutions (Dullien 2008).
During the 2008/2009 global financial crisis financial institutions did not only pool corporate debt and mortgage loans, but also sub-prime mortgage loans. As indicated earlier, these are loans made by financial institutions to debtors who would not qualify for conventional mortgages (Bodie et al. 2009:476). Such mortgages usually have a floating interest rate, thus interest payments of debtors change according to changes in interest rates (Maier 2004:350).
With housing prices starting to decline in late 2007 and coupled with increasing interest rates, especially in the USA, many debtors were unable to repay their debt. This resulted in major repayment failures, which eventually led to huge losses in securities such as collateralised debt obligations. With debtors unable to service their debt, financial institutions were no longer able to pay interests on the different tranches, thus leaving investors with major losses and write-offs. Not only high-risk tranches were affected, but also senior and lower-risk tranches. Rating agencies experienced severe criticism as they provided sub-prime mortgage loans with high ratings (Bodie et al. 2009:476; Welp 2008).
According to the International Monetary Fund (IMF) (2008), the damaged caused by collateralised debt obligations during the financial crisis of 2008 is estimated to be $240 billion. Only large scale intervention of several governments assured that major financial institutions did not experience bankruptcy, thus avoiding a complete breakdown of the global financial system.