Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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!

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