20 March 2011

Just Some Examples of Financial Innovations

From banks’ financial statements and risk reports one can find funny things indeed, funny and absurd or even dangerous for the financial system itself. It’s hard to believe that even the most sophisticated institutional investors and financial regulators fully understand these instruments and structures, the risks involved and what systemic consequences they may have. Below are some pearls that I recently spotted. Let them speak by themselves.

Securitisation sounds too ordinary today. So now there are re-securitisations, i.e. securitisations that have underlying securitisation positions. Basel II Enhancement defines: “541(i) A re-securitisation exposure is a securitisation exposure in which the risk associated with an underlying pool of exposures is tranched and at least one of the underlying exposures is a securitisation exposure. In addition, an exposure to one or more re-securitisation exposures is a re-securitisation exposure.”  Was it understandable? Well, only if you are in this business or have done a thorough background study before.

Mortgage-Backed Security (MBS) may at least sound more-less okay. Residential Mortgage-Backed Security (RMBS) is not far from that. The term Collateralised Debt Obligation (CDO) is also not something completely new. But the term Residential Mortgage-Backed Securities Collateralised Debt Obligation (RMBS CDO) sounds very artificial.

Or take Asset-Backed Security (ABS): when combining it with the term “CDO” and adding some more specifications, we get things like: “highgrade and mezzanine ABS CDO”, “direct subprime Asset-Backed Security CDO super senior positions” and “ABS CDO Super Senior”. Are they all referring to the same thing just named differently by different banks? Or what the hell is an “ABS CDO Super Senior”? What for stands “Super Senior”?

Here come the definitions (taken from the Pillar 3 Disclosure of Barklays) which are understandable only to those who anyway know the terms or have spent a great deal of time for figuring them out:
* ABS CDO Super Senior’ – The super senior tranches of debt linked to collateralised debt obligations of asset backed securities (defined below). Payment of super senior tranches takes priority over other obligations.
* ‘Asset Backed Securities (ABS)’ – Securities that represent an interest in an underlying pool of referenced assets. The referenced pool can comprise any assets which attract a set of associated cash flows but are commonly pools of residential or commercial mortgages and, in the case of Collateralised Debt Obligations (CDOs), the referenced pool may be ABS or other classes of assets.
* ‘Collateralised Debt Obligations (CDOs)’ – Securities issued by a third party which reference Asset Backed Securities (ABSs) (defined above) and/or certain other related assets purchased by the issuer. CDOs may feature exposure to sub-prime mortgage assets through the underlying assets. CDO2 securities represent investments in CDOs that have been securitised by a third party.

Credit Default Swaps (CDSs) are not enough. As single name Credit Default Swaps may carry too much risk for a company who provides protection, Index and Basket Credit Default Swaps have been invented. Those are CDSs that reference multiple names through underlying baskets or portfolios of single name Credit Default Swaps. Generally, in the event of a default on one of the underlying names, the company will have to pay a pro rata portion of the total notional amount of the credit default index or basket contract. Of course, tranching techniques are applied. In tranched transactions, the credit risk of an index or basket is separated into various portions of the capital structure, with different levels of subordination. The most junior tranches cover initial defaults, and once losses exceed the notional of the tranche, they are passed on to the next most senior tranche in the capital structure.  (These explanations are from Form 10-K of Morgan Stanley, again not meant for outsiders to be understood, let alone adequate risk assessment.)

One more sort of artificial creations is Collateralised Synthetic Obligations (CSOs). This is said to be a form of synthetic Collateralised Debt Obligation (CDO) that does not hold assets like bonds or loans but invests in Credit Default Swaps (CDSs) or other non-cash assets to gain exposure to a portfolio of fixed income assets.

Further, there are not only funny instruments but also interesting entities: not just SPVs (Special Purpose Vehicles) and SIV-s (Structured Investment Vehicles), but you may find vehicles or companies called SIV-lites and CDPCs (Credit Derivative Product Companies), for example. What are those things supposed to be?

Without going into more details, SIV-lites are defined as riskier cousins of SIVs in a Reuters Factbox. These vehicles are less restricted in what investments they may hold and many have snapped up the securities linked to subprime mortgages that have spooked investors.

Regarding CDPSs, securitization news from August 2006 explains: Credit derivative product companies are structured finance operating companies that serve as counterparties to other financial institutions in credit default swaps or specialized insurance policies against default events. [...] CDPCs serve an important need in the structured finance and capital markets by providing high quality credit protection, in a market that can be illiquid. Investment managers with positions in cash bonds and other credit instruments that require innovative credit risk management strategies are target clients of CDPCs. In many ways the CDPCs provide credit enhancement products similar to those provided by monocline bond insurers.” Sounds easy?

Once again, these were just some examples of financial innovations. Basically you can find everything or almost everything for which you have imagination – and if it doesn’t exist, it will be invented soon. It’s not that difficult to understand the logic of things getting increasingly complex. If a bank securitises its loans, the securitised loans will in turn be securitised and once more re-securitised, we get things like CDO-squared and CDO cubed. If a credit protection provider wants to protect itself against the default events, it asks for a CDPS who would provide services needed. And voilà: here we have a financial structure that no one really captures. In this light forecasting or stress testing all this sounds like self-deception at best.

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