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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA


par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010
  

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2.12 Assets Influencing Investment Decision-Making

In spite of the in-depth idea of risk and return, risk management, financial regulations and value creation towards investment decision-making discussed above, some prominent economists still suggest that they are some assets within the financial markets that help in influencing investment decisions-making processes. Some of these include:

2.12.1 Collateralized Debt Obligations (CDOs)

CDOs are investment grade securities which are backed by bonds, loans as well as other assets. Note that CDOs do not specialise in just one debt type rather they are more of non-mortgage loans or bonds. With CDOs, the different debt types are often referred to as `tranches' with each tranche having different maturities and risks associated with it. Bear in mind that the higher the risk the higher the CDO to be paid. These CDOs are very unique in that they represent different types of credit risks and debts. No doubt, they are being looked at as structured finance vehicles aimed at issuing multiple classes of liabilities as well as rating debt tranches having different credit risk/return profiles.

With CDOs, the securities are divided into different classes of risk because the interest and
the principal payments are being made with reference to the risk class with the most senior

classes being looked upon as the safest securities. Some investors warned that CDOs are assumed to be spreading risks through diversification rather than reducing risks of the underlying assets. As a result of this, one of the reasons for the outbreak of the present financial crisis was the failure of the credit rating agencies in adequately accounting for large risks when they were rating these CDOs.

According to Moody's Investors Service, the growth of the CDO markets never accelerated until in the early 2000s when these CDOs were introduced. They got to their peak in the first half of 2007 although it was so short-lived because statistics show that from the first half of 2007 to the second half of the same year, the CDO issuance is assumed to have dropped by 50% . This drastical drop was considered to have resulted from liquidity problems especially as investors disappeared leaving residential mortgage-backed securities to deteriorate (Steven, 2008). Below is a table summarising the global CDO market issuance data for the period of 2006-2007.

Table 2: Global CDO Market for 2006-2007

Period

Total Issuance in millions of USD

2006-Q1

108,012.7

2006-Q2

124,977.9

2006-Q3

138,628.7

20006-Q4

180,090.3

2007-Q1

184,757.4

2007-Q2

179,493.0

2007-Q3

91,529.2

2007-Q4

29,946.7

Figure 6: Global CDO Market for 2006-2007

Source: Thomson Financial

Looking at both the table and the graph, it can be observed that the global CDO issuance was increasing steadily between Q1-06 and Q1-07. It got to its peak during the first quarter of 2007 but this was so short lived because by the fourth quarter of the same 2007, the global market has dropped drastically. Because of what was experienced in the first quarter of 2007, academicians as well as economists have regarded CDO as one of the most important new financial innovations of the past decade no doubt it has registered an increasing number of appeal from many asset managers and investors. This is so because, the CDOs enabled the originators of the underlying assets pass on credit risks to other investors and institutions, thereby making it possible for investors to be forced to understand the in-depth of how the risk for CDOs is being calculated. As if that is not enough, when the CDOs is being issued,

the issuer (typically an investment bank), earns a commission done at the time of the issue as well as a management fee during the life of the CDO.

Note that for any CDO transaction to be effected some participants need to be present. These include investors, underwriters (structurers and arrangers of CDOs- assigning different interest rates to different securities with more risky classes of securities bearing higher interest rates so that investors can be attracted to those securities),(Chromow and Little, 2005), asset managers, trustee and collateral administrators as well as accountants and attorneys with each having different functions and interests. Banks were allowed to participate only at the beginning of 1999 following the Gramm-Leach-Bliley Act (also known as the Financial Services Modernization Act). This is because this Act helped in opening up markets within the banking industry, securities companies as well as insurance companies.

According to Steven, 2008, balancing risk perception, monitoring the performance of underlying assets, getting investors to return to the market and finding liquidity again are some of the things that need to be restructured in the CDO for it to survive. The growth of the CDO was as a result of investors' demand although the issuing of these CDOs were reduced in 2008 because investors had disappeared and liquidity problems began thereby portraying CDOs as greater risks indicators.

CDOs offer returns that are sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Because of this discrepancy, CDOs have been criticized and looked up to as some sort of complex instruments which are difficult to value. No doubt some economists refer to CDOs as financial weapons of mass destruction thereby blaming them for making the 2007-2009 credit crises more severe than it should have been and led to the subsequent failure of some big financial institutions such as Lehman Brothers.

There exists so many different types of CDOs of which some include: CLOs (collateralized loan obligations)- these are mostly CDOs that are backed up primarily by leveraged bank loans; SFCDOs (structure finance CDOs)-CDOs backed by structured products; CBOs (collateralized bond obligations)-CDOs backed by fixed income securities; CSOs (collateralized synthetic obligations)-implying CDOs backed by credit derivatives, etc as well as there are some CDOs backed by commercial real estate assets, corporate bonds, insurance, etc. With all these different types of CDOs, bear in mind that as of the year 2007, 47% of these CDOs were backed by structured products, 45% were backed by loans and just less than 10% were backed by fixed income securities.

CDOs are known to vary in structure as well as the underlying assets although the basic principle is the same. It is evident that the growth of the CDOs plus the increasing appetite of the CDOs managers for more debt securities are having an important impact in the real estate debt markets (Chromow and Little, 2005). Apportioning different credit rating levels to the different tranches of CDOs makes things easier to be understood since it will be easier for institutional investors to make their investment decisions. This is in the sense that with credit rating agencies rating an asset with AAA signifies the asset is very safe. Therefore, with investors bearing this in mind, they will be able to sell the most risky assets to those they know can withstand high risks while the safest (AAA-rated) assets would be held by the more risk-averse investors.

This credit rating is done so as to get the exact size of classes and this is done with the help of credit rating agencies such as Standard and Poor's and Moody's. These agencies rate the highest/safest class with AAA although this class has the lowest interest, followed by the AA assets. Note that the lowest priority classes are either not rated at all or referred to as the junk class (Chromow and Little, 2005). Because of this increased demand for AAA assets, the lower quality securities that were issued against the initial package of mortgages needed to be

repackage with similar securities from other packages thereby resulting in the creation of new AAA securities referred to as portions of the CDOs since investors used to rely heavily on these securities while the credit rating agencies do their valuations.

Contrary to the above, this process does not work well all the time. Investors have learnt to believe that assets with a triple `A' are always the safest. Unfortunately, this was not the case all the time. These credit rating agencies did rate some toxic assets with AAA, which was therefore misleading. Hence one of the causes of the global financial crises was as a result of this mistake done by these credit rating agencies. This is because investors hurried up to these assets thinking they were safe not knowing that they were toxic assets whose financial values have significantly fallen.

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