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CDOs & SIVs Discussion Post

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11 views3 pages

CDOs & SIVs Discussion Post

Uploaded by

elona.gjoni05
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Categories

Strategic objectives

Structure

Operations

Purpose

Issuance

Impact on investment markets


Collateralized Debt Obligations (CDOs)

The main goal of CDOs is to repackage loans or debt


instruments into tranches that are sold to investors. CDOs allow
banks to offload risky assets from their balance sheets and
transfer credit risk to investors in exchange for a return. The
focus is on distributing risk while offering higher returns to those
willing to take on more credit risk.

CDOs are structured into tranches based on the level of risk,


with senior tranches being less risky and junior or equity
tranches being the most risky. Each tranche has different levels
of exposure to default risk and therefore offers different returns.
In the event of a default, investors in higher tranches are paid
first while lower tranches absorb the first losses.

CDOs operate by pooling various debt instruments, such as


mortgages, bonds, or loans, into one portfolio, which is then
divided into tranches based on risk. The operation is managed
by a collateral manager, who selects the assets and ensures the
cash flows are properly distributed according to the payment
waterfall.

The main purpose of a CDO is to redistribute credit risk across


different investors. They allow banks and other financial
institutions to remove riskier loans from their balance sheets
while offering investors varying levels of risk exposure based on
their risk tolerance.

CDOs are issued by investment banks, which pool various debt


securities and divide them into tranches. The issuance is usually
through a special purpose vehicle (SPV), which holds the pooled
assets and sells the tranches to different investors based on
their risk appetite.

CDOs had a significant impact on investment markets by


increasing liquidity and enabling the broad distribution of credit
risk. However, they also contributed to the 2008 financial crisis
due to their complexity and the difficulty in accurately assessing
the risk associated with lower tranches, especially when the
underlying assets, such as subprime mortgages, began to
default in large numbers.
Structured Investment Vehicles (SIVs)

The strategic objective of SIVs is to profit from the difference


between short-term borrowing costs and the returns on long-
term, higher-yield assets. SIVs issue short-term commercial
paper to fund the purchase of long-term assets such as
mortgage-backed securities, aiming to generate returns from the
interest rate spread.

SIVs are off-balance-sheet entities, typically set up by banks,


that issue short-term debt (like asset-backed commercial paper)
to finance long-term investments in assets like CDOs or
mortgage-backed securities. SIVs are highly leveraged, and the
assets they hold often have lower liquidity than the debt they
issue. They are not structured in tranches like CDOs but instead
rely on maturity transformation to generate profits.

SIVs operate by issuing short-term liabilities to finance long-


term, higher-yielding assets. The entity continually borrows in
the short-term markets (such as issuing commercial paper) and
uses the proceeds to purchase long-term assets. The viability of
an SIV depends heavily on the liquidity of the commercial paper
market and the stability of long-term asset values.

The purpose of SIVs is to take advantage of arbitrage


opportunities between short-term and long-term interest rates.
By borrowing short-term and investing in long-term assets, SIVs
aim to profit from the interest rate spread.

SIVs issue asset-backed commercial paper (ABCP) or medium-


term notes (MTNs) to fund the purchase of long-term assets. The
issuance of commercial paper is typically in the short-term debt
markets and can be rolled over frequently as the paper matures.

SIVs also had a profound impact on markets, especially during


the 2008 financial crisis. Because SIVs relied on continuous
access to short-term funding, they were highly vulnerable to
liquidity crises. When investors became wary of holding asset-
backed commercial paper during the crisis, many SIVs were
forced to sell assets at fire-sale prices, further exacerbating the
market downturn.

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