they provided great examples of product risk whereby people didn't really

understand the product that they were buying and model risk, and that really

models were completely inadequate for pricing these securities.

Legal risk and so on. Why legal risk?

Well, the actual contracts underlying these CDOs ran to maybe many thousands of

pages and so it's hard to believe that anybody fully understood what exactly

they were purchasing when they invested in CDO squared's and so on.

Before discussing these classes of securities, these CDO-squared's, recall

first how a CDO is constructed. So, we've got an underlying pool of

bonds, say 125 bonds. we might have what's called as we

mentioned earlier, a special purpose vehicle.

Which is a legal entity into which we would place these bonds.

And then from these bonds, we can construct the CDO.

So the bonds form the underlying collateral for the CDO.

And then the CDO is tranched up into an equity mezzanine and so on.

Tranches and people can invest in these different tranches and get very different

risk profiles as a result. So, that's how a CDO is constructed.

How about a CDO squared? Well here's an example of a CDO squared.

We're going to assume that a hundred CDOs, CDO number one up to CDO number

100. We're going to take the mezzanine piece

of each of these CDOs. So we're going to assume the mezzanine

piece corresponds to attachment point of 3% up to 7%.

And then we are actually going to construct a CDO square using these

mezzanine pieces. So the CDO squared is constructed from

mezzanine tranches of underlying CDOs. So basically, you can think of these

mezzanine pieces as now corresponding to the bonds underlying the CDOs.

So basically a loss will only occur in say the equity tranche here.

When there is at least some loss in the mezzanine tranche of one of these

underlying CDOs. If none of these underlying CDOs ever

experience a loss in their mezzanine tranches then there will never be a loss

anywhere in the CDO squared and in particular in the equity tranche here.

On the other hand if all of these mezzanine tranches experience losses.

In fact, if all of them are blown out, in other words maybe losses go right through

the mezzanine tranches in all of these tranches, well then this CDO squared will

face complete wipe out as well. All the way up through the[UNKNOWN]

mezzanine and senior tranches. Remember the mezzanine tranches are the

underlying bonds, if you will, for this CDO squared.

It's also worth pointing out that many bonds act as collateral for multiple

CDOs. So behind this, remember there are bonds

behind each of these CDOs. And in many cases what you'll have is,

you'll have a bond being in the reference portfolio for this CDO, but it might also

be in the reference portfolio down here for this CDO.

So there would be a lot of overlaps of names, of bonds going into these

different CDOs. So this is just repeating in words what

we showed visually on the previous slide. There's not much else to say here, so

let's move on. Here's a question.

How would you price and risk manage a CDO squared?

Here are some considerations. And by the way a discussion of CDO

squared can also be found on the paper by[UNKNOWN] that I referred to in an

earlier module. They discuss some of these issues there

as well. So here's some considerations.

The legal contract governing each of the mezzanine tranches in the underlying

portfolio of CDO's could be on the order of 150 pages long.

So, therefore, if you really want to do your due diligence, really understand the

legal details underlying a CDO squared, you would need to read approximately 100

time 150, which is 15,000 pages of legal documents.

To just say good luck. You should also of course read the

contract governing CDO squared. How do you keep track of the CDO

squared's performance? Just to keep track of the performance of

the CDO squared, remember you're going to have to keep track of the performance of

all of these underlying bonds. You're going to have to feed the

performance of these underlying bonds into each of these 100 CDOs and figure

out what's going on in each of these CDOs.

And then based on that, you're going to have to figure out what's going on in the

CDO-squared. In order to do that, you're probably

going to have to write several thousand lines of computer code, and that is just

to keep track of the actual performance. It is not to actually price the

CDO-squared. Or to, risk manage the CDO squared.

You might need a model to price it. In fact, it's hard to say that any model

really could ever possibly price that CDO squared correctly or give you a good

sense of how much a fair value is for a CDO squared.

So these are very difficult securities to manage.

How would you perform scenario analysis? how would you estimate the value at risk?

Or the conditional value at risk of a portfolio of CDO-squared's?

It's it seems very difficult to even imagine doing such analysis.

But why stop there? There are also ABS CDO's.

An ABS CDO is an a, is a CDO where the underlying securities, the underlying

bonds are themselves acid backed securities.

So going back to our CDO squared instead of having a CDO number 1 up to CDO number

100 this could be ABS number 1 up to ABS number 100.

And these ABSs could in fact be mortgage back securities.

So there would be underlying pools of loans feeding into these ABSs.

Which then feed into the CDO itself. Uhhh you can have CDO-cubes uhhhm.

And why stop there? So here's how a CDO-cube would work.

You got your n CDOs and a couple of slides ago we had n is equal to a 100.

Now we've got n CDO's. From that we construct say 100

CDO-squared. So imagining here that the n, number n is

greater than 100, so we can construct CDO-squared out of these n CDO'S maybe

using the mezzanine tranches from these CDOS.

Now we have our CDO squares. Let's take the mezzanine tranches of

these CDO-squared and construct another CDO that would give us a CDO-cubed.

So, if your head is spinning at this point, it's not surprising.

And yet, there were trades apparently on CDO-cubed in the marketplace leading up

to the financial crisis. So, one other point I'll make about the

financial crisis and the subprime crisis before, before ending this module is the

following. So there were securities, I mentioned in

the previous slide, called ABS CDOs. And very often, actually, it was

sub-prime mortgage ABS's that were feeding into these CDOs.

And so you can imagine this being the CDO, maybe there's equity mezzanine and

so on. So, maybe this is the zero to 3% tranche.

Maybe this is, I don't know, a 6 and 9% tranche.

And maybe the underlying pool of securities that feeds into this CDO.

Are some mortgage backed securities. So we've got a bunch of mortgage backed

securities feeding in here. Well, an interesting antidote about the

financial crisis is that the sub prime crisis actually didn't come suddenly to

many people. There were several money marketers,

including banks and so on who had a good sense that the subprime crisis was coming

down the line. And one way to profit from that belief

was to actually buy protection on the 0 to 3% tranche of an ABS CDO.

So if you buy protection here, what will happen is that you're going to get paid

off. You're going to make money.

If you see lots of defaults in the 0 to 3% piece, or lots of losses in the 0 to

3% piece of this CDO. And if you expect the subprime crisis to

come down the line, then you're going to assume that the underlying mortgage

backed securities are indeed going to see a lot of losses.

Because people are defaulting on their loans and so on.

And if they're defaulting on their loans and you're seeing losses in the

underlying mortgage pool, then you expect to see losses inside this tranche as

well. And so you could profit from that by

buying insurance on this tranche. And so thats what some players did.

They bought insurance on this tranche. But, when you buy insurance you've got to

pay an insurance premium. And the insurance premium which you have

to pay quarterly could be quite substantial.

So rather than having to pay out this amount of money every quarter, some of

these players or banks got clever and said, you know what, instead of paying

out money every quarter on this tranche, why don't we sell protection or sell

insurance up here? On this tranche, say.

and if you sell insurance on this tranche, well then you are going to be

taking in a premium. And you could use the premium you take in

here to fund the insurance premium you have to pay out for your protection here.

The only problem with that is because this tranche is much riskier than this

tranche, you have to sell a lot more insurance up here to cover your payments

down here and that's what some players did.

They thought that the sub prime crisis might blow through these tranches up to

here say, but that the higher tranches would be safe and that they would never

incur losses and so on. And so they thought it would be a good

idea to sell protection on these more senior tranches and use the premium to

fund protection on the equity tranche. And so that was a good idea.

It, it meant you didn't have to spend any money net on your position.

The premium here was funded by the premium you're taking in up here.

The problem was, that the subprime, crisis came along, and was much more

severe than anybody anticipated. And in fact, the losses didn't stop at

this point, or at least the mark-, market losses didn't stop at this point.

The mark to market losses went like this, and blew out these tranches as well.

And so the players who actually put on the straight, ended up losing an awful

lot of money. Because they were selling protection on a

much larger notional up here than the notional they were buying protection on

down here. So this is just an aside.

And the reason I wanted to mention it is, number one, many players actually did see

the sub prime crisis coming along and they used these ABS CDOs in order to make

plays on what was happening, or what might happen with the sub prime, with the

sub prime crisis. But also it emphasizes how even if your

opinion is correct, and their opinion was correct.

The sub prime crisis was coming and it did occur.

It can still be very difficult to execute a trade properly.

So they executed the trade by buying protection down here, selling protection

up here but their execution didn't work. In fact, the sub prime crisis was worse

than what they anticipated. And some of these players ended up losing

an awful lot of money as a result.