11 - Exotic CDOs

Summary

Introduction

The majority of the text up until now has been concerned with plain vanilla synthetic CDOs (however the sobriquet ‘plain vanilla’ does not really do justice to the complexity of the product). In this chapter we will briefly consider a number of variations on the basic synthetic CDO/securitisation theme.

Section 11.2 will look at CDO squared and higher (cubed etc.) trades. These trades are a natural extension of the basic pooling and tranching concept where the assets in the underlying pool are themselves CDO assets. However, as we will see, the introduction of an additional layer of tranching introduces additional complexities into the modelling methodology and the risk management. Section 11.3 relaxes the constraint that the underlying collateral is CDSs and considers (typically cashflow) CDOs of general asset backed security (ABS) collateral. The marketplace for ABSCDOs is enormously diverse and a thorough treatment of this part of the structured finance world warrants a full textbook on its own. The discussion presented here will be necessarily brief. ABSCDOs have also received an enormous amount of coverage in popular media due to the credit crunch of 2007 and the role that securitisation of risky assets played in it.

Section 11.4 introduces CDSs where the underlying reference entity is not a corporate or sovereign entity, but is instead an ABS. This apparently simple extension of the basic CDS concept introduces a whole host of additional modelling complexities.