## 4. Growth of the Global Synthetic CDOs Market

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### Introduction
- CRT instruments (credit derivatives and structured credit products) enable institutions to transfer and disperse credit risk across financial and other sectors, providing a stabilization mechanism akin to reinsurance.
- Theoretical net outcome: benefit to financial stability and efficiency.
- Key concerns:
  - Limited liquidity and lack of transparency in some CRT market segments.
  - Complexity of quantitative valuation and hedging techniques exposes participants to potentially large losses.
  - Counterparty creditworthiness and adequacy of market/legal infrastructure are additional vulnerabilities.
  - Increasing interlinkages among financial institutions raise potential for misunderstood risk exposures and contagion.
- Evidence of past losses: German Landesbanks experienced substantial losses in credit markets in 2002−03.
- Paper focus: financial stability issues related to CRT markets, with emphasis on credit derivatives use in the banking and insurance sectors in the United Kingdom.

### Growth and Structure of Credit Risk Transfer Instruments
- Market expansion and key measures:
  - Credit derivatives began trading in 1996 and have grown rapidly since.
  - Value of credit derivatives products exceeded total volume of outstanding U.S. Treasury bonds at end-2004.
  - Projected to surpass $8 trillion by 2006 (British Bankers’ Association).
  - London market estimated at $2.2 trillion in 2004, about 44 percent of total global market of $5 trillion; New York market at 40 percent.
- Structured credit products and CDO mechanics:
  - CDOs pool credit risk and tranche it into seniority-based slices.
  - Three common securitization mechanisms in CDOs:
    - reference portfolio construction (bank loans/negotiable instruments/credit derivatives);
    - use of an SPV to de-link portfolio credit risk from originator;
    - tranching with seniority ranks for cash flow rights.
  - Motivations to issue CDOs: arbitrage (excess spreads), balance sheet management (reduced funding cost, regulatory capital), fee income and assets-under-management, underwriting fees and cross-selling.
  - CDOs improve liquidity where underlying bond and loan secondary markets are relatively illiquid.
- Participant composition (sources: Fitch Ratings, BBA, Credit Suisse First Boston):
  - Main participants: lending institutions (net buyers of protection / net sellers of CDOs) and insurance companies (net sellers of protection / net buyers of CDOs).
  - Emerging participants: hedge funds, proprietary traders, asset managers, some pension funds acting as protection sellers.
  - BBA protection buyers composition:
    - Banks 38%, Insurance companies 20%, Securities firms 16%, Hedge funds 15%, Pension funds 4%, Mutual funds 4%, Corporates 2%, Government/export credit agencies 1%.
  - BBA protection sellers composition:
    - Banks 51%, Insurance companies 7%, Securities firms 16%, Hedge funds 16%, Corporates 3%, Mutual funds 3%, Pension funds 3%, Government/export credit agencies 1%.
  - CSFB protection sellers (buyers of CDOs) composition:
    - conduits 39.9%, foreign banks 25.5%, insurance companies 20.4%, US banks 10.0%, structured funds 0.3%, Asian banks 1.3%, money managers 3.9%.
- Synthetic CDOs scale and drivers:
  - Synthetic CDOs about 16 percent of credit derivatives market; CDSs 51 percent (BBA 2004).
  - Synthetic CDOs insured less than $400 billion of U.S. corporate bonds in 2001; estimated to cover some $2 trillion by end-2005 (JPMorgan).
  - $2 trillion would represent about 40 percent of the entire U.S. corporate bond market of almost $5 trillion.
  - Demand particularly strong in Europe due to legal/taxation barriers to true-sale securitizations and smaller outstanding corporate bond markets.
- Market advantage and settlement risks:
  - Growth driven by ease of assembly and dispersion relative to cash CDOs.
  - Synthetic CDO supply appears limitless because they can be created without holding actual bonds as underlying assets.
  - Potential problem under physical settlement if insufficient bonds are available; markets introduced auction mechanisms to cash-settle index trades in default incidents.

### Interlinkages Across Financial Institutions
- Increasing linkages:
  - Insurers invest in banks’ equity and debt; insurers provide trade credit insurance; banks finance receivables supported by insurance.
  - Banks provide insurers with liquidity facilities and letters of credit.
  - Bancassurance formation increases ownership links; example: 6 of the 10 largest U.K.-owned banks had equity shares in life insurance subsidiaries at end-2003.
  - Loans to insurers and pension funds amounted to just over 6 percent of major U.K. banks’ Tier 1 capital.
  - Equity prices of bancassurers in the U.K. were adversely affected by disruptions in the life insurance sector over 2001–03, indicating spillovers via ownership links.
- Risk shifting and roles:
  - Repackaging credit risk shifted exposures outside banking sector to insurers, hedge funds, mutual funds, and pension funds.
  - Banks’ roles: portfolio management, intermediation, market making, structuring CRT products.
- Types of risk introduced or amplified by CRTs:
  - Market risk: changes in credit spreads of underlying portfolio names.
  - Liquidity risk: difficulty selling assets in thin secondary markets.
  - Basis risk: imperfect matching when hedging tranches with standardized index tranches.
  - Counterparty risk: default on settlement claims.
  - Legal risk: incomplete or untimely documentation.
  - Ratings risk: ratings reflect average risk and may miss dispersion; potential for “ratings arbitrage.”
  - Model risk: valuation reliant on complex and evolving models.
- Example sensitivity:
  - May 2005 spike in banking-sector credit risk amid rumors of hedge fund losses after GM and Ford downgrades; hedge funds’ performance affects banks through fee income and financing links.

### Exposure of U.K. Financial Institutions to Credit Derivatives
- Methodology and data:
  - Direct exposure assessment limited by lack of public information; authors use indirect VAR-based approach measuring how credit derivatives market developments explain variability in firms’ equity returns.
  - Daily data for August 28, 2003–September 15, 2005.
  - Firms analyzed: Aviva, Barclays, Halifax Bank of Scotland (HBOS), HSBC, Lloyds, Legal & General, Royal and Sun Alliance (RSA), Royal Bank of Scotland (RBS).
  - Factors include: equity prices (Bloomberg L.L.P.), slope of yield curve (10-year minus 2-year U.K. government yields, Bloomberg generic series), iTRAXX tranche prices (equity tranche and mezzanine tranches from JPMorgan).
  - Tranche attachment points used: equity tranche 0–3 percent; mezzanine tranches 3–6 percent, 6–9 percent, 9–12 percent, and 12–22 percent. Super-senior tranche excluded (time series began mid-2004).
  - VAR of order p and subsequent VMA representation used to compute variance decompositions and long-term cumulative impacts.
- Interpretation assumption:
  - No assumption whether institution is long or short; assume losses fall within attachment and detachment points of benchmark iTRAXX in case of defaults.
  - Higher fraction of equity return volatility explained by a senior tranche implies lower credit exposure and lower potential systemic impact.
- Empirical findings:
  - U.K. insurance companies tend to have more conservative CRT exposures, favoring more senior mezzanine tranches (attachment points 9–12 percent and 12–22 percent).
  - Bancassurance businesses tend to be more exposed to riskier junior mezzanine tranches (3–6 percent and 6–9 percent), with HBOS as an exception (substantial exposure to 12–22 percent senior mezzanine tranche).
  - Barclays also appears most exposed to the senior mezzanine tranche.
  - Overall assessment: CRT market did not pose a substantial threat to U.K. financial sector stability at the time of the study, with diversity of holdings across major institutions helping to limit potential impact from a negative shock.
  - Reputation risk highlighted as an important contagion channel—failure of one institution could dent public confidence due to interlinkages.
- Subperiod dynamics:
  - Major U.K. financial institutions became more conservative over time, shifting exposures toward more senior mezzanine tranches, except RBS.
  - Holdings across institutions remained diverse over time.
- Table 1: Impact of Volatility in the CRT Market on Major U.K. Financial Groups, August 2003–September 2005 (In percent) — dependent variable (iTRAXX tranches) explained fraction of equity return volatility:
  - Bank dependent variable:
    - Barclays 0.2, HBOS 3.6, HSBC 9.3, Lloyds 0.4, RBS 0.9, AVIVA 1.8, Legal & 26.0, RSA 0.3.
  - Equity tranche (0–3 percent):
    - Barclays 8.6, HBOS 0.3, HSBC 17.9, Lloyds 0.2, RBS 2.4, AVIVA 7.3, Legal & 0.7, RSA 3.3.
  - Mezzanine 3–6 percent:
    - Barclays 2.1, HBOS 10.4, HSBC 51.6, Lloyds 32.7, RBS 38.9, AVIVA 12.5, Legal & 13.2, RSA 0.7.
  - Mezzanine 6–9 percent:
    - Barclays 24.1, HBOS 0.4, HSBC 0.9, Lloyds 35.3, RBS 14.9, AVIVA 27.4, Legal & 4.7, RSA 33.9.
  - Mezzanine 9–12 percent:
    - Barclays 17.3, HBOS 12.3, HSBC 5.2, Lloyds 6.6, RBS 13.9, AVIVA 35.8, Legal & 5.0, RSA 53.7.
  - Mezzanine 12–22 percent:
    - Barclays 47.6, HBOS 72.9, HSBC 15.0, Lloyds 24.6, RBS 28.9, AVIVA 15.2, Legal & 50.4, RSA 8.0.
  - 10 less 2 year govt yield:
    - Barclays 0.1, HBOS 0.0, HSBC 0.1, Lloyds 0.2, RBS 0.0, AVIVA 0.0, Legal & 0.0, RSA 0.0.
  - Note: VAR shocks not orthogonalized; variance decomposition ranks importance but correlated shocks mean individual variances do not sum to total variance.
  - Sources: Bloomberg L.L.P. and IMF staff calculations.

### Regulatory and Supervisory Initiatives
- Overarching stance: CRT markets improve risk distribution and should be encouraged; regulators must implement measures to prevent misuse while allowing market development.
- United States (OCC response to securitization lessons):
  - Implemented supervisory reforms for bank securitization programs:
    - develop cadre of specialized examiners for securitization;
    - recognize high person-hour needs for such examinations;
    - develop independent valuation capabilities for residual risk component (equity piece of securitized instrument);
    - obtain information on every securitization vehicle for every bank.
  - Banking practice recommendations:
    - independent legal and accounting review of every vehicle;
    - perform “stress to breakage” risk analysis to complement residual risk valuation;
    - put in place contingency liquidity and reserve planning.
- United Kingdom (FSA approach):
  - Emphasis on understanding extent to which real risk is transferred.
  - Conducted surveys (including via the Joint Forum) to identify end investors and risk management practices.
  - FSA adopts conservative routine data-collection stance under its cost-benefit framework; prioritizes addressing model risk via hypothetical portfolio exercises to understand firm modeling approaches and challenges.
  - FSA and New York Federal Reserve working with market participants to resolve trade confirmation and assignment backlogs.
- Accounting and disclosure improvements:
  - IFRS likely to improve valuations of structured credit and credit derivatives in financial statements.
  - IAS 39 introduces fair value accounting for financial assets and liabilities of listed companies; credit derivatives in trading books recorded at fair value.
  - Within banking book, valuation depends on instrument purpose: hedging underlying transactions requires fair value; hold-to-maturity may be recorded at cost.
  - IFRS 7 covers disclosure of details on credit derivatives.
  - U.K. adoption of IFRS on January 1, 2005; European Commission implemented restricted fair value option on November 16, 2005 (retroactive to January 1, 2005).
- Recommended supervisory improvements (areas for action):
  - ensure supervisory staff keep up to date with latest techniques and tools;
  - ensure timely and complete paperwork for CRT transactions;
  - ensure risk management systems can cope with CRT market stresses and encourage ongoing improvements in credit risk management;
  - require regular stress testing of open positions in CRT instruments, notably structured credit exposures;
  - encourage market participants to use richer and more consistent risk measurement techniques in addition to formal ratings;
  - consider need for greater disclosure by financial institutions of holdings in CRT instruments.

### Conclusion
- CRTs have facilitated dispersion of credit risk across sectors; theoretically net-positive for stability and efficiency, but specific risks (modeling, legal, counterparty, liquidity) could be amplified by limited market liquidity and opacity.
- Study focus: structured credit product use in U.K. banking and insurance sectors and implications for financial stability; VAR-based indirect exposure assessment used due to limited public exposure data.
- Empirical conclusion:
  - Structured credit market did not pose a substantial threat to U.K. financial sector stability at the time of the study.
  - U.K. insurance companies tended to prefer “safer” senior tranches.
  - Bancassurance entities tended to be more exposed to junior mezzanine tranches.
  - Diverse holdings across major institutions may limit impact of a significant negative shock.
- Ongoing regulatory challenge: balance adequate regulation, supervision, and surveillance with encouraging market development; authorities in major CRT markets have taken initiatives and continue to enhance supervisory techniques.

### Appendix I — HOW COLLATERALIZED DEBT OBLIGATIONS (CDOS) WORK
- Tranche structure and investor payoffs:
  - Investors purchase different tranches commensurate with risk-return preferences.
  - Riskiest tranche (equity) offers the highest return but bears the initial losses from defaults in the pool.
  - Tranche ordering by increasing risk of defaults: super-senior, senior, mezzanine, equity.
  - Holders of mezzanine, senior, and super-senior tranches have protection from losses of more junior tranches.
- Credit enhancements:
  - Overcollateralization of assets, reserve accounts, or trapping excess spread enable higher credit ratings than the average rating of the underlying portfolio.
- Tranche yield determinants:
  - Estimating tranche yields requires the originator to estimate the distribution of losses in the pool.
  - Distribution of losses depends largely on default correlation among names referenced in the CDO.
  - Lower default correlation → higher compensation to the equity tranche investor; higher default correlation → higher compensation to senior tranche investors.
  - Mezzanine tranche compensation lies between equity and senior tranche extremes (Gibson, 2004).

### Appendix I — SYNTHETIC CDOS, CDS, AND SINGLE-TRANCHE STRUCTURES
- Synthetic CDO mechanics:
  - Synthetic CDOs replace the pool of bonds with credit derivatives, specifically credit default swaps (CDS); synthetic CDOs are classified as credit derivatives.
  - In a synthetic CDO transaction:
    - the SPV sells protection to the originator of the deal in return for agreed fees; and
    - the risk is transferred from the SPV to investors through issuance of tranches of fully-funded synthetic CDOs, credit default swaps (which are unfunded), or a combination of both (partially funded CDOs).
- Funded vs unfunded tranches:
  - Funded tranche: investor pays the notional amount at initiation; funds invested in low-risk securities; defaults result in write-downs of principal; investor receives LIBOR plus a spread reflecting riskiness.
  - Unfunded tranche: no initial money changes hands; investor (protection seller) receives a spread and pays out upon defaults affecting the tranche; creates counterparty credit risk for the protection buyer.
  - Credit default swaps are unfunded credit derivatives.
- Single-tranche CDOs ("bespoke tranches"):
  - Created in 2003 as a more flexible alternative to traditional CDOs.
  - Only one tranche (usually a mezzanine tranche) is sold to the investor; the arranger becomes the direct counterparty since there is no SPV.
  - Allows seller to meet specific investor needs more timely and cost effectively than traditional CDO structures requiring sale of all classes of tranches.
- Tranche attachment and detachment points:
  - Default losses borne by a tranche range between the attachment point and detachment point.
  - Example: a 3−6 percent tranche has an attachment point of 3 percent and a detachment point of 6 percent.
  - If accumulated loss ≤ 3 percent of total initial notional, the tranche is unaffected.
  - When loss > 3 percent, further losses reduce the tranche’s notional until the detachment point 6 percent is reached, at which point the tranche is wiped out.

*Source: IMF working paper chapter "4. Growth of the Global Synthetic CDOs Market."*

### References..............................................................................................................

### References

### Tables
- 1. Impact of Volatility in the CRT Market on Major U.K. Financial Groups, August 2003– September 2005 .......................................................................................................................14

### Figures
- 1. Growth of the Global Credit Derivatives Market ..................................................................5
- 2. CDOs: Protection Buyers and Sellers ....................................................................................6
- 3. Composition of Protection Sellers (Buyers of CDOs) ...........................................................7

*_wp06139 - References.............................................................................................................._*

### 4. Growth of the Global Synthetic CDOs Market......................................................................8

### 4. Growth of the Global Synthetic CDOs Market

### Introduction
- CRT instruments (credit derivatives and structured credit products) enable institutions to transfer and disperse credit risk across financial and other sectors, providing a stabilization mechanism akin to reinsurance.
- Theoretical net outcome: benefit to financial stability and efficiency.
- Key concerns:
  - Limited liquidity and lack of transparency in some CRT market segments.
  - Complexity of quantitative valuation and hedging techniques exposes participants to potentially large losses.
  - Counterparty creditworthiness and adequacy of market/legal infrastructure are additional vulnerabilities.
  - Increasing interlinkages among financial institutions raise potential for misunderstood risk exposures and contagion.
- Evidence of past losses: German Landesbanks experienced substantial losses in credit markets in 2002−03.
- Paper focus: financial stability issues related to CRT markets, with emphasis on credit derivatives use in the banking and insurance sectors in the United Kingdom.

### Growth and Structure of Credit Risk Transfer Instruments
- Credit derivatives and structured credit products have grown rapidly since credit derivatives began trading in 1996.
- Definition: a credit derivative transfers the risk that total return on a credit asset falls below an agreed level without transferring the underlying asset; cash flows depend on the credit quality of the underlying.
- Market size and projections:
  - Value of credit derivatives products exceeded total volume of outstanding U.S. Treasury bonds at end-2004.
  - Projected to surpass $8 trillion by 2006 (British Bankers’ Association).
  - London market estimated at $2.2 trillion in 2004, about 44 percent of total global market of $5 trillion; New York market at 40 percent.
- Structured credit products and CDOs:
  - CDOs pool credit risk and tranche it into seniority-based slices.
  - Three common securitization mechanisms in CDOs:
    - reference portfolio construction (bank loans/negotiable instruments/credit derivatives);
    - use of an SPV to de-link portfolio credit risk from originator;
    - tranching with seniority ranks for cash flow rights.
  - Motivations to issue CDOs: arbitrage (excess spreads), balance sheet management (reduced funding cost, regulatory capital), fee income and assets-under-management, underwriting fees and cross-selling.
  - CDOs improve liquidity where underlying bond and loan secondary markets are relatively illiquid.
- Participant composition (sources: Fitch Ratings, BBA, Credit Suisse First Boston):
  - Main participants: lending institutions (net buyers of protection / net sellers of CDOs) and insurance companies (net sellers of protection / net buyers of CDOs).
  - Emerging participants: hedge funds, proprietary traders, asset managers, some pension funds acting as protection sellers.
  - BBA protection buyers composition: Banks 38%, Insurance companies 20%, Securities firms 16%, Hedge funds 15%, Pension funds 4%, Mutual funds 4%, Corporates 2%, Government/export credit agencies 1%.
  - BBA protection sellers composition: Banks 51%, Insurance companies 7%, Securities firms 16%, Hedge funds 16%, Corporates 3%, Mutual funds 3%, Pension funds 3%, Government/export credit agencies 1%.
  - CSFB composition for protection sellers (buyers of CDOs) highlights conduits 39.9%, foreign banks 25.5%, insurance companies 20.4%, US banks 10.0%, structured funds 0.3%, Asian banks 1.3%, money managers 3.9%.
- Synthetic CDOs:
  - Growth driven by ease of assembly and dispersion relative to cash CDOs.
  - Synthetic CDOs: about 16 percent of credit derivatives market; CDSs 51 percent (BBA 2004).
  - Synthetic CDOs insured less than $400 billion of U.S. corporate bonds in 2001; estimated to cover some $2 trillion by end-2005 (JPMorgan).
  - $2 trillion would represent about 40 percent of the entire U.S. corporate bond market of almost $5 trillion.
  - Demand particularly strong in Europe due to legal/taxation barriers to true-sale securitizations and smaller outstanding corporate bond markets.

### Interlinkages Across Financial Institutions
- Increasing linkages across banks and insurers:
  - Insurers invest in banks’ equity and debt; insurers provide trade credit insurance; banks finance receivables supported by insurance.
  - Banks provide insurers with liquidity facilities and letters of credit.
  - Bancassurance formation (bank–insurer mergers) increases ownership links; example: 6 of the 10 largest U.K.-owned banks had equity shares in life insurance subsidiaries at end-2003.
  - Loans to insurers and pension funds amounted to just over 6 percent of major U.K. banks’ Tier 1 capital.
  - Equity prices of bancassurers in the U.K. were adversely affected by disruptions in the life insurance sector over 2001–03, indicating spillovers via ownership links.
- Repackaging credit risk into slices shifted risk outside banking sector to insurers, hedge funds, mutual funds, and pension funds.
- Banks play major roles: portfolio management (diversify/hedge banking book), intermediation, market making, and structuring CRT products.
- Types of risk introduced or amplified by CRTs:
  - Market risk: changes in credit spreads of underlying portfolio names.
  - Liquidity risk: difficulty selling assets in thin secondary markets.
  - Basis risk: imperfect matching when hedging tranches with standardized index tranches.
  - Counterparty risk: default on settlement claims.
  - Legal risk: incomplete or untimely documentation.
  - Ratings risk: ratings reflect average risk and may miss dispersion; potential for “ratings arbitrage” by choosing agencies based on best ratings.
  - Model risk: valuation reliant on complex and evolving models.
- Example market sensitivity: May 2005 spike in banking-sector credit risk amid rumors of hedge fund losses after GM and Ford downgrades; hedge funds’ performance affects banks through fee income and financing links.

### Exposure of U.K. Financial Institutions to Credit Derivatives
- Direct exposure assessment limited by lack of public information; authors use indirect VAR-based approach to estimate exposure by measuring how credit derivatives market developments explain variability in firms’ equity returns.
- Empirical setup:
  - Daily data for August 28, 2003–September 15, 2005.
  - Firms analyzed: Aviva, Barclays, Halifax Bank of Scotland (HBOS), HSBC, Lloyds, Legal & General, Royal and Sun Alliance (RSA), Royal Bank of Scotland (RBS).
  - Factors include: equity prices (Bloomberg L.L.P.), slope of yield curve (10-year minus 2-year U.K. government yields, Bloomberg generic series), iTRAXX tranche prices (equity tranche and mezzanine tranches from JPMorgan).
  - Tranche attachment points used: equity tranche 0–3 percent; mezzanine tranches 3–6 percent, 6–9 percent, 9–12 percent, and 12–22 percent. Super-senior tranche excluded (time series began mid-2004).
  - VAR of order p and subsequent VMA representation used to compute variance decompositions and long-term cumulative impacts.
- Interpretation assumption: no assumption whether institution is long or short; assume losses fall within attachment and detachment points of benchmark iTRAXX in case of defaults. Higher fraction of equity return volatility explained by a senior tranche implies lower credit exposure and lower potential systemic impact.
- Empirical findings summary:
  - U.K. insurance companies tend to have more conservative CRT exposures, favoring more senior mezzanine tranches (attachment points 9–12 percent and 12–22 percent).
  - Bancassurance businesses tend to be more exposed to riskier junior mezzanine tranches (3–6 percent and 6–9 percent), with HBOS as an exception (substantial exposure to 12–22 percent senior mezzanine tranche).
  - Barclays also appears most exposed to the senior mezzanine tranche.
  - Overall assessment: CRT market did not pose a substantial threat to U.K. financial sector stability at the time of the study, with diversity of holdings across major institutions helping to limit potential impact from a negative shock.
  - Reputation risk highlighted as an important contagion channel—failure of one institution could dent public confidence due to interlinkages.
- Subperiod analysis (August 28, 2003–September 6, 2004 and September 7, 2004–September 15, 2005):
  - Major U.K. financial institutions became more conservative over time, shifting exposures toward more senior mezzanine tranches, except RBS.
  - Holdings across institutions remained diverse over time.
- Table 1: Impact of Volatility in the CRT Market on Major U.K. Financial Groups, August 2003–September 2005 (In percent)
  - Dependent variable (iTRAXX tranches) explained fraction of equity return volatility (sample entries; shaded numbers in original represent each institution's biggest exposure):
    - Bank dependent variable: Barclays 0.2, HBOS 3.6, HSBC 9.3, Lloyds 0.4, RBS 0.9, AVIVA 1.8, Legal & 26.0, RSA 0.3.
    - Equity tranche (0–3 percent): Barclays 8.6, HBOS 0.3, HSBC 17.9, Lloyds 0.2, RBS 2.4, AVIVA 7.3, Legal & 0.7, RSA 3.3.
    - Mezzanine 3–6 percent: Barclays 2.1, HBOS 10.4, HSBC 51.6, Lloyds 32.7, RBS 38.9, AVIVA 12.5, Legal & 13.2, RSA 0.7.
    - Mezzanine 6–9 percent: Barclays 24.1, HBOS 0.4, HSBC 0.9, Lloyds 35.3, RBS 14.9, AVIVA 27.4, Legal & 4.7, RSA 33.9.
    - Mezzanine 9–12 percent: Barclays 17.3, HBOS 12.3, HSBC 5.2, Lloyds 6.6, RBS 13.9, AVIVA 35.8, Legal & 5.0, RSA 53.7.
    - Mezzanine 12–22 percent: Barclays 47.6, HBOS 72.9, HSBC 15.0, Lloyds 24.6, RBS 28.9, AVIVA 15.2, Legal & 50.4, RSA 8.0.
    - 10 less 2 year govt yield: Barclays 0.1, HBOS 0.0, HSBC 0.1, Lloyds 0.2, RBS 0.0, AVIVA 0.0, Legal & 0.0, RSA 0.0.
  - Sources: Bloomberg L.L.P. and IMF staff calculations.
  - Note: VAR shocks not orthogonalized; variance decomposition ranks importance but correlated shocks mean individual variances do not sum to total variance.

### Regulatory and Supervisory Initiatives
- General stance: CRT markets improve risk distribution and should be encouraged; regulators must implement measures to prevent misuse while allowing market development.
- United States (OCC response to securitization lessons):
  - Implemented supervisory reforms for bank securitization programs:
    - develop cadre of specialized examiners for securitization;
    - recognize high person-hour needs for such examinations;
    - develop independent valuation capabilities for residual risk component (equity piece of securitized instrument);
    - obtain information on every securitization vehicle for every bank.
  - Banking practice recommendations:
    - independent legal and accounting review of every vehicle;
    - perform “stress to breakage” risk analysis to complement residual risk valuation;
    - put in place contingency liquidity and reserve planning.
- United Kingdom (FSA approach):
  - Emphasis on understanding extent to which real risk is transferred.
  - Conducted surveys (including via the Joint Forum) to identify end investors and risk management practices.
  - FSA adopts conservative routine data-collection stance under its cost-benefit framework; prioritizes addressing model risk via hypothetical portfolio exercises to understand firm modeling approaches and challenges.
  - FSA and New York Federal Reserve working with market participants to resolve trade confirmation and assignment backlogs.
- Accounting and disclosure improvements:
  - International Financial Reporting Standards (IFRS) likely to improve valuations of structured credit and credit derivatives in financial statements.
  - IAS 39 introduces fair value accounting for financial assets and liabilities of listed companies; credit derivatives in trading books recorded at fair value.
  - Within banking book, valuation depends on instrument purpose: hedging underlying transactions requires fair value; hold-to-maturity may be recorded at cost.
  - IFRS 7 covers disclosure of details on credit derivatives.
  - U.K. adoption of IFRS on January 1, 2005; European Commission implemented restricted fair value option on November 16, 2005 (retroactive to January 1, 2005).
- Recommended supervisory improvements (areas for action):
  - ensure supervisory staff keep up to date with latest techniques and tools;
  - ensure timely and complete paperwork for CRT transactions;
  - ensure risk management systems can cope with CRT market stresses and encourage ongoing improvements in credit risk management;
  - require regular stress testing of open positions in CRT instruments, notably structured credit exposures;
  - encourage market participants to use richer and more consistent risk measurement techniques in addition to formal ratings;
  - consider need for greater disclosure by financial institutions of holdings in CRT instruments.

### Conclusion
- CRTs have facilitated dispersion of credit risk across sectors; theoretically net-positive for stability and efficiency, but specific risks (modeling, legal, counterparty, liquidity) could be amplified by limited market liquidity and opacity.
- Study focus: structured credit product use in U.K. banking and insurance sectors and implications for financial stability; VAR-based indirect exposure assessment used due to limited public exposure data.
- Empirical conclusion: structured credit market did not pose a substantial threat to U.K. financial sector stability at the time of the study:
  - U.K. insurance companies tended to prefer “safer” senior tranches;
  - bancassurance entities tended to be more exposed to junior mezzanine tranches;
  - diverse holdings across major institutions may limit impact of a significant negative shock.
- Ongoing challenge for regulators: balance adequate regulation, supervision, and surveillance with encouraging market development; authorities in major CRT markets have taken initiatives and continue to enhance supervisory techniques.

*Source: IMF working paper chapter "4. Growth of the Global Synthetic CDOs Market."*

### APPENDIX I

### APPENDIX I

### HOW COLLATERALIZED DEBT OBLIGATIONS (CDOS) WORK
- Investors purchase different tranches of a CDO commensurate with their risk-return preferences.
  - Riskiest tranche (equity) offers the highest return but bears the initial losses from defaults in the pool.
  - More conservative tranches pay lower returns but are insulated from initial defaults.
  - Tranche ordering by increasing risk of defaults: super-senior, senior, mezzanine, equity.
  - Holders of mezzanine, senior, and super-senior tranches have protection from losses of more junior tranches.
- Credit enhancements that can protect tranches include overcollateralization of assets, reserve accounts, or trapping excess spread, enabling higher credit ratings than the average rating of the underlying portfolio.
- Estimating tranche yields requires the originator to estimate the distribution of losses in the pool.
  - The distribution of losses depends largely on default correlation among names referenced in the CDO.
  - Lower default correlation → higher compensation to the equity tranche investor; higher default correlation → higher compensation to senior tranche investors.
  - Compensation dependence for mezzanine tranche investors lies between equity and senior tranche extremes (Gibson, 2004).

### SYNTHETIC CDOS, CDS, AND SINGLE-TRANCHE STRUCTURES
- Synthetic CDOs replace the pool of bonds with credit derivatives, specifically credit default swaps (CDS).
  - Synthetic CDOs are classified as credit derivatives.
  - In a synthetic CDO transaction:
    - the special purpose vehicle (SPV) sells protection to the originator of the deal in return for agreed fees; and
    - the risk is transferred from the SPV to investors through issuance of tranches of fully-funded synthetic CDOs, credit default swaps (which are unfunded), or a combination of both (partially funded CDOs).
- Funded vs unfunded tranches:
  - Funded tranche: investor pays the notional amount at initiation; funds invested in low-risk securities; defaults result in write-downs of principal; investor receives LIBOR plus a spread reflecting riskiness.
  - Unfunded tranche: no initial money changes hands; investor (protection seller) receives a spread and pays out upon defaults affecting the tranche; creates counterparty credit risk for the protection buyer.
  - Credit default swaps are unfunded credit derivatives.
- Single-tranche CDOs ("bespoke tranches"):
  - Created in 2003 as a more flexible alternative to traditional CDOs.
  - Only one tranche (usually a mezzanine tranche) is sold to the investor; the arranger becomes the direct counterparty since there is no SPV.
  - Allows seller to meet specific investor needs more timely and cost effectively than traditional CDO structures requiring sale of all classes of tranches.
- Synthetic CDO supply appears limitless because they can be created without holding actual bonds as underlying assets.
  - This can cause problems under physical settlement if insufficient bonds are available for settlement.
  - Markets have introduced auction mechanisms to cash-settle index trades in default incidents (example: Delphi and Collins & Aikman).

### TRANCHES, ATTACHMENT POINTS, AND DETACHMENT POINTS
- Default losses borne by a tranche range between the attachment point and detachment point.
  - Example: a 3−6 percent tranche has an attachment point of 3 percent and a detachment point of 6 percent.
  - If accumulated loss ≤ 3 percent of total initial notional, the tranche is unaffected.
  - When loss > 3 percent, further losses reduce the tranche’s notional until the detachment point 6 percent is reached, at which point the tranche is wiped out.

*Italic source attribution: APPENDIX I, from the provided source content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06139.pdf_