Subprime and Synthetic CDOs: Structure, Risk, and Valuation
3 June 2010
By Dr. Thomas Schopflocher et al.
Collateralized debt obligations (CDOs) and other structured financial products containing subprime mortgages have been a focal point of the credit crisis, giving rise to a growing amount of investigative journalism as well as credit crisis litigation. It is widely agreed that the leading edge of the credit crisis was the meltdown of the US subprime mortgage market that began in early 2007. Many of these mortgages were structured into asset-backed securities (ABS) that were then further structured into CDOs. Given their prominent role, it is clear that disputes will continue to revolve around CDOs and other subprime-backed structured products for some time. Through the end of March 2010, the credit crisis had yielded at least 395 securities filings (excluding arbitrations). Of these, at least 41 are CDO-related.
Though many market participants were conversant with these structures, it will usually be the case that a lay audience does not have such familiarity. This paper goes behind the current headlines to describe in plain English the fundamental analytics of the ABS-backed CDOs and synthetic CDOs that were instrumental in the financial crises. The authors also discuss the principles of their valuation, including the important issue of correlation.
