CDOs: Understanding risk weights

I emailed Mike Peterson, the editor of Creditflux, to ask him about the "risk

weight" figures we say yesterday. (If you recall, the risk weighting

on synthetic CDOs went up from 2.89 in 2005 to 3.45 in 2006, but it wasn’t clear

what that meant.) Mike explained:

We risk weight each synthetic CDO tranche by multiplying it by a factor depending

on its seniority. So anything between 0% and 3% is multiplied by 20, anything

between 15% and 100% is mutliplied by 0.4, etc. It’s a crude version of a

delta.

Is that clear? Let me try to explain. Synthetic CDOs are structured to behave

just like normal CDOs, where you bundle up a bunch of bonds and then tranche

them. The top-rated tranches get paid first. Once they’re paid, the next tranche

down gets paid. And so on.

The way that Mike is measuring the seniority of these tranches is by looking

at something called the "attachment and detachment points". He explains:

Any tranche with [loss] attachment and detachment points between 0% and 3%

of the portfolio. If you attach at 0% and detach at 3% you get hit from the

moment of the first loss in the portfolio and by the time losses get to 3%

you are finished.

A first-loss tranche such as that one counts as an equity tranche, and carries

a risk weight of 20 in Mike’s scheme. On the other hand, if you only start suffering

losses once 15% of the portfolio has been wiped out, then you’re safe as houses,

and Mike assigns your tranche a risk weight of just 0.4.

So now we’re a bit closer to understanding what those risk-weight numbers mean.

Let’s say you took a barbell strategy on a synthetic CDO, buying an almost-risk-free

tranche from 15% to 100%, and an equity tranche from 0% to 3%. Then the average

risk weight would be (85*0.4+3*20)/88 = 1.07. That compares, I think, to a risk

weight for the all the tranches combined of 1. (I do hope that Mike will correct

me if I’m wrong here!) In other words, if you have all of the very safest tranches,

plus the entire equity tranche, you’re still taking more risk overall than is

in the structure as a whole – because you take all of the first loss.

Now the clever thing about synthetic CDOs, unlike normal CDOs, is that you

don’t need to actually sell every tranche from 0% all the way through to 100%.

And in fact there’s really little if any demand for the safest tranches of synthetic

CDOs, since it’s possible to get similar returns with better liquidity elsewhere

in the fixed-income world. So increasingly people have been buying just the

riskier tranches of these animals, with detachment points in the single digits.

And that explains the average risk weight going up to 3.5. But remember that

equity is 20, so 3.5 is still relatively safe, and I’m not sure I’d

describe it, as the FT did, as "ultra-risky".