Cdo Basic Structure free essay sample

A CDO cash-flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection of CDO securities, called as tranches. While there are many variations, a standard prioritization scheme is simple subordination: Senior CDO notes are paid before mezzanine and lower-subordinated notes are paid, with any residual cash flow paid to an equity piece. A cash-flow CDO is for which the collateral portfolio is not subjected to active trading by the CDO manager, implying that the uncertainty regarding interest and principal payments to the CDO tranches is determined mainly by the number and timing of defaults of the collateral securities. A market-value CDO is one in which the CDO tranches receive payments based essentially on the mark-to-market returns of the collateral pool, as determined in large part by the trading performance of the CDO manager. The trustee of the CDO is responsible for monitoring the contractual provisions of the CDO. Tranches are categorized as senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the CDOs collateral otherwise underperforms, scheduled payments to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. Senior and mezzanine tranches are typically rated, with the former receiving ratings of A to AAA and the latter receiving ratings of B to BBB. The ratings reflect both the credit quality of underlying collateral as well as how much protection a given tranche is afforded by tranches that are subordinate to it. CDO: Life of a Static Managed Deal One important distinction is that between static and managed deals. With the former, collateral is fixed through the life of the CDO. Investors can assess the various tranches of the CDO with full knowledge of what the collateral will be. The primary risk they face is credit risk. With a managed CDO, a portfolio manager is appointed to actively manage the collateral of the CDO. The life of a managed deal can be divided into three phases: †¢ Ramp-up lasts about a year, during which the portfolio manager initially invests the proceeds from sales of the CDOs securities. †¢ The reinvestment or revolver period lasts five or more years. The manager actively manages the CDOs collateral, reinvesting cash flows as well as buying and selling assets. †¢ In the final period, collateral matures or is sold. Investors are paid off. At the time they purchase the CDOs securities, investors in a managed deal do not know what specific assets the CDO will invest in, and those assets will change over time. All investors know is the identity of the portfolio manger and the investment guidelines that he will work under. Accordingly, investors in managed CDOs face both credit risk as well as the risk of poor management. Investors have the added burden of paying portfolio management fees. Today, most CDOs are managed deals. In many cases, the portfolio manager is the sponsor. CDOs can be structured as cash-flow or market-value deals. The former is analogous to a CMO. Cash flows from collateral are used to pay principal and interest to investors. If such cash flows prove inadequate, principal and interest is paid to tranches according to seniority. At any point in time, all immediate obligations to a given tranche are met before any payments are made to less senior tranches. With a market value deal, principal and interest payments to investors come from both collateral cash flows as well as sales of collateral. Payments to tranches are not contingent on the adequacy of the collaterals cash flows, but rather the adequacy of its market value. Should the market value of collateral drop below a certain level, payments are suspended to the equity tranche. If it falls even further, more senior tranches are impacted. An advantage of a market value CDO is the added flexibility they afford the portfolio manager. Balance Sheet CDO Arbitrage CDO These names correspond to respective motivations of the sponsoring organization. With a balance sheet deal, the sponsoring organization is a bank or other institution that holds—or anticipates acquiring—loans or debt that it wants to remove from its balance sheet. Similar to a traditional ABS, the CDO is a vehicle for it to do so. Arbitrage deals are motivated by the opportunity to add value by repackaging collateral into tranches. This is the same motivation for most CMOs. In finance, the law of one price suggests that the securities of a CDO should have the same market value as its underlying collateral. In practice, this is often not the case. Accordingly, a CDO can represent a theoretical arbitrage. In addition to balance-sheet and arbitrage CDOs, TruPS CDOs represent a third, smaller segment of the market. Much of the arbitrage in an arbitrage CDO arises from a persistent market imperfection related to the somewhat arbitrary distinction between investment grade and junk debt. Many institutional investors face limits on their ability to hold below-investment-grade debt. This can take the form of regulations, capital requirements, and investment restrictions imposed by management. Insurance companies, pension plans, banks and mutual funds can all face some sorts of limitations. As a result, junk often trades at spreads to investment grade debt that are wider than might be explained purely by credit considerations. With a CDO, a portfolio of below-investment-grade debt can be repackaged into tranches, some of which receive investment grade—and even AAA—ratings. Synthetic CDO A synthetic deal holds high quality or cash collateral that has little or no default risk. It exposes investors to credit risk by adding credit default swaps (CDSs) to the collateral. Synthetic CDOs can be static or managed. They can be balance-sheet or arbitrage deals. Arbitrage synthetic deals are motivated by regulatory or practical considerations that might make a bank want to retain ownership of debt while achieving capital relief through CDSs. In this case, the sponsoring bank has a portfolio of obligations, called the reference portfolio. It retains that portfolio, but offloads its credit risk by transacting CDSs with the CDO. For arbitrage synthetic deals, two advantages are †¢ An abbreviated ramp-up period (for managed deals), and †¢ The possibility that selling protection through CDSs can be less expensive than directly buying the underlying bonds. This is often true at the lower end of the credit spectrum. The biggest advantage to (balance sheet or arbitrage) synthetic CDOs often is the fact that they dont have to be fully funded. For a cash CDO to have credit exposure to USD 100MM of bonds, it must attract USD 100MM in investments so it can buy those bonds. With a synthetic deal, credit exposure to USD 1000MM in obligations might be supported by just USD 150MM in high-quality collateral. In such a partially-funded deal, the entire USD 1000MM reference portfolio is tranched, but only the lower-rated tranches are funded. In this example, the most senior USD 850MM tranch would be called a super senior tranch. It might be retained by the sponsor or sold off as a CDS. The funded piece might comprise USD 100MM of investment grade tranches and USD 50MM of mezzanine and unrated tranches. The asset manager generally starts to acquire (or â€Å"warehouse†) assets prior to the closing date with the intention of transferring them to the SPV on the closing date. However, since the proceeds of the notes are available to pay for the assets only after the notes have been issued on the closing date, a bridge facility (or â€Å"warehouse facility†) is often used to acquire assets during a â€Å"pre-closing period† of several weeks before the closing date. The size of the warehouse facility depends on the amount of assets to be acquired on or before the closing date. Ramp-up Period On the closing date, the SPV issues two or more tranches of debt and equity to investors. It then purchases the assets with the proceeds from the sale of debt and equity, either on the closing date or, in most cases, during the â€Å"ramp-up period† of between 60 and 180 days following the closing date. Under certain circumstances, the ramp-up period may be longer. The purchase of assets during the ramp-up period exposes the transaction to the risk of adverse price and spread movements. The severity of this â€Å"ramp-up risk† is directly proportional to the amount of assets bought during the ramp-up period and the length of the ramp-up period. Reinvestment Period Following the ramp-up period, there is usually a â€Å"reinvestment period† (usually the initial 3 to 5 years) during which the cash flow from principal repayments due to amortization, maturity, prepayment and sale of assets are reinvested. These proceeds may be invested in short-term, liquid assets until the asset manager decides to reinvest in assets that meet the CDO’s investment guidelines. During the time that cash remains invested in short-term, liquid assets, the portfolio may suffer from negative arbitrage because the coupon rates of the CDO’s liabilities would exceed that of its short-term assets. The asset manager must therefore carefully consider the interim period when it keeps proceeds from repayment of principal in cash or cash equivalent liquid assets. The transfer of loans from a seller’s books to the SPV is more complicated than the acquisition of debt securities. Sometimes lending terms prohibit the assignment (i. e. ale) of loans, because the borrower values the relationship with the lending bank and wishes to protect it. In all cases, banks that wish to securitize their corporate loan portfolios to gain capital relief must carefully manage the underlying lending relationships. Amortization Period The reinvestment period is followed by the â€Å"amortization period,† during which all cash received from repayment of principal is used t o pay down the liabilities and cannot be reinvested in eligible assets. The amortization period can be as short as 5 years for high yield CDOs and as long as 30 years for ABS/MBS CDOs. During this period the portfolio becomes more concentrated, and its cash flows become lumpier. On the closing date, the SPV also enters into agreements with the following parties: Asset Manager The asset manager is by far the most important participant in any CDO transaction. In arbitrage transactions, the asset manager is responsible for managing the SPV’s portfolio of assets and receives a predetermined fee from the SPV for this service. The asset manager enjoys tremendous discretion in managing assets within the transaction guidelines. In balance sheet transactions, however, the issuing bank plays a more limited role, which mostly consists of administering and servicing assets transferred from its balance sheet. Trustee/Custodian The trustee, or custodian, performs a fiduciary function. Trustee may also serve as calculation agent, and is responsible for safe custody of SPV’s assets and for ensuring compliance with the CDO’s requirements. While the asset manager advises and directs trading, the trustee carries out trades, after ensuring that various collateral quality and coverage tests are met. Hedge Counterparty Traditionally, the hedge counterparty has provided interest rate hedges (basis swaps and rate caps). With the evolution of CDOs and their spread beyond the United States, hedge counterparties have begun to offer a wider range of hedging products, including currency swaps, total return swaps, timing hedges, liquidity swaps, etc. Synthetic Security Counterparties Synthetic security counterparties sell the SPV credit linked notes, credit default swaps, total return swaps and other credit derivatives. In some transactions, the SPV also enters into an insurance agreement with a bond insurer, who acts as an external credit enhancer. Bond Insurer The bond insurer guarantees the payment of principal and interest on one or more classes of notes issued by the CDO. To insure (or â€Å"wrap†) payments on notes, the bond insurer usually issues an insurance policy (or in synthetic transactions, writes a portfolio default swap with the SPV) guaranteeing the timely payment of interest and ultimate principal on the guaranteed notes, which are generally the senior-most notes issued by the SPV. The rating of the wrapped notes reflects the claims paying ability of the bond insurer. Typically, bond insurers involved in CDO transactions have AAA ratings. However, in recent years, bond insurers with lower ratings have also participated in CDO transactions, reflecting investors’ growing level of comfort with CDOs. Evaluation of CDO Over colletralization ratio for subordinated notes A divided by B A = Principal amount of performing assets plus lower of the fair market value or assumed recovery rate of defaulted assets plus cash and short-term investments not comprising interest income B = Principal amount of the senior notes plus principal amount of the mezzanine notes including any capitalized interest plus principal amount of the subordinated notes including any capitalized interest Interest Coverage Ratio for Subordinated Notes A divided by B A = Interest to be received in cash during the period on the portfolio and short-term investments plus (or minus) any scheduled amounts to be received from (or payable to) the hedge counterparty B = Capped senior expenses plus interest amount due on senior notes plus interest amount due on mezzanine notes including interest on capitalized interest plus interest amount due on subordinated notes including interest on capitalized interest Par Value Vs Market Value To calculate the overcollateralization ratio, all the performing securities are accounted for at their par amount regardless of their market prices. Discounts and premiums reflected in the market values are disregarded, because cash flow CDOs are designed to pay off their liabilities through the maturity or amortization of the underlying assets, and not through their sale. The only time market value becomes important is when the terms of the transaction require defaulted assets to be sold within a certain period (usually between 3 to 12 months after default). This so-called â€Å"forced sale† of defaulted assets exposes the transaction to market value risk. For this reason, overcollateralization ratios sometimes value defaulted assets at the lower of (a) market value or (b) the expected recovery value assigned by the rating agencies. The use of market value therefore disregards whatever recoveries the asset manager could ultimately achieve through the workout process. It is important to note that using market value to calculate the overcollateralization ratio may in rare cases impact equity investors. If the decline in the market value of a defaulted asset is significant enough to cause a breach of an overcollateralization test, cash flows that would otherwise be available to the equity investors may be diverted to pay down the senior notes, until the tests are met. The use of market value, therefore, may potentially lower the return on the equity and, at the same time, expose the senior notes to prepayment risk. Coverage Ratios by Note Class The minimum subordinated note coverage ratios are generally set lower than the minimum mezzanine note coverage ratios, which are, in turn, set lower than the minimum senior coverage ratios. For this reason, subordinated notes coverage tests are breached earlier than mezzanine note coverage tests. The lower the minimum ratio required for any coverage test, the lower the amount of losses that will breach that test. However, the notes are almost always repaid sequentially regardless of which test is breached. The levels at which these tests are breached are predetermined and have important implications for both subordinated notes and equity. If any of the coverage ratios fall below the test level, CDOs generally prohibit the reinvestment of any principal proceeds from repayments, amortization and recoveries on defaulted assets. Instead, these proceeds are held until the next payment date, when they are used to sequentially pay down the rated notes. Priority of Payments The priority of payments (also known as the â€Å"payment waterfall† or â€Å"waterfall†) refers to the sequence in which payments must be made to the holders of various note classes and to other parties to the transaction. The payments are usually separated into collections from interest and collections from principal. Most CDOs make sequential repayment of principal. This means that the principal of the senior most outstanding class is repaid fully before any repayment of principal is made to the next class. A small number of CDOs repay principal of various tranches â€Å"pro rata,† whereby principal is paid down pro rata according to the size of each tranche. Some transactions also make principal repayments in a â€Å"fast pay/slow pay† manner, such that a larger amount of cash is allocated to repay the principal of the senior notes and a smaller amount is allocated to the subordinated tranches. In most payment waterfalls, payments are made first from interest and then from principal. When collections from interest are insufficient, they are generally taken from principal. When coverage tests are breached, the priority of payments changes to divert any available cash to either pay down the notes or reinvest in collateral until all coverage tests are met. When principal repayments are made sequentially, the overcollateralization ratio increases for the senior most class outstanding at that time. This increased principal (par) coverage helps offset the incremental risk arising from a more concentrated portfolio as assets mature and their proceeds are used to pay down the senior notes. Major Risk for Equity Investors Like any other structured finance product, investment in CDOs involves risk. The major risks associated with investment in and/or managing CDOs are summarized below: Credit Risk Credit risk refers to the risk of default on a CDO’s investment portfolio. While over collateralization provides protection from losses to the rated notes, equity investors do not have the benefit of overcollateralization and subordination. However, CDO transactions are usually structured to provide equity investors with the targeted returns assuming a given amounts of losses on the underlying portfolio. Equity investors weigh their expected returns against the likelihood of those losses and other assumptions. Interest Rate Risk The interest rate risk arises from various factors in CDOs and depends on the complexity of structure and the nature of hedging. In most arbitrage cash flow CDOs it is in the form of basis risk i. e. a mismatch between fixed and floating rates asset and liabilities. Most arbitrage CDOs hedge this risk with interest rate swaps, caps, and/or floors. However, the interest rate risk in CDOs is difficult to hedge fully due to the active management of assets, limited ability to buy or sell interest rate hedges, active management and embedded option. Liquidity Risk The liquidity risk in the CDO notes is of two types. First, the secondary market for CDO notes is, at best, fairly limited. This is particularly true of the tranches rated below AAA. Second, CDOs often invest in assets that may have limited liquidity. Depending on the amount of exposure to the relatively illiquid assets, the asset manager may not be able to liquidate / substitute some assets when needed. The liquidity risk would be enhanced if the relatively illiquid assets mature after the legal final maturity date of the CDO’s notes and equity. This risk also usually arises in CDOs from the inclusion of zero-coupon bonds, step-up bonds, PIK bonds, and bonds that make interest payment less frequently (e. g. annually) than the notes issued by the CDO (e. g. semi-annually). The Prepayment Risk The prepayment risk in CDOs is mostly borne by the senior most notes since the payments waterfall in most arbitrage cash flow CDOs is sequential. This risk is enhanced in transactions that have tighter coverage ratios. Transactions which are structured with lesser room between initial coverage ratios and the levels at which they are breached would have greater prepayment risk. Furthermore, all other things remaining constant, tighter triggers can allow lower subordination at the same rating level. If a CDO invested mostly in long-dated, bullet maturity assets (like high yield bonds), there may not be any cash available from principal repayments to effect the repayment of the senior notes. Reinvestment Risk CDOs’ investment guidelines can often be too restrictive. Although these restrictions are designed to protect the investors, they can result in delays in reinvestment of available proceeds in assets that satisfy the reinvestment criteria. Currency Risk CDO have made forays into investing in assets denominated in more than one currency. This feature has been facilitated by the introduction of euro in early 1999. Such transactions have so far been fairly limited. The foreign currency risks in CDOs are complex and difficult to hedge fully. The direction of interest rate movements over long periods coupled with the amount and timing of prepayment, sale, default, recoveries, reinvestment, mandatory redemption upon breach of coverage tests and trading restrictions result in a large number of possible combination of events that can cause currency loss or gain. Counterparty/ Bivariate Risk CDOs typically limit the counterparty credit risk by dealing only with highly rated entities for interest rate hedges, foreign currency hedges, credit derivates, loan participations and securities lending (if any). Bivariate risk in CDOs refers to the risk that payments on an underlying debt instrument could be interrupted by the declining credit quality of another entity. For example, credit linked notes are subject to the credit risk of the counterparty in addition to the credit risk of the referenced obligor. Similarly, repayment of debt issued by corporate obligors in the emerging markets could be impeded by the sovereign’s ability to enact laws that could limit or prevent the availability of foreign currencies to corporations for debt servicing. Systemic Risk And finally, all of the risks discussed above will be more pronounced in an economic downturn that may result in large-scale ratings downgrade and/or defaults. Sharp increase in ratings downgrade is concomitant with economic downturn and emblematic of systemic risk. CDO notes may be downgraded solely due to downgrade of sufficient number of underlying assets. This risk may be greater for CDOs with little or no cushion in their subordination levels. CDOs could potentially be more prone to systemic risk than other investments due to a host of reasons such as trading limitations arising primarily out of their status as a structured vehicle (with limited financial and management flexibility). CDO structures, however, also provide protection from systemic risk by insulating the investors from decline in market values of the performing assets. Fair Spread Estimation with Monte Carlo Simulation Pricing a CDO using Monte Carlo simulation involves creating simple paths of correlated default times. These default times are used to calculate the payments on two legs and value each leg. Default Leg: the present value of tranche losses triggered by credit events during the CDO lifetime. †¢ Premium Leg: the present value of the premium payments weighted by the outstanding capital (original tranche amount minus accumulated losses) The fair spread of CDO can be computed by dividing the present value of the default leg E[DL] through the pre sent value of the premium leg E[PL]. Case Study: HVB Asset Management Asia (HVBAM) Excerpt from the article: HVB Asset Management Asia (HVBAM) has brought to market the first ever hybrid collateralized debt obligation (CDO) managed by an Asian collateral manager. The deal, on which HVB Asia (formerly known as HypoVereinsbank Asia) acted as lead manager and underwriter, is backed by 120 million of asset-backed securitization bonds and 880 million of credit default swaps Under the structure of the transaction, Artemus Strategic Asian Credit Fund Limited a special purpose vehicle registered in the Cayman Islands issued 200 million of bonds to purchase the 120 million of cash bonds and deposit 80 million into the guaranteed investment contract, provided by AIG Financial Products. In addition, the issuer enters into credit default swap agreements with three counterparties (BNP Paribas, Deutsche Bank and JPMorgan) with a notional value of 880 million. On each interest payment date, the issuer, after payments of certain senior fees and expenses and the super senior swap premium, will use the remaining interest collections from the GIC accounts, the cash ABS bonds, the hedge agreements, and the CDS premiums from the CDS to pay investors in the CDO transaction The transaction was split into five tranches, including an unrated 20 million junior piece to be retained by HVBAM. The 127 million of A-class notes have triple-A ratings from Fitch, Moody’s and SP, the 20 million B-notes were rated AA/Aa2/AA, the 20 million C bonds were rated A/A2/A, while the 13 million of D notes have ratings of BBB/Baa2 and BBB. Liability side of the structure The issuer (Artemus Strategic Asian Credit Fund Limited, an SPV at Cayman, from now on shortly called ‘Artemus’) issued 200mm of bonds, split in five tranches reflecting different risk-return profiles. Artemus (as protection buyer) also entered into a CDS agreement (super senior swap) on a notional amount of 800mm with a super senior swap counterparty. Such counterparties (protection sellers on super senior swaps) are typically OECD-banks with excellent credit quality. Because the liability side has a funded (200mm of notes) and an unfunded (800mm super senior swap) part, the transaction is called partially funded. Asset side of the structure The proceeds of the 200mm issuance have been invested in a guaranteed investment contract (GIC account; 80mm in eligible collateral assets) and asset backed securities (ABS bonds; 120mm). Additionally, the issuer sold protection on a pool of names with an aggregated notional amount of 880mm. Because the asset side consists of a mixture of debt securities and synthetic assets (CDS), the transaction is called hybrid. Note that the GIC is kind of ‘risk-free’ (AAA-rated securities, cash-equivalent). [pic] Settlement of credit events If credit events happen on the 880mm CDS agreement (Artemus is protection seller), a settlement waterfall takes place as follows. †¢ Proceeds from the GIC account are used by Artemus to make payments on the CDS agreement. †¢ If proceeds from the GIC are not sufficient to cover losses, principal proceeds from the debt securities are used to pay for losses. If losses exceed the notional amount of the GIC and principal proceeds, then ABS securities are liquidated and proceeds from such liquidation are used for payments on the 880mm CDS agreement. †¢ Only if all of the above mentioned funds are not sufficient for covering losses, the super senior swap will be drawn (Artemus bought protection from the super senior swap coun terparty). The volume of the GIC plus the super senior swap notional amount exactly match the 880mm CDS agreement, and the 120mm ABS Securities plus the 880mm CDS volume ‘asset-back’ the 1bn total tranche volume on the liability side. However, these coverage equations refer only to principal and swap notional outstanding. But there is much more credit enhancement in the structure, because additional to the settlement waterfall, interest proceeds, mainly coming from the premium payments on the 880mm CDS agreement and from the ABS bonds, mitigate losses as explained. Distribution of proceeds Principal proceeds (repayment/amortization of debt securities) and interest proceeds (income on ABS bonds, the GIC, hedge agreements and premium from the 880mm CDS agreement) are generally distributed sequentially top-down to the note holders in the order of their seniority. On top of the interest waterfall, fees, hedge costs and other senior expenses and the super senior swap premium have to be paid. Both, principal and interest payments are subject to change in case certain coverage test are broken. There are typically two types of coverage tests in such structures: †¢ Overcollateralization tests (O/C) take care that the available (principal) funds in the structure are sufficient for a certain (over)coverage (encoded by O/C-ratios greater than 100%) regarding repayments due on the liability side of the transaction. Interest coverage tests (I/C) make sure that any expenses and interest payments due on the liability side of the structure and due to other counterparties involved, e. g. , hedge counterparties, are (over)covered (encoded by I/C-ratios greater than 100%) by the remaining (interest) funds of the transaction. If a test is broken, cash typically is redirected in a way trying to bring the broken test in line again. In this way, the interest stream is used to mitigate losses by means of a changed waterfall. Excess Spread Interest proceeds are distributed top-down to the note holders of classes A, B, C and D. All excess cash left-over after senior payments and payments of coupons on classes A to D is paid to the subordinated note investors. Here, HVB Asset Management Asia (HVBAM) retained part of the subordinated note (the so-called equity piece). Such a constellation is typical in arbitrage structures: Most often, the originator/arranger keeps some part of the most junior piece in order to participate in the excess spread of the interest waterfall. Additionally, retaining part of the ‘first loss’ of a CDO to some extent ‘proves’ to the market that the originator/arranger itself trusts in the structure and the underlying credits. As indicated above, if tests are broken excess cash typically is redirected in order to protect senior note holder’s interests. Here, the timing of defaults is essential: If defaults occur at the end of the lifetime of the deal (backloaded), subordinated notes investors had plenty of time to collect excess spread and typically will achieve an attractive overall return on their investment even if they loose a substantial part of their invested capital. In contrast, if defaults occur at an early stage of the transaction (frontloaded), excess cash will be redirected and no longer distributed to the equity investor. This is a bad scenario for equity investors, because they bear the first loss (will loose money) but now additionally miss their (spread) upside potential because excess cash is trapped. A word on super senior swaps In most transactions the likelihood that the super senior tranche gets hit by a loss will be close to zero. Scenarios hitting such a tranche typically are located far out in the tail of the loss distribution of the underlying reference pool. Looking at super senior swaps from a heuristic (non-mathematical) point of view, one can say that in order to cause a hit on a super senior tranche the economy has to turn down so heavily that it is very likely that problems will have reached a level where a super senior swap hit is just the tip of the iceberg of a heavy global financial crisis. Subprime mortgage crisis: Role played by CDO From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. Mezzanine ABS CDOs are mainly backed by the BBB or lower-rated tranches of mortgage bonds, and in 2006, $200 billion in mezzanine ABS CDOs were issued with an average exposure to subprime bonds of 70%. As delinquencies and defaults on subprime mortgages occur, CDOs backed by significant mezzanine subprime collateral experience severe rating downgrades and possibly future losses. As the mortgages underlying the CDOs collateral decline in value, banks and investment funds holding CDOs face difficulty in assigning a precise price to their CDO holdings. Many are recording their CDO assets at par due to the difficulty in pricing. The pricing challenge arises because CDOs do not actively trade and mortgage defaults take time to lead to CDO losses. However, in June 2007, two hedge funds managed by Bear Stearns Asset Management Inc. faced cash or collateral calls from lenders that had accepted CDOs backed by subprime loans as loan collateral. The now defunct Bear Stearns, at that time the fifth-largest U. S. securities firm, said July 18, 2007 that investors in its two failed hedge funds will get little if any money back after unprecedented declines in the value of securities used to bet on subprime mortgages. Some CEOs have lost their jobs as a result of the crisis. On 24 October 2007, Merrill Lynch reported third quarter earnings that contained $7. 9 billion of losses on collateralized debt obligations. A week later Stan ONeal, Merrill Lynchs CEO, resigned from his position, reportedly as a result. On 4 November 2007, Charles (Chuck) Prince, Chairman and CEO of Citigroup resigned and cited the following reasons : as you have seen publicly reported, the rating agencies have recently downgraded significantly certain CDOs and the mortgage securities contained in CDOs. The new issue pipeline for CDOs backed by asset-backed and mortgage-backed securities slowed significantly in the second-half of 2007 and the first quarter of 2008 due to weakness in subprime collateral, the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds, and a general downturn in the global credit markets. Global CDO issuance in the fourth quarter of 2007 was US$ 47. 5 billion, a nearly 74 percent decline from the US$ 180 billion issued in the fourth quarter of 2006. First quarter 2008 issuance of US$ 11. billion was nearly 94 percent lower than the US$ 186 billion issued in the first quarter of 2007. Moreover, virtually all first quarter 2008 CDO issuance was in the form of collateralized loan obligations backed by middle-market or leveraged bank loans, not by home mortgage ABS. This trend has limited the mortgage credit that is available to homeowners. CDOs purchased much of the riskier portions of mortgage bonds, helping to support issuance of ne arly $1 trillion in mortgage bonds in 2006 alone. Investors criticized SP, Fitch Ratings and Moodys Investors Service, saying their ratings on bonds backed by U.S. mortgages to people with limited credit didnt reflect the lax lending standards that caused their backward-looking default rates to be inapplicable to risk level of the loans being made. In the first quarter of 2008 alone, rating agencies announced 4,485 downgrades of CDOs.