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Nothing below this
pointWith thanks to Sivan Mahadevan, Pinar Onur, Peter Polanskyji, Andrew Sheets who produced many of the slides herein
Are there Central Problems in Credit? Peter Cotton, Sep 2006
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Why did Black commit suicide?
Dottore Turati - Alexander Luzhin (Black to Move)
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Table of Contents
Section 1: Synthetic CDOs
Section 2: Trading Correlation
Section 3: Problems
Section 4: Open Problems
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Section 1:Collateralized Debt
Obligations
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CDOs are Companies
Source: Morgan Stanley
Priority of Claim on Assets
Rises with Seniority
Corporate Capital Structure
Junior Senior
Senior Mezzanine
Junior Mezzanine
First Loss or Equity
CDO Capital Structure
Senior Debt
Subordinate Debt
Preferred Stock
Equity (Common)
Priority of Claim on
CollateralRises with Seniority
Senior
Priority of Claim on Assets
Rises with Seniority
Corporate Capital Structure
Junior Senior
Senior Mezzanine
Junior Mezzanine
First Loss or Equity
CDO Capital Structure
Senior Debt
Subordinate Debt
Preferred Stock
Equity (Common)
Priority of Claim on
CollateralRises with Seniority
Senior
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A Typical CDO Capital Structure
Source: Morgan Stanley
Super Senior Tranche (70%)
AAA Tranche (7.5%)
AA Tranche (3%) A Tranche (2.5%) BBB Tranche (4%)
Losses from
Reference Portfolio are borne
by tranches in reverse seniority
order
BB Tranche (3%)
Equity Tranche (10%)
0%
10%
19.5%%
30%
22.5%
13%
17%
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Copyright 2006 Morgan Stanley
Meet the Tranches…
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Growth in credit markets
Global Total Synthetic CDO Issuance (USD Billions)
0
50
100
150
200
250
300
350
2002 2003 2004 2005 Q1 2006
funded unfunded
Source: CreditFlux
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Other ways to invest
Single Name CDS
Small Baskets
TranchedCredit Risk
Credit Options
Indexation (TRAC-XSM Dow Jones CDX)
BasisTrades
CurveTrades
CapitalStructure
Trades
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Section 2:Trading Correlation
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Corporate defaults are not independent
BBs – 1 Yr and 5 Yr by Cohort
0%
5%
10%
15%
20%
25%
30%
1970 1975 1980 1985 1990 1995 2000 2005
Source: Morgan Stanley, Moody’s
Cohort
5 Year1 Year
(If history is to be believed)
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Corporate defaults are not independent
Zero Correlation Market Difference
Series CDX 4 CDX 5 CDX 6CDX
4 CDX 5 CDX 6 CDX 4 CDX 5 CDX 65 Yr
3-7% 6 13 24 42 51 70 36 38 46
7-10% 0 0 0 8 13 16 8 13 16
10-15% 0 0 0 4 6 8 4 6 8
7 Yr
3-7% 138 176 226 155 171 196 17 -5 -307-10% 0 0 1 32 37 44 32 37 43
10-15% 0 0 0 14 16 19 14 16 19
10 Yr
7-10% 37 53 75 93 99 107 56 46 32
10-15% 0 0 1 46 47 52 46 47 51
Source: Morgan Stanley
(If the market is to be believed)
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Correlation and Minefields
Low Correlation
High Correlation
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Correlation Intuition
Fundamental Correlation Relationships
bp
Source: Morgan Stanley
Senior Tranches Subordinate Tranches
0
100
200
300
400
0% 20% 40% 60% 80% 100%
Subordinate tranches Spread decreases as
correlation rises
Senior tranches Spread increases as
correlation rises
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Correlation example: Pensions and Labor Costs
Issues such as pension and labor costs that have plagued the airline industry may spread to other sectors
Similar issues could prove to be a driver in determining default correlation across sectors
This list highlights companies where significant potential exists for a high realized default correlation
Not Only One Sector – Unfunded Pension Liabilities Relative to Equity
Market Capitalization
1Market Cap based on the average of the 6 months prior to the bankruptcy filing
Source: Morgan Stanley
Issuer Ticker Industry Group Funding Gap/
Mkt Cap
Delta Air Lines Inc1 DAL Airlines 1235%
Northwest Airlines Corp1 NWAC Airlines 875%Exide Technologies XIDE Auto Parts & Equipment 266%Delphi Corp DPH Auto Parts & Equipment 256%Continental Airlines Inc CAL Airlines 215%AK Steel Holding Corp AKS Iron/Steel 147%AMR Corp AMR Airlines 145%Goodyear Tire & Rubber Co GT Auto Parts & Equipment 112%Hayes Lemmerz Int’l Inc HAYZ Auto Parts & Equipment 102%Dura Automotive Systems Inc DRRA Auto Parts & Equipment 81%Visteon Corp VC Auto Parts & Equipment 73%Ford Motor Co F Auto Manufacturers 68%Austral Pacific Energy Ltd AEN Oil & Gas 62%General Motors Corp GM Auto Manufacturers 43%ArvinMeritor Inc ARM Auto Parts & Equipment 40%Unisys Corp UIS Computers 36%Navistar International Corp NAV Auto Manufacturers 34%Smurfit-Stone Container Corp SSCC Forest Products & Paper 33%Abitibi-Consolidated Inc ABY Forest Products & Paper 33%Tenneco Automotive Inc TEN Auto Parts & Equipment 32%Bowater Inc BOW Forest Products & Paper 29%PolyOne Corp POL Chemicals 27%Dana Corp DCN Auto Parts & Equipment 25%Hercules Inc HPC Chemicals 22%TRW Automotive Holdings Corp TRW Auto Parts & Equipment 22%Terra Industries Inc TRA Chemicals 22%Timken Co TKR Metal Fabricate/Hardware 29%Alcan Inc AL Mining 24%
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Section 3:Problems
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Real-World Correlation?
World A – likelihood of 100 defaults are equally related to one another
- World B – the default propensity
of three companies are highly correlated to each other but not to the rest
Correlation – Details Matter
Source: Morgan Stanley
WORLD A
Credit 1 2 3 45
… 100 Average
1 50% 50% 50% 50% … 50% 50%
2 50% 50% 50% 50% … 50%
3 50% 50% 50% 50% … 50%
4 50% 50% 50% 50% … 50%
5 50% 50% 50% 50% … 50%
… … … … … …
100 50% 50% 50% 50% 50%
WORLD B
Credit 1 2 3 45
… 100 Average
1 90% 90% 10% 10% … 10% 48%
2 90% 90% 10% 10% … 10%
3 90% 90% 10% 10% … 10%
4 10% 10% 10% 50% 50% … 50%
… … … … …
100 10% 10% 10% 50%50%
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Dynamics of a Static Model
TRACERS spread scenario with five defaults in the first two years
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Modeling correlation in spreads (intensity models)
(For illustration, we identify spreads with hazard rates)
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Problem 1: Model Construction
Build a dynamic credit model for hundreds of assets:
Consistent across sub-portfolios Internally consistent and computable dynamics Tractable pricing and estimation Can be calibrated to CDS, index, options, tranches
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Problem 2: Estimation
c.f. Specification analysis of affine term structure models
• Dai & Singleton• Duffie & Singleton• Gallant & Tauchen• Hansen
An efficiently simulated can be efficiently, consistently estimated…eventually
Advantages
• Elegant• Can include arbitrarily complex products• No likelihood function required
(5000 iterations)(1000 steps)(10,000 paths)(1 sec) = 2180 years
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Problem 3: Deal Dynamics
How will structured deals & companies evolve?
- Ratings stability - Contingent payments - Corporate events
- Optimal management
How will desks optimize their correlation trading operations?
- Monetization strategies - Contingent hedging costs - Risk management - Capital allocation
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Board Vision
Dottore Turati - Alexander Luzhin (Black to Move and Win)
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Raising the bar
Solve hard modeling & numerical problems
Leverage emerging technologies
Leverage advances in other fields
--> Enhance and challenge human decision making
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Important Disclosures
The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and/or one or more of its affiliates (collectively, “Morgan Stanley”) and the research analyst(s) named on page one of this report.
Morgan Stanley policy prohibits research analysts from investing in securities/instruments in their MSCI sub industry. Analysts may nevertheless own such securities/instruments to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition.
Morgan Stanley is involved in many businesses that may relate to companies or instruments mentioned in this report. These businesses include market making, providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, investment services and investment banking. Morgan Stanley trades as principal in the securities/instruments (or related derivatives) that are the subject of this report. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report.
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Other Important DisclosuresThe securities/instruments discussed in this report may not be suitable for all investors. This report has been prepared and issued by Morgan Stanley primarily for distribution to market professionals and institutional investor clients. Recipients who are not market professionals or institutional investor clients of Morgan Stanley should seek independent financial advice prior to making any investment decision based on this report or for any necessary explanation of its contents. This report does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. You should consider this report as only a single factor in making an investment decision.
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