Collateralized Debt Obligations Collateralized Debt Obligations (CDOs) were at the epicentre of the financial crisis that shook the worlds markets and institutions in 2008. These powerful instruments are important investment vehicles that should be overseen with great care. In its simplest form, a CDO is a structured product that takes the cash flows emanating from a security or portfolio of securities and distributes them into tranchesthat is, classes of securities with claims to cash flows that differ in priority. The CDO traces its roots to the earliest types of securitized lending that altered the way that loans are managed. Since then, CDOs have evolved into novel risk management tools, represented by dozens of variations designed to appeal to distinctive risk appetites. For example, distressed debt CDOs securitize a portfolio of high-yield debt into tranches of collateralized securities with vastly different credit ratings. This transformative process allows institutions to move certain assets off their balance sheet by placing them into the hands of willing investors. The result for the institution 7 can be improved regulatory compliance and reduced capital requirements; it also provides investors in the tranches with improved investment opportunities, such as enhanced diversification and credit risk protections. How the Market for CDOs Developed The evolution of the CDO dates back to a time when small banks and savings and loan associations (S&Ls) were experiencing disruptive change in their industry. Traditionally, S&Ls had been in the business of aggregating small deposits and lending money via mortgage loans. During what has been considered the good old days, the managers of S&Ls operated under the 3-6-3 rule, meaning that they borrowed money at 3%, lent money at 6%, and were on the golf course every Wednesday at 3 oclock in the afternoon. Because mortgages exhibit a relatively low incidence of default, and because S&Ls developed an expertise in originating and servicing these loans, the 3-6-3 rule worked as long as market interest rates stayed within certain bands that kept their mortgage portfolios safe. In the 1970s, when mortgage rates rose quickly and entered a regime of high volatility, the interest rate risk embedded in the very structure of the S&L model was exposed for its worst features. Long-duration mortgage loan portfolios generated fixed-income returns that lagged behind the swiftly increasing money market rates that investors could obtain elsewhere. Because S&Ls were prevented by Regulation Q from raising deposit rates to competitive levels, depositors withdrew money, straining S&L cash flows to the point at which deregulation finally allowed S&Ls to offer more competitive rates. But these higher deposit rates caused the S&Ls to officially enter into the 10-5-7 rule: borrowing short-term at 10%, earning an average of 5% on loans, and spiralling toward bankruptcy. The days of having financial institutions hold massive mortgage loan portfolios were over. The mortgage-lending business became securitized with pass-through certificates: securities that allowed investors to own pro rata positions in portfolios of mortgages. These first-generation mortgage-backed securities allowed banks and S&Ls to continue to originate and service mortgages while also moving them off the balance sheet. Investment banks were active intermediaries issuing and managing these new structures (collateralized mortgage obligations, CMOs) as a way to earn fees. Not all investors wanted to hold these mortgage pass-through securities that offered cash flows for the next 2530 years. Some investors wanted the short-term cash flows only, and other investors, such as pension funds and insurance companies, were happy to invest primarily in the long-term cash flows. The key innovation of the CDO instrument is the creation of tranches that have claims to cash flows with different priorities and thus diverse cash flow and risk characteristics. So, for example, investors with high interest rate risk appetites could gravitate to the long-term tranches, whereas low-risk investors with shorter time horizons could gravitate to the short-term tranches. Derivatives can be valuable innovations when they help complete a market, allowing investors to tailor portfolios to their capacity to tolerate risk. The mortgage CDO market (i.e., CMOs) of the 1980s and 1990s focused on creating tranches that differed by interest rate risk only (i.e., uncertain longevities). The cash flows to 8 the tranches contained interest rate risk (in this case, experienced as the inclination of the borrowers to prepay some or all of the mortgage principal). Nevertheless, the power of structured products to slice and dice the interest rate risk enabled investors to assemble risk exposures that caused a minor financial crisis caused by rising interest rates in 1994. The rising interest rates coupled with the risk exposures enabled by misuses of CMOs led to fund collapses (e.g., Askin Capital Management), financial institution collapses (e.g., Kidder Peabody Group Inc.), and substantial losses by governmental entities (most famously, Californias Orange County). The success of CDO mortgage products led to expansion of the concept to other asset typesin particular, bonds and mortgages that contained default risk. CDOs with substantial exposures to assets with default risk were at the centre of the financial crisis in 2008. CDOs composed of bonds with default risk divvied up the impact of bond defaults by varying the exposure of each tranche to the losses of defaults in the CDOs collateral pool. For example, consider a financial institution with an asset bucket of $100 million of belowinvestment-grade loans that will be moved off the balance sheet through a CDO arrangement. The institution has created a subsidiary known as a special purpose vehicle (SPV) whose legal status is separate from the institution and whose obligations do not directly affect the financial health of the institution. The term bankruptcy remote is typically used to describe this arrangement because the reference portfolio is held in trust as a single-purpose entity. In this relatively simple arrangement, the SPV takes ownership of the reference portfolio of $100 million, issues a new set of securities to investors with the reference portfolio serving as collateral, and uses the money raised by the sale of the tranches to compensate the financial institution for the collateral portfolio. In return for the operation and management of the CDO, the CDO manager will charge a fee equal to a percentage of assets under management.

Using the case study above, evaluate the possibility of using of CDOs and CMOs in Namibia to securitize portfolios of high-yield debt into tranches of collateralized in catastrophic times like COVID-19 impact in Erongo Region as well as drought and floods in Oshana Region. To what extent can CDOs and CMOs as alternative investments provide a lasting solution to the devastating impacts of these catastrophic risks (CAT-risks). What other alternative investments can be used and why do you think they can be best for this function? (30 marks)