COLLATERALIZED DEBT OBLIGATIONS (CDOs)



COLLATERALIZED DEBT OBLIGATIONS (CDOs)
Collateralized Debt Obligations (CDOs) is advancement of securitization discussed in the paper of Strategic Financial Management. While in securitization the securities issued by SPV are backed by the loans and receivables the CDOs are backed by pool of bonds, asset backed securities, REITs, and other CDOs. Accordingly, it covers both Collateralized Bond Obligations (CBOs) and Collateralized Loan Obligations (CLOs).

CREDIT DERIVATIVES


CREDIT DERIVATIVES

Credit Derivatives is summation of two terms, 
Credit +  Derivatives.

 As we know that derivative implies value deriving from an underlying, and this underlying can be anything we discussed earlier i.e. stock, share, currency, interest etc.

Initially started in 1996 due to the need of the banking institutions to hedge their exposure of lending portfolios today is one of the structured finance product.

Plainly speaking the financial products are subject to following two types of risks:
(a) Market Risk: Due to adverse movement of the stock market, interest rates and foreign exchange rates.

(b) Credit Risk: Also called counter party or default risk, this risk involves non-fulfilment of obligation by the counter party.

While, financial derivatives can be used to hedge the market risk, credit derivatives emerged out to mitigate the credit risk. Accordingly, the credit derivative is a mechanism whereby the risk is transferred from the risk averse investor to those who wish to assume the risk.

Although there are number of credit derivative products but in this chapter, we shall discuss two types of credit Derivatives ‘Collaterised Debt Obligation’ and ‘Credit Default Swap’.


LIMITATION OF CREDIT RATING


LIMITATIONS OF CREDIT RATING
1) Rating Changes – Ratings given to instruments can change over a period of time. They have to be kept under rating watch. Downgrading of an instrument may not be timely enough to keep investors educated over such matters.

2) Industry Specific rather than Company Specific – Downgrades are linked to industry rather than company performance. Agencies give importance to macro aspects and not to micro ones and over-react to existing conditions which come from optimistic/pessimistic views arising out of up/down turns.

3) Cost Benefit Analysis – Rating being mandatory, it becomes a must for entities rather than carrying out Cost Benefit Analysis. Rating should be left optional and the corporate should be free to decide that in the event of self rating, nothing has been left out.

4) Conflict of Interest – The rating agency collects fees from the entity it rates leading to a conflict of interest. Rating market being competitive there is a distant possibility of such conflict entering into the rating system.

5) Corporate Governance Issues – Special attention is paid to

a) Rating agencies getting more of its revenues from a single service or group.

b) Rating agencies enjoying a dominant market position engaging in aggressive competitive practices by refusing to rate a collateralized/securitized instrument or compelling an issuer to pay for services rendered.

c) Greater transparency in the rating process viz. in the disclosure of assumptions leading to a specific public rating.


CREDIT RATING AGENCIES ABROAD


CREDIT RATING AGENCIES ABROAD 

(i) Standard and Poor’s (S & P) Ratings

S&P Global Ratings have been in the credit rating business for more than 150 years. They are the world’s leading provider of credit ratings. Their credit ratings are important not only for the corporates but also for the government and the financial sector. Their credit rating is basically an expression of opinion about the credit quality of a company i.e. whether that company is able to meet its financial obligations in time or not. S & P is operating in about 28 countries. And, to its credit, if we take all corporate sector investment-grade ratings issued, just 1% has defaulted over the most recent five-year period. 

(ii) Fitch Ratings
Fitch is among the top three credit rating agencies in the world. Fitch Ratings is headquartered in both New York and London. Fitch Ratings' long-term credit ratings are assigned on an alphabetic scale from 'AAA' to 'D'. It was first introduced in 1924 and later adopted and licensed by S&P. It is a global leader in financial information services with operations in more than 30 countries. 

(iii) Moody’s Ratings

Moody’s is an important contributor in the global financial market providing credit rating services that helps in the building up of a transparent and integrated financial market. The Corporation, which reported revenue of $3.6 billion in 2016, employs approximately 10,700 people worldwide and maintains a presence in 36 countries.


RATING REVISIONS


RATING REVISIONS

Credit Rating is an opinion expressed by a credit rating agency at a given point of time based on the information provided by the company and collected by credit rating agency. However, the information collected from the company at the time of giving credit rating to it is amenable to change.

Therefore, revision of credit rating is required.

To protect the interest of investors, SEBI has mandated that every credit rating agency shall, during the lifetime of the securities rated by it, continuously monitor the rating of such securities and carry out periodic reviews of all published ratings.

Moreover, India Ratings & Research (A Fitch Group Company) continuously monitors the ratings assigned to a particular instrument. In case of any changes in the ratings so assigned, India Ratings discloses the same through press releases and on its websites.

For instance, the CRISIL has updated long term credit rating of Sterlite Technologies Limited to ‘CRISIL AA-/Stable from CRISIL A+/Watch Developing’ and also its short term credit rating have been upgraded to CRISIL A1+ from CRISIL A1/Watch Developing. Additionally, CRISIL has removed its rating on bank loan facilities and debt instruments of the company from ‘Watch with Developing Implications’ and it has also withdrawn its rating on ‘bonds’ at the Company’s request, as there is no amount outstanding against the said instrument.


CREDIT RATING METHODOLOGIES (FINANCIAL RISK)


CREDIT RATING METHODOLOGIES

(ii) FINANCIAL RISK

Financial Risk is referred as the unexpected changes in financial conditions such as prices, exchange rate, Credit rating, and interest rate etc. Though political risk is not a financial risk in direct sense but same can be included as any unexpected political change in any foreign country may lead to country risk which may ultimately result in financial loss.

Accordingly, the broadly Financial Risk can be divided into following categories.

(a) Counter Party Risk

(b) Political Risk

(c) Interest Rate Risk

(d) Currency Risk

Now, let us discuss each of the above mentioned risks: 

(a) Counter Party Risk

This risk occurs due to non honoring of obligations by the counter party which can be failure to deliver the goods for the payment already made or vice-versa or repayment of borrowings and interest etc.

Thus, this risk also covers the credit risk i.e. default by the counter party. 

(b) Political Risk 

Generally this type of risk is faced by overseas investors, as the adverse action by the government of host country may lead to huge loses. This can be on any of the following forms :
  • Confiscation or destruction of overseas properties. 
  • Rationing of remittance to home country. 
  •  Restriction on conversion of local currency of host country into foreign currency. 
  •  Restriction as borrowings. 
  •  Invalidation of Patents 
  •  Price control of products
(c) Interest Rate Risk
This risk occurs due to change in interest rate resulting in change in asset and liabilities. This risk is more important for banking companies as their balance sheet’s items are more interest sensitive and their base of earning is spread between borrowing and lending rates.

As we know that the interest rates are of two types i.e. fixed and floating. The risk in both of these types is inherent. If any company has borrowed money at floating rate then with increase in floating rate the liability under fixed rate shall remain the same. This fixed rate, with falling floating rate the liability of company to pay interest under fixed rate shall comparatively be higher.

(d) Currency Risk

This risk mainly affects the organization dealing with foreign exchange as their cash flows changes with the movement in the currency exchange rates. This risk can affect the cash flow adversely or favorably. For example, if rupee depreciates vis-à-vis US$ receivables will stand to gain vis-à-vis to the importer who has the liability to pay bill in US$. The best case we can quote, Infosys (Exporter) and Indian Oil Corporation Ltd. (Importer).

CREDIT RATING METHODOLOGIES (BUSINESS RISK)


CREDIT RATING METHODOLOGIES
The general methodology adopted by credit rating companies is to analyze various aspects of a business. They are briefly discussed as below:

(i) BUSINESS RISK
Business risk occurs when there is a possibility of a company earning lower profits than anticipated or incurring a loss. Business risk can be segregated into four categories - Strategic risk, compliance risk, operational risk and reputational risk. We have briefly discussed each one as follows:

(a) Strategic Risk: A successful business always needs a comprehensive and detailed business plan. Everyone knows that a successful business needs a comprehensive, well-thought-out business plan. But it’s also a fact of life that, if things changes, even the best-laid plans can become outdated if it cannot keep pace with the latest trends. This is what is called as strategic risk. So, strategic risk is a risk in which a company’s strategy becomes less effective and it struggles to achieve its goal. It could be due to technological changes, a new competitor entering the market, shifts in customer demand, increase in the costs of raw materials, or any number of other large-scale changes.

We can take the example of Kodak which was able to develop a digital camera by 1975. But, it considers this innovation as a threat to its core business model, and failed to develop it. However, it paid the price because when digital camera was ultimately discovered by other companies, it failed to develop it and left behind. Similar example can be given in case of Nokia when it failed to upgrade its technology to develop touch screen mobile phones. That delay enables Samsung to become a market leader in touch screen mobile phones.

However, a positive example can be given in the case of Xerox which invented photocopy machine. When laser printing was developed, Xerox was quick to lap up this opportunity and changes its business model to develop laser printing. So, it survived the strategic risk and escalated its profits further.

(b) Compliance Risk: Every business needs to comply with rules and regulations. For example with the advent of Companies Act, 2013, and continuous updating of SEBI guidelines, each business organization has to comply with plethora of rules, regulations and guidelines. Non compliance leads to penalties in the form of fine and imprisonment.

However, when a company ventures into a new business line or a new geographical area, the real problem then occurs. For example, a company pursuing cement business likely to venture into sugar business in a different state. But laws applicable to the sugar mills in that state are different. So, that poses a compliance risk. If the company fails to comply with laws related to a new area or industry or sector, it will pose a serious threat to its survival.

(c) Operational Risk: This type of risk relates to internal risk. It also relates to failure on the part of the company to cope with day to day operational problems. Operational risk relates to ‘people’ as well as ‘process’. We will take an example to illustrate this. For example, an employee paying out Rs. 1,00,000 from the account of the company instead of Rs. 10,000.

This is a people as well as a process risk. An organization can employ another person to check the work of that person who has mistakenly paid Rs. 1,00,000 or it can install an electronic system that can flag off an unusual amount.

(d) Reputational Risk: Reputational impact mostly follows a decision under business risk. For example closing of project in a country on the ground of viability, (Just like what GM has done in India) creates bad reputation for the company. For example in the above case it is observed that employees are reacting negatively to the decision and feeling insecure.

On the other hand, adding related products down the line adds customer confidence and boost investor’s confidence. For example several Indian banks have embarked on opening e-trading account. This has added to the reputation and market confidence.