THEEDGE MALAYSI A | FEBRUARY 4, 2013 capital 44

x
D
ecember 2012 wormed
out another account of
an interesting innova-
tion in the financial
world with the Lev-
eraged Super Senior
product. Deutsche Bank is being
blamed for not valuing these prod-
ucts correctly in its financial state-
ments, that otherwise would have
been recognised as a loss of about
US$12 billion (RM37.3 billion) .
I would like to enlighten read-
ers, as plainly as possible, on what
a Leveraged Super Senior is and the
complexities that could follow.
First, the synthetic CDO
A Leveraged Super Senior is a cred-
it derivative product. It is a part
of a collateralised debt obligation
(CDO). A CDO is simply a basket of
credit products (bonds and loans)
in which investors not only share
the returns (coupons and interest
income) but also take hits when
any of the credit products default.
Not all investors share the losses
proportionately as the CDO basket
is divided (or tranched) to cater for
very risky investors,the not so risky
investors and so on.
It is worth noting at this point,
that there are also synthetic CDOs
which operate in the same way, ex-
cept that the basket now consists
of credit default swaps (CDS). CDS
are traded widely in global markets,
they are said to be even more liquid
than the bond markets, and their
spreads provide a more accurate
estimate of default risk in entities
compared with bonds. [Readers can
examine CDS further in my previ-
ous article (Jan 11, 2010) available
on my blog]
In Chart 1, lets say an issuer (in
most cases, an investment bank)
creates a ve-year synthetic CDO,
backed by credit default swaps of
100 reference entities of investment
grade status, roughly BBB rating.
The total notional value of the CDS
amount to $1 billion.
Based on the analysis of the port-
folio loss intensity,the issuer divides
the portfolio into several tranches
and calls them the equity tranche,
the junior tranche and so on, as in
the chart.The issuer then sells these
tranches to investors as credit-linked
notes. A reasonably risky investor
who likes the junior tranche may
take up the whole tranche and pay
$30 million as if he was buying a
ve-year corporate bond.The issuer
will pay him a regular premium (or
spread) for ve years.Lets say,in the
Leveraged Super Seniors of the pre-credit crisis
BY
JASVI N JOSEN
DlvA1lvS wCLD
third year, there were some big de-
faults in many individual CDS that
amounted to losses of $50 million in
the portfolio.The losses will rst be
borne by the equity investors up to
$40 million. The balance of the $10
million loss will be borne by the jun-
ior investor. This means the junior
investor will not get back $10 million
of his initial principal paid.
On the other hand, a risk-averse
investor may only be interested in
the senior note that is rated AAA,
which pays a lower spread but is
almost default-free as nobody per-
ceives losses in the portfolio to creep
above 10% of the portfolio.
e Leveraged Super Senior
Now, what about the super senior
tranche? This tranche is viewed as
super safe, even safer than the
AAA-rated senior tranche. The is-
suer is only prepared to pay a tiny
spread (say 0.1%) to the investor. In
all likelihood,no investor will be in-
terested. Innovation takes place to
make the super senior tranche more
appealing. Investors who buy this
tranche will only need to pay one-
tenth the notional value but receive
the full spread. How does this hap-
pen? In Chart 1,we see that although
the super senior tranches notional
value is $850 million, investors ef-
fectively only fund $85 million of it.
This means the investor only needs
to pay $85 million principal but re-
ceive a full spread on the $850 million
notional.The tranche is now known
as a Leveraged Super Senior.
The table shows a numerical ex-
ample of the investors return,which
has now improved greatly,from 0.1%
to 1.0%.
Portfolio Notional $100,000,000
Super Senior Tranche 15% - 100%
Super Senior Notional $850m
Amount initially funded $85m
(Leverage) (10.0 times)
Spread on 0.1% * $850m
Super Senior =$850,000
Implied Return on
Funded Portion 1.00%

e trigger points
As long as there are no defaults that
crawl beyond 15% of the $100 million
portfolio,the leveraged super senior
is out of trouble. However,
there is still a remote risk
that defaults could crawl
above the 15% point. This
may be possible for a highly
correlated CDS portfolio
where one default will trigger sev-
eral other defaults.
Lets say the highly correlated CDS
had begun to default and losses now
stand at $300 million. This means
$150 million of the losses has crept
into the super senior tranche. But
we know that the investors only paid
$85 million for the tranche! The bank
stands to lose $65 million.
To avoid this from happening,
triggers are put in place for the lev-
eraged super senior. For example, if
the losses of the CDS pool touches
$120 million,the leveraged super sen-
ior investors will be called either to
put in more collateral or unwind the
structure.This is called a loss trigger.
Another trigger called a spread trig-
ger is based on the collective spreads
of the CDS portfolio. If the spreads
move beyond a certain point, the
trigger will be breached and again
super senior investors will have the
option of either putting in more col-
lateral or unwinding the investment.
In essence,the triggers are aimed at
governing the overall health of the
super senior tranche.
Gap risk
Even with the trigger in place,there
is a lingering risk for the issuer.Con-
sider a situation where the spreads
on the CDS in the portfolio shoot
up but have not breached any of
the triggers of the Leveraged Super
Senior trades yet.The issuer marks-
to-market the leveraged super sen-
ior trades in his accounts daily. If
his valuations show that the trade
has a marked-to-market prot,how
sure is the issuer that the collateral
adequately covers this amount? This
is gap risk.
In the next article, I will focus
on the mark-to-market valuation
of leveraged super senior trades and
explain how gap risk plays an im-
portant role.
Jasvin Josen is an ex-investment
banker from Europe, specialising
in valuation and risk in financial
derivatives. She is currently
back in Malaysia, providing
consultancy and training.
Readers can follow her at http://
derivativetimes.blogspot.com or
send their comments to Jasvin@
souqmatters.com
Example of a synthetic CDO capital structure
CHART 1

In Chart 1, let us say an issuer (in most cases, an investment bank) creates a 5-year
Synthetic CDO, backed by credit default swaps of 100 reference entities of
investment grade status, roughly BBB rating. The total notional of the CDSs amounts
to $1billion.
Based on the analysis of the portfolio loss intensity, the issuer divides the portfolio
into several tranches and calls them the equity tranche, the junior tranche, etc., as in
the chart. The issuer then sells these tranches to investors as credit linked notes. A
reasonably risky investor who likes the junior tranche may take up the whole tranche
and pay $30m as if he was buying a 5-year corporate bond. The issuer will pay him a
regular premium (or spread) for five years. Let us say, in the third year, there were
some big defaults in many individual CDSs that amounted to losses of $50m in the
portfolio. The losses will first be borne by the Equity Investors up to $40m. The
balance of the $10m loss will be borne by the junior investor. This means that the
junior investor will not get back $10m of his initial principal paid.
On the other hand, a risk-averse investor may only be interested in the senior note
that is rated AAA, which pays a lower spread, but it is almost default-free, as nobody
perceives losses in the portfolio to creep above 10% of the portfolio.
The Leveraged Super Senior
Now, what about the super senior tranche? This tranche is viewed as super safe,
even safer than the AAA rated senior tranche. The issuer is only prepared to pay a
tiny spread (say 0.1%) to the investor. In all likelihood, no investor will be interested.
with