INTRODUCTION:

In its current form, structured finance has gained a significant level of expansion within the international market
since the year 2000. This trend has realized various innovative products catering to modern financial institutions'
intricate needs. In this report, we will focus on two products: Constant Proportion Debt Obligations (CPDOs) and
Mortgage-Backed Securities (MBS). Based on these real-world case studies, we will then elaborate on why some
firms decided to employ structured products instead of traditional financial instruments.

This report tries to dig out the core motivations of this shift and focuses on the special requirements, gaps, and
opportunities that are fulfilled via structured products. This will uncover the grounds that financial firms are
attracted towards the use of CPDOs and MBS and the failures of the traditional products that failed to provide per
the ever-changing needs of the firms.

Further, this report will critique the social and ethical considerations in the growing use of these complex financial
instruments. It will evaluate specialized financial products that are tailor-made to cater to specific investor needs.
Since the level of income generated from Constant Proportion Debt Obligations (CPDOs) remained adequately
stable over time relative to the level of risk, the benefit this instrument provided to investors was a means to
generate consistent income over time with less active management needed by automatically adjusting the
instrument Whereas, Mortgage-Backed Securities (MBS) are a means of investing in a pool of mortgage loans
that will offer the investor a diversified and tailor-made investment by the specific risk-return tolerance.

CPDOs often contain a mix of debt-based instruments like corporate bonds, mortgage-backed securities,
asset-backed securities, and collateralized loan obligations. To manage risk or achieve specific investment
goals, CPDOs can also include credit default swaps (which act like debt insurance), derivatives
(instruments linked to other assets), or even commodities. The exact combination of products in a CPDO
depends on the investor's risk tolerance and the design created by the investment manager.

Mortgage-backed securities (MBS) are an investment similar to bonds, composed of a bundle of home
loans bought from the banks that issued them. These loans are then packaged together and sold to
investors. The investors in MBS receive regular payments from the pool of mortgages, which include both
interest and principal payments made by the homeowners. The appeal of MBS lies in its ability to provide
investors with a stream of income while spreading the risk of default across many mortgages. However,
the complexity and risk of MBS became widely recognized during the financial crisis of 2007-2008, when
high levels of defaults on subprime mortgages led to significant losses for many investors.
Constant Proportion Debt Obligations (CPDOs)

The CPDO is a fully funded structured credit product. A special purpose vehicle (SPV) issues floating rate notes
and receives par from the investors. The proceeds are held in a cash account as collateral for a long position (i.e.,
seller of protection) in a portfolio of CDS. For the “plain vanilla” index CPDO, the portfolio is composed of equal
shares of the CDX North American and iTraxx European investment grade five-year CDS indices. This portfolio
is sometimes known as the Globoxx index. The notional size of the long position is a multiple of the size of the
cash account, and in this sense a CPDO is leveraged. The maturity of a CPDO is typically ten years. Leverage is
adjusted dynamically over the lifetime of the CPDO. Each day, the manager of the SPV calculates the shortfall,
which is the gap between the current net asset value (NAV) of the SPV holdings (i.e., the sum of the cash account
and the mark-to-market value of the CDS index portfolio) and the present value of all future contractual payments,
inclusive of management fees. The target leverage is given by an increasing function of the shortfall. Details of
the specification vary across issuers. But a typical formula is

Leverage is subject to an upper bound (set at 15 in the first CPDO) and is typically at the upper bound at issuance.
If the shortfall decreases to zero, the CDS portfolio is unwound and the proceeds held as cash to fund remaining
contractual payments. This is referred to as a cash-in event. On the other hand, if NAV falls to a predetermined
lower threshold (usually 10% of par), the CDS portfolio is unwound and remaining funds are paid out to the
noteholders. This cash-out event is equivalent to a default, where the recovery rate for the noteholders is (at best)
the cash-out threshold level. The CPDO contract may also impose a gap risk test to ensure that NAV can withstand
a specified widening of index spreads and a specified level of default losses. If the NAV falls below the gap risk
trigger, the SPV must partially unwind in order to restore compliance. The CDS portfolio is kept in the on-the-
run indices. Every six months, the CDX and iTraxx indices are refreshed. Names that have fallen below
investment grade or for which CDS trading is no longer liquid are dropped from the indices and replaced with
new names. On the index roll date, the SPV must purchase protection on the off-the-run index and sell protection
on the on-the-run index. (Willemann, 2009)

Example:

One of the most notable examples of a company that issued CPDOs is ABN AMRO, a Dutch bank. In 2006, ABN
AMRO launched a CPDO product called "Surf," which was marketed as offering significantly higher yields than
traditional corporate bonds, with a target of earning around 200 basis points over the Euro Interbank Offered Rate
(EURIBOR). The Surf CPDOs attracted a lot of attention and were initially very successful, leading to other
financial institutions creating similar products.
However, the financial crisis of 2007-2008 exposed the high risks associated with CPDOs. The volatility and
credit spread widening during the crisis period resulted in substantial losses for CPDO investors. The ratings of
many CPDOs were downgraded, and the market for these products collapsed. The failure of CPDOs like Surf
highlighted the dangers of complex financial instruments that promised high returns without considering the risks
involved.

The CPDO example, particularly ABN AMRO's Surf, is a cautionary tale about the potential pitfalls of investing
in complex and highly leveraged financial products without a thorough understanding of their mechanisms and
risks.

Mortgage-backed securities (MBS)

Mortgage-backed securities (MBS) are financial instruments that represent a claim on the cash flows from pools
of mortgage loans, typically residential property loans. Banks and other financial institutions issue these loans
and then sell them to a government agency or investment bank, which pools them together and creates the MBS.
These securities are then sold to investors, who receive periodic mortgage payments from the homeowners. This
structure allows for the distribution of the credit and prepayment risks associated with individual mortgages
among a wide range of investors. MBS can vary in complexity, from straightforward pass-through participation
certificates to more complex structured products. They are crucial in providing liquidity to the mortgage market,
enabling lenders to issue more housing loans.

A notable example of an entity deeply involved in the MBS market is Morgan Stanley, a leading global financial
services firm. In the years leading up to the 2007-2008 financial crisis, Morgan Stanley was actively involved in
creating, selling, and trading MBS. The firm structured and sold MBS products, earning significant profits.
However, the collapse of the housing market and the ensuing financial crisis exposed Morgan Stanley, like many
other financial institutions, to substantial losses. The firm's investments in MBS, particularly those tied to
subprime mortgages, led to massive write-downs as the value of these securities plummeted. Morgan Stanley's
experience with MBS during this period exemplifies these financial instruments' potential risks and rewards,
highlighting the importance of understanding the underlying mortgage risk and market conditions. (Vickery,
2022)
CPDO - SURF

BOND SUMMARY

The image provides detailed information on a Collateralized Debt Obligation (CDO), specifically a CPDO
(Constant Proportion Debt Obligation), named SURF 2007-BC2 A1. Specialty Underwriting & Residential
Finance B.V., part of a series from 2007, issues this security. The current balance of the CPDO is approximately
$30.8 million, priced at a bid-ask spread of 68.971214 / 69.73998. The rating has significantly deteriorated from
its original AAA/Aaa to D/Ca by S&P and Moody's, respectively, suggesting a default or near-default status. The
CPDO shows a coupon rate, or the interest paid to investors, of roughly 5.68% as of the latest coupon date, with
monthly payments due to investors. The platform indicates a collateral call of 10%. It reflects various performance
metrics, including the prepayment speed (CPR), default rates (CDR), delinquency rates (SEV), and other
indicators of the underlying loans' performance. Negative credit support suggests reduced credit loss protection,
which might explain the severe rating downgrade. This CPDO's data provides an intricate picture of the security's
financial health, which is critical for investors monitoring their investments or assessing potential risks associated
with this structured credit product.
GROUP SUMMARY
The image details a Constant Proportion Debt Obligation (CPDO) named SURF 2007-BC2 A1. It indicates that
this CPDO, issued by Specialty Underwriting & Residential Finance B.V., has a current balance of
approximately $25.6 million, a weighted average coupon (WAC) of 4.661%, and shows performance indicators
such as cumulative loss at $88,924,433 and a high percentage of modified loans at 82.61%. These figures,
including geographic distribution and borrower credit scores, suggest significant changes in the CPDO's
portfolio since issuance, providing a snapshot of its current risk and performance status.

STRUCTURAL SUMMARY

It shows that this CPDO has a tranche labelled "FLTR, STEP, IRC" and is cross-collateralized, meaning multiple
collateral pools back it. The current bond/deal balance is 69.57% of the original, and there is a note of a 100%
collateral call.

The credit enhancement section indicates a negative credit support figure of -19.84%, which is a decrease from
the original 23.70%, and the current thickness is greater than the original, suggesting changes in the protection
level against losses. The structure of the CPDO includes a no-wrap provision, indicating that there is no additional
credit protection, such as a financial guarantee.

Additionally, an expired hedge is in place, specifically a fixed-US0001M rate swap, which suggests that there
were previous attempts to manage interest rate risk. Triggers and tests for the CPDO have failed, as indicated,
which could imply breaches in covenants or thresholds set for the security's performance. Overall, the snapshot
provides a detailed look into the CPDO's complex structure, risk mitigants, and current status, which would be
necessary for investors or risk managers assessing the security.
MBS - Residential

BOND SUMMARY

The image provides detailed information on a Mortgage-Backed Security (MBS) issued by Morgan Stanley
Residential Mortgage, series 2023-1 class A9. It displays a current balance of $311,600,125 with a coupon
(interest rate) of 4%. The MBS has a high credit rating (AAA by Fitch and KBRA), indicating a low risk of
default. Payment details indicate the next payment is due on 03/25/2024 with a monthly payment frequency. The
screenshot also provides the factor rate for recent months, showing a slight decrease, which typically represents
the proportional amount of the original principal remaining in the pool of mortgage loans. Prepayment rates (VPR)
and delinquency rates (CDR, D60+) are also listed, providing insight into how quickly loans are being paid off
and the health of the loan payments, respectively. The minimum investment size is $100,000, indicating the
smallest amount one can invest in this particular MBS.
GROUP SUMMARY

The image shows a Mortgage-Backed Security (MBS) named MSRM 2023-1 A9 issued by Morgan Stanley
Residential Mortgage. The security's current balance is approximately $332.7 million, down from the original
$349.4 million. It lists a weighted average coupon (WAC) of 4.230% and a weighted average maturity (WAM) of
approximately 338 months. The loan-level data indicates a weighted average loan age (WALA) of 120 months
and a high loan-to-value ratio (HPL LTV) of 66.05%, which may suggest a level of risk. The cumulative loss on
the pool is around $766, indicating past defaults or foreclosures, and 1% of the loans are modified, possibly to
avoid further losses. The geographic concentration is mainly in California (CA), with an average borrower credit
score provided. The dashboard also displays prepayment (CPR) and delinquency rates (CDR), both useful for
assessing the prepayment speed and credit quality of the underlying loans.

STRUCTURAL SUMMARY

The details indicate that this MBS is a cross-collateralized structure without any credit enhancement, such as
excess spread, subordination, or a wrap provider. The current bond/deal balance percentage is 93.63%, and a
collateral call feature is 10%. The security's performance triggers and tests have passed the senior percent trigger
and subordinate lockout, typically designed to protect senior and subordinated tranches, ensuring that certain
performance metrics are maintained to avoid a payout event or restructuring. The 'unevaluated' status for the
cumulative loss trigger suggests that this specific test was not applied or assessed at the time of the screenshot.
The platform also notes certain structural features such as shifting interest (shifting of payments between tranches)
and a unique allocation for any excess spread, which is the interest left after all obligations have been paid. This
information is used to assess the risk and structure of the MBS for potential investors or current holders.
CPDOs (Constant Proportion Debt Obligations)

Background of Firms Using CPDOs:

• Firms that invest in CPDOs are typically looking for higher yields than what is available from conventional
fixed-income investments. These are often institutional investors, such as hedge funds, banks, and
insurance companies, with a high-risk tolerance and a sophisticated understanding of credit markets.

Requirements/Gaps/Opportunities:

• Requirements: Investors seek higher returns without proportionately increasing their risk exposure.

• Gaps: Traditional bonds or credit instruments may offer lower returns, leading investors to seek
alternative products with higher yield potential.

• Opportunities: CPDOs offer a leveraged play on credit markets, allowing investors to earn significantly
higher returns if the credit market performs well.

Expectations from Using CPDOs:

• Investors expect to achieve higher returns than those available from traditional credit investments,
leveraging the credit market's performance.

Why Conventional Products Failed:

• Conventional products may fail to offer the desired returns within the risk parameters acceptable to
sophisticated investors. CPDOs provide a structured, albeit riskier, alternative to meet these yield
expectations.

Social and Ethical Implications:

• The complexity and leverage inherent in CPDOs can lead to significant losses, as seen during the financial
crisis. The ethical considerations include the transparency of risks to investors and the systemic risk posed
by the widespread adoption of such leveraged instruments.

MBS (Mortgage-Backed Securities)

Background of Firms Using MBS:

• MBS are primarily used by banks, mortgage lenders, real estate investment trusts (REITs), and
government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. These entities use MBS to
free up capital, manage risk, and indirectly invest in the housing market.
Requirements/Gaps/Opportunities:

• Requirements: Lenders need liquidity to issue more mortgages and manage the risk of default.

• Gaps: Holding individual mortgages on their balance sheets can limit lenders' ability to issue new loans
and diversify risk.

• Opportunities: By pooling mortgages and selling the resulting MBS to investors, lenders can achieve
liquidity, spread risk, and continue lending.

Expectations from Using MBS:

• Lenders expect to convert illiquid assets (mortgages) into liquid securities, enabling further lending and
risk management. Investors in MBS seek regular income and a relatively safe investment, assuming proper
due diligence and understanding of the underlying mortgage risks.

Why Conventional Products Failed:

• Holding individual mortgages restricts capital and diversification opportunities for lenders. For investors,
traditional bonds may not offer the exact yield or diversification benefits as MBS.

Social and Ethical Implications:

• The 2008 financial crisis highlighted the risks of MBS, particularly when underlying mortgage quality is
poor or misunderstood. Ethical considerations include transparency, the quality of mortgage underwriting,
and the potential impact on homeowners and the broader economy.

Bibliography
Cont, R., & Jessen, C. (2012). Constant Proportion Debt Obligations (CPDOs) Modeling and risk analysis. Quantitative
Finance, 8-35.

Rajan, F. A. (2007). AN EMPIRICAL ANALYSIS OF THE PRICING OF COLLATERALIZED DEBT OBLIGATIONS. Allstate Professor
of Insurance and Finance, UCLA Anderson School and the NBER, 21-56.

Vickery, A. F. (2022). Mortgage-Backed Securities. Federal Reserve Bank of New York, 7-38.

Willemann, M. B. (2009). Constant Proportion Debt Obligations: A Post-Mortem Analysis. Finance and Economics
Discussion Series, 3-29.

Image source: Bloomberg