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A bespoke portfolio is a table of reference securities. A bespoke portfolio may serve as the reference portfolio for a synthetic CDO arranged by an investment bank and selected by a particular investor or for that investor by an investment manager.
Bespoke portfolios can have very different default
/ref> CDO tranches linked to bespoke portfolios continued to trade after the financial crisis of 2007–08 but in considerably reduced amounts.
Oliver Cousseran and Imene Rahmouni. Banque de France Financial Stability Review, No. 6. June 2005 p. 48 Also, arrangers like CDOs on bespoke portfolios because they are relatively easy to set up. Traditional CDOs take three to six months to arrange and typically cost $2 to $4 million in legal, rating and marketing costs, whereas single tranches on bespoke portfolios can be arranged in four to six weeks and upfront costs are typically less than $500,000.
/ref> The hedge funds would do this by specifying their own bespoke portfolio and asking 5 to 10 dealers to quote bids and offers on tranches on the portfolio, usually allowing the dealers only a few hours to quote. Often both dealers would report a first-day profit on the trade. Part of the problem lies in calibrating tranches on a bespoke portfolio to observable data generated from credit CDS index tranche, index tranche prices. Matching a bespoke portfolio to a credit index can be extremely subjective. Rajan, McDermott and Roy discussed the problem and its possible solution: "... we have no insight into the value of a tranche that spans, for example, part of two index attachment points ... by being able to relate orrelationskews across a range of portfolios through their risk characteristics and maturities, one can price and hedge customized tranches of bespoke portfolios."The Structured Credit Handbook. Arvind Rajan, Glen McDermott, Ratul Roy. John Wiley & Sons Inc.- Chichester, 2007. p. 21
/ref> However, it is extremely difficult to obtain certainty as to the correlation Skewness, skew appropriate to a given bespoke portfolio. The aforementioned 2005 Banque de France report pointed out that CDO tranche issuance referencing bespoke portfolios "may have a major impact on credit spreads due to their leverage". Because CDO tranches on bespoke portfolios could have very narrow spreads between their attachment and detachment points – far less than the 3% to 5% thickness on index tranche products – they could be far more leveraged, meaning that a small movement in credit default swap spreads could cause a very large change in the value of CDO tranches linked to bespoke portfolios. This in turn meant that changes in observed correlations on index tranches caused very large scale buying of CDS protection by swaps dealers during the financial crisis, increasing instability and illiquidity.
Overview
The list of reference securities making up a portfolio is one of the primary drivers of the investment outcome of a synthetic CDO.Structured Products and Related Credit Derivatives - A Comprehensive Guide for Investors. pp254-255. Lancaster Schultz Fabozzi. John Wiley & Sons, Inc. - Chichester, 2008 Because the portfolio is not that of a corporate credit index like theCDX
The Cdx gene family, also called caudal genes, are a group of genes found in many animal genomes. Cdx genes contain a homeobox DNA sequence and code for proteins that act as transcription factors. The gene after which the gene family is named (the ...
or iTraxx, the mean default
Default may refer to:
Law
* Default (law), the failure to do something required by law
** Default (finance), failure to satisfy the terms of a loan obligation or failure to pay back a loan
** Default judgment, a binding judgment in favor of ei ...
probabilities of the reference securities, their distribution of default probabilities, their default correlation
In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistics ...
s and the recovery amounts upon default can vary greatly.
In principle, the investor chooses the reference securities and decides on the "attachment" and "detachment" pointsMerrill Lynch Credit Derivatives Handbook 2006 - Volume 2, page 4. Merrill Lynch, 14 February 2006 (that is, the amount of losses that occur before the investor suffers its first dollar of loss; and the upper limit beyond which the investor suffers no further losses). In reality, the arranger demands a good deal of input into the selection of the reference portfolio. Most arrangers manage their risks by buying and selling protection on single-name CDS or on the CDX indexes and therefore they usually avoid taking positions in CDS that cannot readily be traded.
Bespoke portfolios can have very different default correlation
In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistics ...
characteristics from credit indices with similar distributions of riskiness. Bespoke portfolios almost invariably have numbers of reference securities similar to those of the major credit indices – 100 to 125 reference securities – but bespoke portfolios can include reference securities that have highly correlated default probabilities, either because they are issued by different subsidiaries of the same parent company, because they include closely related but separate companies, or because the bespoke portfolios include much higher concentrations in single industries than occurs in credit indices.Merrill Lynch Credit Derivatives Handbook 2006 - Volume 2, page 14. Merrill Lynch, 14 February 2006 Determining the fair default correlations for a bespoke portfolio can be very difficult. The chart on the right shows that differences in correlation can greatly change the probability distribution
In probability theory and statistics, a probability distribution is the mathematical function that gives the probabilities of occurrence of different possible outcomes for an experiment. It is a mathematical description of a random phenomenon i ...
of defaults and thus change the fair value of any given CDO tranche linked to a particular portfolio.
Initially, bespoke portfolios referenced in most synthetic CDOs were static, meaning that the list of reference securities would change only because of default, because of a succession event, or because of the disappearance of a reference security or its issuer. From 2004 onwards, managed transactions were also issued. Managed bespoke portfolios are those where a third party investment manager is appointed to select the bespoke portfolio but also to buy and sell the underlying reference securities to exploit trading opportunities or avoid credit losses.
A synthetic CDO can be structured as a swap between an investor and an arranger, in which case the investor does not need to fund the purchase of the synthetic CDO notes. The majority of bespoke portfolio linked CDOs, however, are embedded into credit-linked notes that are purchased by the investor.
Market size
The overall volume of CDOs on bespoke portfolios rose rapidly in the early 2000s. In 1999, synthetic CDO issuance in total was less than $10 billion. 2005 issuance of bespoke portfolio tranches was cited by Rajan, McDermott and Roy as $294 billion.The Structured Credit Handbook. Arvind Rajan, Glen McDermott, Ratul Roy. John Wiley & Sons Inc. - Chichester, 2007. p./ref> CDO tranches linked to bespoke portfolios continued to trade after the financial crisis of 2007–08 but in considerably reduced amounts.
Cited advantages
As mentioned above, the key advantage to investors was that it allowed them to specify the reference securities in the bespoke portfolio as well as the tranche's attachment and detachment points and other characteristics. A report from the Banque de France stated that: "this avoids some of the dangers of traditional CDO structures, such as the risks of moral hazard or adverse selection in the choice of the names in the portfolio ...".The CDO market; Functioning and implications in terms of financial stabilityOliver Cousseran and Imene Rahmouni. Banque de France Financial Stability Review, No. 6. June 2005 p. 48 Also, arrangers like CDOs on bespoke portfolios because they are relatively easy to set up. Traditional CDOs take three to six months to arrange and typically cost $2 to $4 million in legal, rating and marketing costs, whereas single tranches on bespoke portfolios can be arranged in four to six weeks and upfront costs are typically less than $500,000.
Criticisms
Because CDOs linked to bespoke portfolios are, by their nature, only held by one or a very small number of investors, there is noliquid
A liquid is a nearly incompressible fluid that conforms to the shape of its container but retains a (nearly) constant volume independent of pressure. As such, it is one of the four fundamental states of matter (the others being solid, gas, a ...
market where they can be bought, sold or valued. Therefore, these CDOs are valued using mathematical models that performed poorly both before and during the financial crisis. Subsequently banking industry regulators have pointed out concerns applicable to CDO tranches on bespoke portfolios that exceed even the regulators' concerns about index-based tranches (which are referred to as "standardized products" in regulatory literature). The Basel Committee on Banking Supervision's Regulatory Consistency Assessment Programme tested banks' internal models to identify the factors "contribut ngto the observed variability in trading book RWAs". "Bespoke products" were found to "exhibit much larger variability than standardised products" with respect to value at risk dispersion.
A key reason for this was the correlation characteristics of bespoke portfolios, which by their nature were unique to the specific portfolio and inherently unobservable in the markets. Brigo, Pallavicini and Torresetti summed up the problem in their 2010 book as follows: "Bespoke corporate pools have no data from which to infer default "correlation" and dubious mapping methods are used."
One result of this was that hedge funds specializing in credit correlation were able to arbitrage tranches among dealers, buying protection from one dealer and almost immediately selling it at a profit to another dealer.Feldstein Who Speared Whale Ready to Unwind Derivatives. Anthony Effinger and Mary Childs. Bloomberg. Jan 8, 2013/ref> The hedge funds would do this by specifying their own bespoke portfolio and asking 5 to 10 dealers to quote bids and offers on tranches on the portfolio, usually allowing the dealers only a few hours to quote. Often both dealers would report a first-day profit on the trade. Part of the problem lies in calibrating tranches on a bespoke portfolio to observable data generated from credit CDS index tranche, index tranche prices. Matching a bespoke portfolio to a credit index can be extremely subjective. Rajan, McDermott and Roy discussed the problem and its possible solution: "... we have no insight into the value of a tranche that spans, for example, part of two index attachment points ... by being able to relate orrelationskews across a range of portfolios through their risk characteristics and maturities, one can price and hedge customized tranches of bespoke portfolios."The Structured Credit Handbook. Arvind Rajan, Glen McDermott, Ratul Roy. John Wiley & Sons Inc.- Chichester, 2007. p. 21
/ref> However, it is extremely difficult to obtain certainty as to the correlation Skewness, skew appropriate to a given bespoke portfolio. The aforementioned 2005 Banque de France report pointed out that CDO tranche issuance referencing bespoke portfolios "may have a major impact on credit spreads due to their leverage". Because CDO tranches on bespoke portfolios could have very narrow spreads between their attachment and detachment points – far less than the 3% to 5% thickness on index tranche products – they could be far more leveraged, meaning that a small movement in credit default swap spreads could cause a very large change in the value of CDO tranches linked to bespoke portfolios. This in turn meant that changes in observed correlations on index tranches caused very large scale buying of CDS protection by swaps dealers during the financial crisis, increasing instability and illiquidity.
See also
*Single-tranche CDO
Single-tranche CDO or bespoke CDO is an extension of full capital structure synthetic CDO deals, which are a form of collateralized debt obligation. These are bespoke transactions where the bank and the investor work closely to achieve a specifi ...
References
{{reflist Investment Derivatives (finance) Fixed-income securities Bonds (finance) Structured finance Mortgage-backed security