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2023-10-31 Meeting notes

2023-10-31 Meeting notes

Owned by Elisa Kendall
Last updated: Oct 31, 2023

Date

Attendees



Agenda

1) Use Case reminder

2) Where we are on our road map. 

3) Open Action Items

4) JIRA Issues Review - https://jira.edmcouncil.org/projects/DER/issues/DER-10?filter=allopenissues

5) Todays content discussion.



6) For next week.

Proceedings:

Today we continued research on DER 138. 

According to Bing / Copilot,: 

A CDO tranche is a portion of a collateralized debt obligation (CDO) that has a specific level of risk and return. A CDO is a type of financial instrument that pools together different kinds of debt, such as mortgages, corporate bonds, or loans, and sells them to investors1

A CDO tranche becomes liable for losses when the total amount of defaults or losses in the underlying debt pool exceeds a certain threshold, called the attachment point. The attachment point is expressed as a percentage of the total value of the debt pool. For example, if a CDO tranche has an attachment point of 10%, it means that it will start to lose money when the cumulative losses in the debt pool reach 10% or more234

The higher the attachment point, the lower the risk and the return for the tranche. The lower the attachment point, the higher the risk and the return for the tranche. The most senior tranches have the highest attachment points and are paid first from the cash flows of the debt pool. The most junior tranches have the lowest attachment points and are paid last from the cash flows of the debt pool. The junior tranches also bear the first losses when defaults occur in the debt pool56

Sources include: bing.com, fincyclopedia.net, ise.ufl.edu, http://uryasev.ams.stonybrook.edu/wp-content/uploads/2012/10/structuring_CDO_JCR_oct12.pdf, https://en.wikipedia.org/wiki/Collateralized_debt_obligation, https://pages.stern.nyu.edu/~igiddy/articles/cdos_explained.pdf


From ChatGPT/GPT4: 

You're correct in pointing out that a tranche in a CDO is not a legal entity and thus cannot be "liable" in the traditional legal sense of being responsible or answerable under law. The term "liable for losses" in the context of CDO tranches is used in a financial or economic sense rather than a legal one.

When it's said that a tranche becomes "liable for losses," it means that the tranche starts to absorb or incur financial losses due to defaults or impairments in the underlying assets. This is based on the contractual agreements and the structuring of the CDO, which dictate the order in which losses are allocated to different tranches. These contracts are typically detailed in the offering documents of the CDO. 

The legal obligations and liabilities in the context of a CDO are generally associated with the parties involved, such as the issuer, underwriter, and investors, rather than the tranches themselves. For instance, investors have the legal obligation to pay for their investment, and issuers have certain legal obligations regarding disclosure and management of the CDO.

Therefore, when discussing a CDO tranche being "liable for losses," it's important to interpret this as a financial mechanism for loss allocation rather than a legal responsibility or liability in the conventional sense.

Question: how is a cdo tranche liable for losses if it's not a legal entity?

Answer: 

A Collateralized Debt Obligation (CDO) tranche isn't a legal entity, but it's a segment of a structured finance product, which is often a legal entity itself, or held within a legal entity. Here's how it works:

  1. Creation of a CDO: A CDO is created by pooling various debt assets like bonds, loans, and mortgages into a single entity, often a Special Purpose Vehicle (SPV). This SPV is usually a legally separate entity created to hold the assets and distribute the risks and returns among investors.

  2. Tranching: The pooled assets within the CDO are then sliced into different tranches. Each tranche has a different level of risk and return. The tranches are typically arranged in a hierarchy based on the level of credit risk: senior tranches (least risky), mezzanine tranches, and equity or junior tranches (most risky).

  3. Liability for Losses: The liability for losses in a CDO is structured through the contractual agreements that create the tranches. When the underlying assets in the CDO experience losses, these losses are allocated to the tranches starting with the equity or junior tranche first, then moving up to mezzanine, and finally to the senior tranche if the losses are severe enough. The legal entity holding the CDO has contractual obligations to distribute losses and payments in this manner.

  4. Investor's Role: Investors buy into a tranche based on their risk tolerance and expected returns. They are essentially buying rights to the cash flows generated by the CDO's assets, and they also accept the risk of loss associated with those assets. The terms of these investments are spelled out in the legal documents that establish the CDO and its tranches.

  5. Enforcement: The legal structure of the CDO and the contractual agreements binding the investors dictate how losses are distributed among the tranches. The trustee or managing entity of the CDO enforces these agreements.

In essence, while a tranche itself is not a legal entity, it is part of a structured financial arrangement with well-defined legal and contractual frameworks that dictate how losses are handled and distributed among investors.



We can leverage the above to complete the DER-138 resolution either Friday or next week.

Decisions:

Action items

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