Risks to Monitor in Structured Finance

Investors of CDOs must note the risks involved in such instruments.  Many were brought to light during the credit crisis in 2008.  They are:

• Default risk of the underlying collateral - This is greater for the equity tranches.
• Financial engineering risk - In 2008, the subprime mortgages, which were the underlying assets of the CDOs, began to default.  This caused most of the CDO tranches to suffer a drawdown.
• Downgrade risk - The credit raters, Standard & Poor's, Moody's and Fitch's may reduce the rating of the CDO tranches.
• CDO default rates - In a one year period in 2008, more than 4,000 CDO securities worth $351 billion were downgraded or defaulted.
• Differences in periodicity - The frequency of interest payments from the collateral may not match the payments on the CDO securities.
• Difference in payment dates - The interest payment schedule from the collateral may not match the payment schedule on the CDO securities.
• Basis risk - The risk when interest payments are calculated on the underlying assets of the CDO based on a different index than the payments on the CDO securities.
• Spread compression - When credit spreads become lower and result in reduced interest payments from the underlying collateral.
• Yield curve risk - Any yield curve shifts or changes in steepness affect CDOs if their underlying assets have different maturity dates.