Cash Flow CDOs and Negative Basis Trades

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Cash Flow CDOs and Negative Basis Trades March
2007 Rita Csejtey
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Table of Contents

• Cash Flow CDOs Definition Market Overview
• Cash Flow CDOs Motivation Life Cycle
• Cash Flow CDOs Credit Risk Drivers
• Differences between Cash Flow Synthetic CDOs
• Negative Basis Trades Definition
• Negative Basis Trades Underwriting
  Surveillance

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Cash Flow CDOs

• Definition
• Cash flow CDO asset-backed security backed by a
  diversified portfolio of cash bonds or loans
• CDO issuer bankruptcy-remote special purpose
  entity that issues multiple tranches of notes,
  and uses note issuance proceeds to purchase a
  diversified portfolio of bonds or loans.
• CDO notes repaid solely from interest and
  principal proceeds on bonds or loans in
  collateral portfolio.
• CDO noteholders are isolated from the credit risk
  of the asset manager, finance company or bank
  sponsoring the CDO, as the sponsoring entity
  should not be able to claw back CDOs
  collateral assets if the entity becomes bankrupt.
  
• However, CDO noteholders do not have recourse to
  the sponsoring entity payment if the cash flow
  from collateral portfolio is insufficient to
  cover interest and principal payments due on CDO
  notes.

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Sample Cash Flow CDO Diagram
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Cash Flow CDOs

• Cash flow CDOs can be classified by collateral
  asset type.
• Most typical in current market
• CDOs of ABS (asset-backed securities) secured by
  portfolios of RMBS, CMBS, and other types of ABS
  (approximately 2/3 of current new issuance)
• CLOs (collateralized loan obligations) secured by
  portfolios of large syndicated leveraged loans
  and/or middle market loans (approximately 1/3 of
  current new issuance)
• CRE CDOs secured by portfolios of large real
  estate loans
• TruPS CDOs secured by portfolios of Trust
  Preferred Securities issued by banks, insurance
  companies, and/or REITs
• EM CDOs secured by portfolios of emerging market
  sovereign and corporate debt
• Evolution of cash flow CDOs
• Bank balance sheet CLOs (mid- to late 1990s)
• Arbitrage CBOs secured by high-yield bonds (late
  1990s/early 2000s)
• CDOs of ABS (since early 2000s earlier
  transactions contained more different types of
  ABS)
• TruPS CDOs (since early 2000s)
• CRE CDOs (recent)
• Hybrid cash flow-synthetic CDOs (since late
  1990s became common in mid 2000s upon
  introduction of ISDA template for CDS referencing
  ABS)

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Cash Flow CDOs Motivation Life Cycle

• Motivation for Cash Flow CDOs
• Spread arbitrage (most common) arbitrage between
  weighted average coupon/spread on collateral
  assets and relatively low weighted average cost
  of funds on CDO notes, majority of which are
  highly rated
• Financing means to finance lending activity
• Regulatory capital relief motivation for early
  balance sheet CLOs now achieved via synthetic
  rather than cash flow CDOs
• Additionally,
• CDO collateral management fees represent stable
  revenue source for collateral managers
• CDOs offer investors access to diverse, in most
  cases managed pools of assets
• Typical Cash Flow CDO Life Cycle
• Warehousing Period (collateral manager begins to
  accumulate collateral assets pre-closing)
• CDO Closing Date (CDO issuer issues notes and
  purchases collateral with proceeds)
• Ramp-up Period (CDO issuer acquires remainder of
  collateral portfolio)
• Effective Date (CDO portfolio fully ramped up)
• Reinvestment Period (for managed deals, several
  years during which collateral manager may
  reinvest collateral sales proceeds and
  amortization proceeds in replacement collateral)
• Non-call Date (date after which CDO notes may be
  called, generally at the equity/residual tranche
  holders option)
• Amortization Period (collateral proceeds are used
  to gradually retire CDO notes)
• Legal Final Maturity (CDO notes legally due set
  far beyond notes expected maturity)

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Cash Flow CDOs Credit Risk Drivers

• IMPORTANT
• Credit exposure is to a specific CDO tranche,
  rather than just to the CDO portfolio or issuer.
• Certain credit risk drivers are shared by holders
  of each tranche of notes issued by a CDO
• Collateral portfolio performance (dependent on
  credit quality and degree of correlation between
  bonds or loans in portfolio)
• True sale of assets in collateral portfolio to
  CDO issuer
• Perfection of CDO issuers security interest in
  collateral assets
• Bankruptcy-remoteness of CDO issuer (look for
  properly structured special purpose entity CDO
  issuer should be prohibited from incurring any
  non-CDO related liability, whether through
  engaging in non-CDO related business activities
  or issuing non-CDO related debt)
• Presence of excess spread (excess spread excess
  of spread on collateral assets over spread on CDO
  liabilities)
• Other credit risk drivers are specific to each
  tranche of notes issued by the CDO
• Subordination level

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Credit Risk Driver Cash Flow Waterfall(s)

• Cash Flow Waterfall(s) section of CDO Indenture
  (primary legal document) that governs the
  priority of payments to the CDOs obligors,
  including holders of various tranches of CDO
  notes, from finite interest and principal
  proceeds yielded by assets in the collateral
  portfolio over the life of the CDO.
• Generally have 2 separate waterfalls
• Interest waterfall specifies order in which
  collateral interest proceeds are distributed to
  CDO obligors
• Principal waterfall specifies order in which
  collateral principal proceeds are distributed to
  CDO obligors
• Coverage Tests
• Most waterfalls incorporate interest coverage and
  principal coverage tests to protect senior
  tranches of notes.
• If these are breached (indicating that the
  transaction has not performed as expected), cash
  flows are diverted from junior classes of notes
  and the residual/equity tranche to senior classes
  of notes.

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Simplified Cash Flow CDO Waterfall
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Sample Cash Flow CDO Waterfall

• Collateral Interest Proceeds
• Trustee and admin fees (6 bps per annum)
• Hedge payments
• Senior management fees (15 bps per annum)
• Class A current interest
• Senior overcollateralization interest coverage
  tests (redeem class A until in compliance)
• Class B current interest
• Mezzanine coverage tests (redeem class A, then
  class B until in compliance)
• Class B deferred interest, if any
• Class C current interest
• Subordinate coverage tests (redeem class A, then
  class B, then class C until in compliance)
• Class C deferred interest, if any
• Subordinate management fees (15 bps per annum)
• After year 10, redeem notes in reverse sequential
  order using 60 of remaining interest proceeds
• Remainder to income (residual) notes

• Collateral Principal Proceeds
• Unpaid trustee and admin fees
• Unpaid hedge payments
• Unpaid senior management fees
• Class A current interest shortfall
• Senior overcollateralization interest coverage
  tests (redeem class A until in compliance)
• Class B current interest shortfall
• Mezzanine coverage tests (redeem class A, then
  class B until in compliance)
• Class B deferred interest, if any
• Class C current interest shortfall
• Subordinate coverage tests (redeem class A, then
  class B, then class C until in compliance)
• Class C deferred interest, if any
• During Reinvestment Period, reinvestment of sales
  and amortization proceeds from collateral
• After Reinvestment Period, sequential paydown of
  class A, B and C notes
• Unpaid subordinate management fees
• Remainder to income (residual) notes

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Differences Cash Flow vs. Synthetic CDOs

• Losses
• A CDO tranche will experience a loss if (and
  when) interest and principal proceeds on
  performing collateral assets recoveries on
  defaulted assets are insufficient to cover
  interest and principal due on the tranche.
• Given that principal on CDO notes is not due
  until legal final maturity in most instances and
  interest due on more junior classes of notes can
  be deferred and capitalized, it may be difficult
  to specify severity of loss on an impaired CDO
  tranche until the final maturity of the CDO
  transaction.
• Losses on defaulted collateral are not
  quantifiable as quickly as losses on synthetic
  CDOs.
• Forced sale of defaulted and potentially illiquid
  collateral assets within a specific time frame
  may depress recoveries.
• May take time to realize recoveries on worked-out
  assets.

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Additional Differences Cash Flow vs. Synthetic
CDOs

• Credit risk is affected by waterfall mechanics,
  coverage tests, and excess spread specific to
  each CDO, in addition to collateral/reference
  portfolio performance and subordination/attachment
  level.
• Individual cash flow CDO tranches credit
  performance affected not only by absolute level
  of defaults and recoveries on collateral
  performance, but also by timing of defaults and
  recoveries.
• Credit exposure to cash flow CDOs reduced over
  time through gradual amortization of CDO
  tranches, rather than through bullet maturity
  typical of synthetic CDOs.
• Importance of legal factors (bankruptcy
  remoteness of CDO issuer true sale of collateral
  assets perfection of security interest in
  collateral assets) to likelihood of repayment
• (Note these factors are also relevant to credit
  risk of CLNs issue by SPE)
• Cash flow CDOs characterized by delayed
  realization of losses on defaulted collateral
  assets defaulted assets remain on cash flow
  CDOs balance sheet until worked out or sold no
  mandatory cash settlement mechanism to determine
  recovery value within a certain time frame.
• (Implication difficult to size losses exactly
  on a cash flow CDO tranche midway through the
  life of the CDO, even if level of defaulted
  assets (net of expected recoveries) reaches
  subordination percentage of tranche)
• Excess spread may offset portion of the losses on
  the collateral portfolio.

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Negative Basis Trades Definition Motivation

• A negative basis trade exists when a monoline
  sells credit protection (via a credit default
  swap) on a tranche of a cash flow CDO.
• Called negative basis trade due to negative
  basis between spread over LIBOR of underlying CDO
  tranche (higher) and premium paid for CDS
  protection on tranche (lower)
• Motivations of various parties
• Funder (often the U.S. branch of a non-U.S.
  bank)
• Relatively low-risk source of income
• Relatively low-risk way to enter CDO market
• Regulatory capital relief for existing CDO
  positions on balance sheet
• Monoline
• Revenue source means to earn premium,
  particularly given that market demand for
  financial guaranties (wraps) on CDO tranches
  has diminished in recent years
• Access to cash flow CDO risk monolines do not
  have balance sheet on which to hold funded CDO
  notes
• Means to diversify CDO book if concentrated in
  synthetic CDOs
• CDO structurer (investment bank)

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Sample Negative Basis Trade

• At closing, new cash flow CLO issues 400MM in
  notes, including 300MM, AAA rated Class A-1
  tranche with coupon of 3-month LIBOR 24 b.p.
  per annum
• Based on pre-closing discussions, funding bank
  buys entire Class A-1 tranche. Bank will hold
  Class A-1 notes until they are fully retired
• Funder receives LIBOR 24 b.p. coupon on
  outstanding balance
• Based on pre-closing discussions, monoline sells
  credit protection via CDS on entire Class A-1 to
  funding bank.
• (More specifically, CDS protection is sold by a
  series of a multi-series master trust, whose
  obligations under the CDS are backed by an
  insurance policy issued by the monoline.)
• Monoline receives 8 b.p. per annum premium on
  outstanding balance
• Funding cost (i.e. funders net earnings per
  annum)
• (24 b.p. 8 b.p.) x outstanding balance
• 16 b.p. x outstanding balance
• Pricing
• Pricing on underlying CDO tranches is
  market-driven function of where comparable
  tranches of similar deals have priced market
  demand for a given CDO/CDO tranche, etc.
• For negative basis trades, division of spread
  (over LIBOR) on underlying CDO tranche between
  monoline and negative basis trade funder is
  individually negotiated

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Negative Basis Trades features of interest

• AAA rating on referenced CDO tranche (generally
  desire higher AAA attachment point)
• Collateral portfolio to consist of pre-approved
  asset class(es) must have expertise to evaluate
  collateral credit quality
• Static transactions attractive, as they eliminate
  uncertainty regarding future composition of
  collateral portfolio
• For managed transactions, strong collateral
  manager with expertise in CDO collateral asset
  class(es) and satisfactory, relevant track record
  
• Collateral eligibility guidelines (and collateral
  reinvestment guidelines for managed transactions)
• Static-out trigger causing managed CDO to
  become static if losses exceed pre-determined
  level
• Satisfactory reporting to facilitate transaction
  surveillance
• Voting rights would prefer full control rights
  need consent rights on certain issues
• Satisfactory risk-reward profile
• Make-whole premium from funder/negative basis
  trade counterparty if CDS is terminated early

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Negative Basis Trades Underwriting Process

• Steps common to both synthetic CDO and cash flow
  CDO/negative basis trade underwriting process
• Evaluation of credits in collateral/reference
  portfolio
• Run risk-adjusted return on capital (RAROC)
  model, taking into account portfolio credit
  quality, tranche subordination/attachment point,
  premium rate, duration of exposure and other
  transaction parameters
• Preparation of credit report and presentation to
  credit committee
• Review and negotiation of credit default swap
  confirm and other ISDA docs
• Additional steps needed to underwrite cash flow
  CDOs
• Cash flow modeling (cash flow projections) based
  on waterfalls and collateral characteristics of
  underlying transaction
• Document review in addition to negotiating ISDA
  docs for negative basis trade CDS, must review
  underlying cash flow CDOs key documents
  (Indenture, Collateral Management Agreement,
  etc.)

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Negative Basis Trades Surveillance Process

• As for synthetic CDOs, must monitor
  collateral/reference portfolio performance.
• However, negative basis trade performance also
  depends on additional variables that must be
  monitored.
• In addition to absolute level of collateral
  portfolio defaults and recoveries, performance of
  any given cash flow CDO tranche is influenced by
• default and recovery timing,
• presence (or erosion) of excess spread,
• whether or not overcollateralization and/or
  interest coverage tests are triggered, etc.
• Monoline incurs a loss to the extent that the CDO
  issuer fails to pay timely interest or ultimate
  principal on the tranche of notes referenced in
  the negative basis trade.
• Rely on Trustee reports (which show compliance
  with overcollateralization and interest coverage
  test, collateral quality tests, etc.) and all
  other reports and notices provided to noteholders
  to monitor transaction performance and payments
  to each tranche of notes issued by underlying
  notes.
• Generally have access to Trustee websites.

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• THE VIEWS AND OPINIONS EXPRESSED HEREIN ARE
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  GROUPS AFFILIATES ASSUME ANY LEGAL LIABILITY OR
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  DISCLOSED OR DESCRIBED HEREIN.