Collateralized Debt Obligations

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Collateralized Debt Obligations
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CDOs

• A collateralized debt obligation (CDO) is an ABS
  backed by a pool of one or more classes of debt
• o A collateralized bond obligation (CBO) has
  bonds and bond-like instruments as collateral
• o A collateralized loan obligation (CLO) has
  loans as collateral
• Types of debt serving as collateral in CDOs
• o Debt and loans
• ?? Secured and unsecured
• ?? Any type of borrower corporate, residential
  mortgage, emerging market, sovereign, etc.
• o Structured Finance CDOs (CF CDOs) are backed by
  securitized products
• ?? MBS
• ?? ABS
• ?? REITs

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CDOs

• Motivations for CDOs
• o Balance sheet management
• o Arbitrage
• ?? Cash flow (ACF CDOs)
• ?? Market value (AMV CDOs)
• Forms of CDOs
• o Cash (involving actual sale of assets to the
  CDO)
• o Synthetic (using credit derivatives to populate
  the collateral pool)

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CDOs

• Life cycle of CDOs
• o Ramp-up period (security sales are used to by a collateral
  manager to populate the CDO with debt assets
• o Reinvestment / Revolving period (5 years)
  principal received on collateral is used to
  finance the acquisition of new assets
• o Wind-down period no new assets acquired, and
  collateral is either sold on the market or
  retired as it is paid off to fund the pay-down of
  outstanding liabilities

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Balance Sheet CDOs

• The objective of a balance sheet CDO is balance
  sheet management by the owner of the assets
• o The seller of the assets is a financial
  institution (usually a bank) that is seeking to
  divest certain assets from its portfolio through
  true sales leading to the issuance of securitized
  products
• o Usually CLOs sometimes called Bank CDOs or
  Bank CLOs
• o Alternative to loan syndication or loan sales
  usually to satisfy non-bank investor appetite for
  bank loans as investments

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Balance Sheet CDOs

• Typical features
• o Bank conveys assets to master trust SPV
• o Typical assets
• ?? Selected by the bank no independent
  collateral or portfolio manager
• ?? 200-400 loans with total size of USD1 4
  billion
• ?? Quality controlled (well return to this),
  usually though average rating and diversity
  scoring
• o Credit enhancements
• ?? Subordination typical balance sheet CDOs have
  a senior tranche, one or more subordinated
  mezzanine tranches, and a residual tranche all
  tranches enhance the quality of those senior to
  them
• ?? A cash collateral account (CCA) funded by the
  seller
• ?? Excess spread interest earned on collateral
  interest paid on senior and subordinated tranches
  fees/expenses
• o Averages around 0.5 per annum for many
  structures
• o In a good year, this excess spread goes to the
  owner of the residual tranche, the bank / seller
• o In bad years, the spread can be diverted to
  other tranches by seniority

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Balance Sheet CDOs

• CLOs existing as early as 1990
• The first traditional balance sheet CDO is
  nevertheless regarded as the Rose Funding
  transaction done in 1996 by National Westminster
  Bank PLC
• o 5 billion structure based on 200 loans
  (15-20 of NatWests loan portfolio)
• o Classes of notes included a senior revolver and
  senior fixed note and investors in 17 countries)

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Balance Sheet CDOs

• Rose Funding provides a model for the typical
  structure of a balance sheet CLO

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Balance Sheet CDOs
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Balance Sheet CDOs Typical Waterfall

• Two maturities are usually issued for each class
  of security
• o Suppose the CDO has a senior A class of
  securities, two classes of subordinated
  securities B and C, and a residual tranche D
• o Suppose the two maturities chosen are 3 years
  and 5 years
• o A-1, B-1, C-1, and D-1 mature in year 3, and
  A-2, B-2, C-2, and D-2 mature in year 5
• The reinvestment period(s)
• o The reinvestment period for each maturity ends
  a year before the securities are due
• o Principal payments on the collateral are
  reinvested at 100 from years 0-2
• o From years 2-4, 50 of the principal received
  on the collateral goes into a cash account as it
  is earned to finance the eventual bullet payment
  of the three-year securities and the other 50 is
  reinvested for eventual payment of the 5-year
  notes

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Balance Sheet CDOs Typical Waterfall
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Balance Sheet CDOs Rating Agency Considerations

• Rating agencies pay attention to several
  features of CDOs
• Collateral Quality
• Collateral Diversification
• o Obligors are divided by industry classification
  
• o Securities across industry groups are presumed
  uncorrelated, whereas securities within groups
  are presumed perfectly correlated
• o A diversity score is calculated using a
  binomial process for defaults on each industry
  classification, and the collateral must meet
  minimum diversity requirements at all times

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Balance Sheet CDOs Rating Agency Considerations

• Likelihood of Default
• o Average rates across bonds in the portfolio are
  often the basis for asset quality tests
• o Some rating agency-specific criteria also may
  be used, such as Moodys Weighted Average Rating
  Factor (WARF)
• Recovery Rates
• o Minimum recovery rates per asset may also be
  asset quality tests
• The rating agencies often ties these three
• variables together
• o Maximum expected loss for each CDO tranche
• o Loss distribution tests for each CDO tranche

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Balance Sheet CDOs Rating Agency Considerations

• Asset quality tests govern the conveyance of
  assets into the CDO during the ramp-up and
  reinvestment periods
• A structure may be forced to liquidate
  collateral and wind down early by repaying debt
  holders immediately if
• o the seller cannot recharge the structure during
  a reinvestment period
• o the seller is downgraded
• o the assets degrade so that the existing assets
  fail a quality test
• In addition, the CDO for rating purposes must
  satisfy coverage tests or the structure may
  terminate and wind-up early
• o O/C Tests the O/C ratio for a given tranche
  must exceed the O/C trigger for that tranche
• ?? The O/C ratio is the collateral principal
  allocated to a tranche divided by the total
  principal allocated to all tranches senior to the
  one in question (including the tranche being
  evaluated)

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Balance Sheet CDOs Rating Agency Considerations

• Asset quality tests govern the conveyance of
  assets into the CDO during the ramp-up and
  reinvestment periods
• A structure may be forced to liquidate
  collateral and wind down early by repaying debt
  holders immediately if
• o the seller cannot recharge the structure during
  a reinvestment period
• o the seller is downgraded
• o the assets degrade so that the existing assets
  fail a quality test

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Balance Sheet CDOs Seller/Sponsor Rationale

• The seller typically retains the residual or
  most deeply subordinated tranche and funds the
  CCA on its balance sheet
• If the capital structure is such that 1 of the
  collateral is allocated to the residual and 1 is
  in the CCA, that means that the bank is funding
  2 of the first risks in the structure
• As long as the structure meets all its tests,
  the seller earns the excess spread
• The real motivation for balance sheet CDOs,
  however, is to improve ROE by reducing regulatory
  capital, which is the lesser of the capital
  charge on the unlevered investment or 100 of the
  liability

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Balance Sheet CDOs Seller/Sponsor Rationale

• Example a bank has 100 million in loans on
  its balance sheet earning an average interest
  rate of LIBOR125 with a funding cost of LIBOR25
  
• o On the banks balance sheet, the net interest
  income or net spread is 100 bps
• o The required regulatory capital is 8 of 100
  million
• o ROE 1 net spread / 8 mn capital charge
  1/8 12.5 per annum
• Example the bank considers selling the loans
  to an independent CDO
• o Suppose the CDO has expenses and fees of 25
  bps, so the funding cost for the loans sold to a
  SPE is LIBOR50 the net spread is now 75 bps
• o Suppose the bank retains a 2 residual interest
  in the CDO, or 2 million, which is deducted from
  the banks equity base
• o The capital charge is 2 million (not 8 of 2
  million)
• o ROE 0.75 net spread / 2 mn capital charge
  .75/2 37.5

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Arbitrage CDOs

• The objective of an arbitrage CDO is to try and
  generate trading profits from perceived
  arbitrage opportunities and trading
  opportunities specifically, to achieve an
  all-in refinancing cost on issuing securities
  that is below the cost of purchasing them
• o There are multiple asset sellers, and the
  sponsor of the structure is now a professional
  portfolio manager the Collateral Manager and
  not the selling institution
• o Usually CBOs comprised of tradeable securities

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Arbitrage CDOs

• Typical features
• o Typical assets
• ?? Selected by the collateral manager, which is
  often a commercial bank, an i-bank, or an
  insurance company
• ?? 20-100 securities with average total size of
  around USD150 million
• ?? Often specialized by type of collateral
  e.g., many arbitrage CBOs are predominantly
  focused on high-yield debt
• o Two basic flavors depending on the nature of
  the arbitrage or trading opportunity to be
  exploited
• ?? Cash flow arbitrage CDOs
• o Static
• o Dynamic
• ?? Market value arbitrage CDOs

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Static Arbitrage Cash Flow CDOs (ACF CDOs)

• ACF CDOs are generally heavily influenced by
  rating agency criteria
• o A CDO manager chooses a target rating for a
  tranche and then determines the credit
  enhancements required to support that rating
• o Example Moodys publishes a matrix that allows
  a CDO manager to determine what percentage of the
  securities can default in a tranche before a
  rating downgrade will occur on the corresponding
  class of securities the matrix gives these
  percentages as a function of the WARF and
  diversity score of the collateral in the
  portfolio

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Static Arbitrage Cash Flow CDOs (ACF CDOs)

• Typical waterfall
• o Suppose the collateral manager buys 20
  securities at 5 million each with an average BB
  rating and an average fixed yield that can be
  swapped for LIBOR 300bps
• o A senior-sub structure is used with 20
  subordination
• o LIBOR100 is allocated to the senior tranche
• o The residual / sub tranche gets the excess
  spread less any default-related losses

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Static Arbitrage Cash Flow CDOs (ACF CDOs)
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Static Arbitrage Cash Flow CDOs Funding Problems

• Static cash flow arbitrage CDOs have two
  problems
• o The ramp-up period during which the CDO manager
  is moving toward full investment is usually
  characterized by negative carry
• ?? A standard CDO is fully funded at closing
  this means the net proceeds from issuing
  securities is adequate to acquire the target
  portfolio
• ?? This does not mean the target portfolio
  actually has been acquired
• ?? As managers acquire the portfolio between the
  closing and effective date, proceeds from the
  securities issue sit idly in money market
  instruments
• ?? Funding costs are excessive significant net
  interest income can be lost during the ramp-up
• ?? Ameliorated if securities do not have to be
  serviced, but this can be a drawback for
  investors
• o Time pressure to become fully invested by
  deadline for end of ramp-up period

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Static Arbitrage Cash Flow CDOs Funding Problems
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Dynamic Arbitrage Cash Flow CDOs

• Reduce excess funding costs by matching net
  interest obligations on liabilities with net
  interest income on assets (both invested and not)
  

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Dynamic Arbitrage Cash Flow CDOs
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Arbitrage Market Value CDOs (AMV CDOs)

• The basic idea behind an AMV CDO is the same as
  a ACF CDO, but the mechanics are a little
  different
• In an AMV CDO, changes in the market values of
  the securities lead to changes in the values of
  the SPEs obligations not a pure cash flow
  waterfall
• In an AMV CDO, the market value of the
  collateral times the advance rate must exceed the
  book value of liabilities
• o The advance rate is the haircut or adjustment
  to the market value of assets held as collateral
  as a cushion against market risk
• o Requiring that the haircut market value exceed
  book value builds in a type of O/C into the
  structure

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Arbitrage Market Value CDOs (AMV CDOs)

• In the event of a shortfall, the CDO manager
  must liquidate assets to bring the required O/C
  back up to the minimum
• o One dollar of par value liquidated only reduces
  the shortfall by one minus the advance rate
• o The amount of collateral that must be
  liquidated to cure a shortfall thus is
• ()RateAdvanceShortfall-1
• Rating agencies require that a market value CDO
  adhere to the minimum O/C requirement, as well as
  meeting a minimum net worth test each quarter