Collateralized Debt Obligations

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Collateralized Debt Obligations

• Kellogg Securitization Colloquium
• May 5, 2003

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www.mayerbrownrowe.com/cdo
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Collateralized Debt Obligations

• Introduction
• Market history
• Market overview
• CDOs are process not asset class
• CDOs are an application of securitization
  technology under rating agency methodology to
  underlying assets to result in rated securities

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Collateralized Debt Obligations

• CDOs include
• Collateralized Bond Obligations (CBOs)
• Collateralized Loan Obligations (CLOs)
• Collateralized Fund Obligations (CFOs) and
• Synthetic Collateralized Debt Obligations (SCDOs
  or CSOs).

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Collateralized Debt Obligations

• CDOs include

• CDOs may soon include Municipal Bonds

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Collateralized Debt Obligations
CDOs began in 1988 with Continental Banks FRENDS
deal, followed by NatWests ROSE deals
2002 CDO estimated issuance was 210Billion
1988
However, minimal CDO activity until 1993, when
market started to take off
CDO estimated current opportunity is 350Billion
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Collateralized Debt Obligations

• CDOs are balance sheet or arbitrage
• Balance sheet CDOs are a funding alternative and
  may have regulatory capital benefits, but are
  linked to sponsor
• Arbitrage CDOs are motivated by true arbitrage

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Collateralized Debt Obligations

• CDOs are cash flow or market value
• Cash flow CDOs use an overcollateralization (OC)
  ratio that measures the par amount of collateral
  adjusted for defaulted items
• Market value CDOs use an OC ratio that measures
  the market value of collateral adjusted for
  defaulted items

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Collateralized Debt Obligations

• CDOs are cash or synthetic or a combination
  thereof
• A cash CDO sells debt and equity securities and
  uses the proceeds thereof to acquire collateral
• A synthetic CDO acquires credit exposure through
  credit derivatives

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Collateralized Debt Obligations

• CDOs use a waterfall to allocate interest
  proceeds and principal proceeds
• CDOs use eligibility criteria and portfolio
  profile to regulate eligible collateral
• CDOs use collateral tests (an OC ratio and an
  interest coverage ratio) to regulate collateral
  quality

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Collateralized Debt Obligations

• Underlying collateral affects the CDO
• Ramp up
• Collateral eligibility and profile criteria
• Trading and reinvestment

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Collateralized Debt Obligations
Banc Of America Securities 2002 CDO Data

• Global CDO issuance rose 38 YoY
• Collateralized Debt Obligations grew 74 YoY
  (208BN)

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Collateralized Debt Obligations
Banc Of America Securities 2002 CDO Data

• Cash CDOs (60.6BN)

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Collateralized Debt Obligations
Banc Of America Securities 2002 CDO Data

• Collateralized Debt Obligations (SCDOs)

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Collateralized Debt Obligations

• CDOs dramatically affect markets for underlying
  collateral
• In 2002, CLOs represented 50 of the leveraged
  loan market
• ABS CDOs greatly facilitate the related ABS by
  providing the required illiquid mezzanine capital
• Previously CBOs represented over 25 of the
  high-yield bond market

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Collateralized Debt Obligations

• Synthetic Collateralized Debt Obligations (SCDOs)
  utilize credit derivatives
• Total credit derivatives are over 2TN and
  projected to grow to 4TN by 2005
• There are active and liquid markets for CDS on
  prime companies in the US and Europe
• But note the so-called 200/200 tiering

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Collateralized Debt Obligations

• Credit derivatives are an extremely sophisticated
  and powerful financial product
• However, their flexibility and novelty often
  makes their characterization more difficult
• Specifically, issues regarding whether the credit
  derivative is insurance for tax purposes or does
  it require insurance company status/regulation

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Collateralized Debt Obligations

• Synthetic CDOs use credit derivatives to acquire
  credit exposure w/o transfer or, in some cases,
  funding of asset
• CDOs, including SCDOs, are an application of
  securitization technology under rating agency
  methodology to underlying assets to result in
  rated securities

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Collateralized Debt Obligations

• Credit derivatives are
• Total Return Swaps or TRS
• Credit Default Swaps or CDS
• Credit-Linked Notes or CLNs

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Basic Total Return Swap
Bank pays Customer the total return on the
referenced assets. Bank has reduced credit risk
to reference assets, but acquires credit risk of
Customer.
Total Return
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Basic Total Return Swap
Customer pays Bank a specified financing charge
and acquires credit risk of reference asset.
Financing Charge
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Basic Credit Default Swap
Bank/Customer buys credit protection on a
referenced entity and pays a credit spread
therefor.
Credit Protection
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Basic Credit-Linked Note
Bank issues a credit linked note that pays (or,
if a credit event occurs, doesnt pay) the
principal of, and interest on, a reference asset.
Bank has reduced exposure to credit risk of
referenced asset.
Credit Linked Note
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Basic Credit-Linked Note
Customer purchases the note and acquires credit
risk of reference asset.
Credit Linked Note
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Collateralized Debt Obligations

• ISDAs 1999 Credit Derivative Definitions and
  elective Supplements regarding
• Convertible, Exchangeable and Accreting
  Obligations
• Successor and Credit Events
• Restructuring
• Draft 2002 Credit Derivative Definitions
  Adoption expected 05/03

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Collateralized Debt Obligations

• Advantages
• Avoid transfer issues (consents, etc.)
• Quicker execution?
• Simpler documentation?

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Collateralized Debt Obligations

• Disadvantages
• More complex accounting (FAS133 and DIG/ED D2
  model) and tax (NPC or financing)
• Precision?
• Legal?

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Collateralized Debt Obligations

• 3 Types of SCDOs
• Balance Sheet SCDOs
• Tranched Basket/Portfolio SCDOs
• Managed Arbitrage SCDOs

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Collateralized Debt Obligations
Balance Sheet SCDOs
Bank obtains economic and regulatory capital
relief. Investors obtain credit exposure and
return
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Collateralized Debt Obligations
Tranched Basket/Portfolio SCDOs
Issuer reduces credit exposure Investors obtain
credit exposure and arbitrage return
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Collateralized Debt Obligations
Managed Arbitrage SCDOs
Manager selects and manages portfolio to enhance
arbitrage opportunity
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Collateralized Debt Obligations
Comparison of Static and Managed SCDOs
Feature Static Managed
Trading CDS Long Only No removal or substitution CDS Long/Short Exposures added and/or removed
Excess Spread Fixed CDS premium Credit-related premium Excess spread released, trapped or used to offset losses CDS premium reflects credit and management
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Collateralized Debt Obligations
Comparison of Static and Managed SCDOs
Feature Static Managed
Liquidity Credit Events Credit Events Trading losses
Counterparty Risk Single CDS counterparty Exposure to protection buyers only One or more CDS counterparties Exposure to protection buyers and/or sellers
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Collateralized Debt Obligations
Comparison of Static and Managed SCDOs
Feature Static Managed
Portfolio Initial guidelines only Minimum WARF, WARR and/or WAS Limits on total CDS short and offset exposure, trading and concentrations
Structure Credit enhancement only OC and IC tests Limits on counterparties and required CDS documentation Ramp-up restrictions and minimum notional balance Excess spread trigger/trap
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Collateralized Debt Obligations

• Trading Criteria
• Minimum CDS reference entity ratings
• Minimum CDS premiums
• Required CDS documentation
• Maximium total CDS notional balance
• Maximum loss threshold (after which switchback
  to static)
• Identical CDS terms for offset
• Mitigated market and counterparty risk
• Required CDS removal for rating
  downgrade/negative watchlist
• Permitted substitution if portfolio
  improvement/maintenance

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Collateralized Debt Obligations

• Conclusion
• Questions