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Structured Finance: Synthetic ABS

Structured Finance: Synthetic ABS. Prof. Ian Giddy New York University. Structured Finance. Asset-backed securitization Corporate financial restructuring Structured financing techniques. Collateralized Debt Obligations. Collateralized loan obligations (CLOs)

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Structured Finance: Synthetic ABS

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  1. Structured Finance:Synthetic ABS Prof. Ian Giddy New York University

  2. Structured Finance • Asset-backed securitization • Corporate financial restructuring • Structured financing techniques

  3. Collateralized Debt Obligations • Collateralized loan obligations (CLOs) • Collateralized bond obligations (CBOs)

  4. Collateralized Debt Obligations • Cash flow backed CLOs and CBOs • Market value backed CBOs • Synthetic CLOs

  5. Cash Flow Backed CLOs Motivations: Free up capital Lower cost of funding Distressed loan arbitrage (3rd party sponsors) BANK (SELLER) LOANS SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE ISSUES LOANS ASSET-BACKED CERTIFICATES

  6. CLO Transaction Structure

  7. CLO Rating Criteria • Initial Review • Originator’s credit evaluation system • Pool composition & stress testing • On-Site Due Diligence • Legal Integrity • Bankruptcy-remoteness of SPV • Validity of asset transfer to SPV • Perfection of security interests in underlying collateral • Determining Credit Enhancement

  8. Source: Fitch, ”Bank CLOs: an Overview”

  9. LOANS Cash flow Backed CLOs CREDIT ENHANCEMENT Senior-Sub with priorities of cash flows Cash reserve accounts Letters of credit Guarantees SPV Investors Cash flows ABS flows

  10. Senior-Sub CLO Structure

  11. Cash Flow Backed CBOs Motivation: Cash flow arbitrage (bonds have good returns relative to risk, but may be illiquid) MANAGER BONDS SALE SPECIAL PURPOSE VEHICLE ISSUES BOND ASSET-BACKED PORTFOLIO CERTIFICATES

  12. Cash Flow Backed CBOs Cash flow CBOs are built around a pool of assets with predictable cash flows. As such, these structures are restricted to investments that meet minimum credit quality, tenor and expected recovery characteristics. The analysis of a cash flow deal and determination of credit enhancement is based on the expected probability of default, severity of loss, and timing of default and recovery of the assets in the pool. The ongoing market price of collateral assets is not important in a cash flow deal. Instead, it is the ability of each asset to pay scheduled principal and interest that makes these deals successful.

  13. BONDS Cash Flow Backed CBOs MANAGER Selects portfolio Collateral cash flows meet ABS interest & principal needs SPV Investors Cash flows ABS flows

  14. BONDS Market Value Backed CBOs Motivation: Price arbitrage (bonds are underpriced, and tradeable) MANAGER SALE SPECIAL PURPOSE VEHICLE ISSUES BOND ASSET-BACKED PORTFOLIO CERTIFICATES

  15. Market Value CBOs A market value CBO can be generally described as an investment vehicle that capitalizes on the arbitrage opportunities that exist between high yielding investments and the lower cost funds of highly rated debt. The transaction is typically capitalized with multiple classes of rated debt and a layer of unrated equity and invests in a pool of investments that is diverse in obligor, industry, and, frequently, asset class. In order to gauge the performance of the transaction, the asset manager will mark the value of each investment to market on a regular basis, usually weekly or biweekly.

  16. BONDS Market Value Backed CBOs MANAGER Trades bonds to meet interest & principal needs SPV Investors ABS flows Cash flows

  17. Characteristics of Market Value CBOs • Market value transactions are often collateralized by leveraged loans, high-yield bonds, mezzanine debt, distressed debt, and public and even private equity. • Market value transactions are less restrictive with respect to cash flow requirements, credit quality, and maturity of the collateral. • The manager can trade the securities.

  18. Rating Agencies Analyze Price Volatility to Determine CE Requirements

  19. Advance rates determine how much rated debt can be issued against the market value of an asset.

  20. Example of Market Value CBO Asset Mix and Financing

  21. Asset-Backed Securities:The Typical Structure FORD (SPONSOR) LOANS. Servicing Agreement SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE ISSUES LOANS. ASSET-BACKED CERTIFICATES

  22. The Alternative: Synthetic ABS DB (Originator) REFERENCE POOL OF LOANS (Stay on balance sheet) CREDIT SWAP AGREEMENT SPECIAL PURPOSE VEHICLE ISSUES TOP QUALITY ASSET-BACKED INVESTMENTS CERTIFICATES

  23. Synthetic ABS or Collateralized Loan Notes • CLNs are SPV debt backed by the credit of the selling bank (or better) • No loans are sold to the SPV • But performance is based on the performance of a reference pool of loans • If the reference credits perform, full debt service is made on the CLN • If the reference credits default, the CLN is deemed “defaulted”and payment is halted.

  24. Synthetic ABS GERMAN BANK (Originator) REFERENCE POOL OF LOANS (Stay on Balance Sheet) CREDIT SWAP AGREEMENT SPECIAL PURPOSE VEHICLE TOP QUALITY INVESTMENTS ISSUES ASSET-BACKED CERTIFICATES

  25. Synthetic ABS GERMAN BANK (Originator) REFERENCE POOL OF LOANS (Stay on Balance Sheet) PROTECTION against POOL DEFAULTS EURIBOR plus “PREMIUM” SPECIAL PURPOSE VEHICLE TOP QUALITY INVESTMENTS ISSUES ASSET-BACKED CERTIFICATES

  26. Credit Swaps in Synthetics: Doubts • Problems with the collateral • Debates about “events of default” • Workouts and other pre-default losses • Problems with the sponsor bank • Obtaining title to the collateral • Those “high quality investments” • And all those swaps

  27. Typical Credit Default Swap Arrangement BANK SPV REFERENCE POOL OF LOANS ABS Deposit and credit guarantee The guarantee: • Pledge of a deposit in the sponsor bank • Part or all of that deposit will be forfeited if there are pool losses • “Losses in the transaction are defined as amounts written off in compliance with the bank’s usual procedures”

  28. Leveraged CDO (Super Senior Tranche)

  29. Promises, Promises

  30. Promising

  31. Case Study: Global High Yield Bond Trust • What is the legal structure of this deal? • What are the assets? • What are the different classes of securities, and their terms? • How do the synthetic CLOs work? (Draw a diagram) • Should investors buy the subordinated tranche?

  32. Global High Yield Bond Trust

  33. www.stern.nyu.edu

  34. www.giddy.org

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