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Collateralized Debt Obligations

Collateralized Debt Obligations. Kellogg Securitization Colloquium May 5, 2003. www.mayerbrownrowe.com/cdo. Collateralized Debt Obligations. Introduction Market history Market overview CDOs are “process” not “asset class”

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Collateralized Debt Obligations

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  1. Collateralized Debt Obligations Kellogg Securitization Colloquium May 5, 2003

  2. www.mayerbrownrowe.com/cdo

  3. 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

  4. 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).

  5. Bonds Loans Emerging Market Debt Trust Preferred Project Finance Distressed Debt Middle-Market Loans Private Equity Hedge Funds Convertible Bonds Collateralized Debt Obligations • CDOs include: • CDOs may soon include: Municipal Bonds

  6. 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Collateralized Debt Obligations CDOs began in 1988 with Continental Bank’s FRENDS deal, followed by NatWest’s 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. Collateralized Debt Obligations • Underlying collateral affects the CDO • Ramp up • Collateral eligibility and profile criteria • Trading and reinvestment

  12. Collateralized Debt Obligations • Global CDO issuance rose 38% YoY • Collateralized Debt Obligations grew 74% YoY ($208BN) Banc Of America Securities’ 2002 CDO Data

  13. Collateralized Debt Obligations • Cash CDOs ($60.6BN): Banc Of America Securities’ 2002 CDO Data

  14. Collateralized Debt Obligations • Collateralized Debt Obligations (SCDOs): Banc Of America Securities’ 2002 CDO Data

  15. 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

  16. 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

  17. 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

  18. 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

  19. Collateralized Debt Obligations • Credit derivatives are • Total Return Swaps or TRS • Credit Default Swaps or CDS • Credit-Linked Notes or CLNs

  20. 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

  21. Basic Total Return Swap Customer pays Bank a specified financing charge and acquires credit risk of reference asset. Financing Charge

  22. Basic Credit Default Swap Bank/Customer “buys” credit protection on a referenced entity and pays a credit spread therefor. Credit Protection

  23. Basic Credit-Linked Note Bank issues a credit linked note that pays (or, if a credit event occurs, doesn’t pay) the principal of, and interest on, a reference asset. Bank has reduced exposure to credit risk of referenced asset. Credit Linked Note

  24. Basic Credit-Linked Note Customer purchases the note and acquires credit risk of reference asset. Credit Linked Note

  25. Collateralized Debt Obligations • ISDA’s 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

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

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

  28. Collateralized Debt Obligations • 3 Types of SCDOs • Balance Sheet SCDOs • Tranched Basket/Portfolio SCDOs • Managed Arbitrage SCDOs

  29. Class A Notes/Swaps CDS Bank CDO Class B Class C Collateralized Debt Obligations Balance Sheet SCDOs Bank obtains economic and regulatory capital relief. Investors obtain credit exposure and return

  30. Class A Notes/Swaps CDS Issuer CDO Class B Class C Collateralized Debt Obligations Tranched Basket/Portfolio SCDOs Issuer reduces credit exposure Investors obtain credit exposure and arbitrage return

  31. Class A Notes/Swaps Manager Class B CDS Bank CDO Class C Collateralized Debt Obligations Managed Arbitrage SCDOs Manager selects and manages portfolio to enhance arbitrage opportunity

  32. Collateralized Debt Obligations Comparison of Static and Managed SCDOs

  33. Collateralized Debt Obligations Comparison of Static and Managed SCDOs

  34. Collateralized Debt Obligations Comparison of Static and Managed SCDOs

  35. 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

  36. Collateralized Debt Obligations • Conclusion • Questions

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