Structured Investment Vehicles

1. Structured Investment Vehicles Financial Engineering in the Bond Markets

2. Readings • The Barclay’s Capital Guide to Cash Flow Collateralized Debt Obligations • Bloomberg Readings

3. Structured Investment Vehicles(SIVs) • What are these securities? • What problems have occurred and who are some of the players? • What are Collateralized Obligations? • How are COs structured, and how could this lead to future problems?

4. SIVs • Structured Investment Vehicles are “Stand-alone” companies that transform cash-flows of “certain assets” into desired cash-flows of “particular investors”. • Certain assets can be Bonds, Loans (Consumer or Commercial) or Mortgages. • Particular Investors can be Pension Plans, Public Entities, Hedge Funds, Financial Institutions, and many, many others.

5. SIVs: Stand-Alones Class A: Seeking AAA Class B: Seeking A Class C: Seeking < BBB Equity: Seeking Speculation or Providing Credit Enhancemt.

6. SIVs: Some Definitions (Barclay’s Guide) • Balance-Sheet vs. Arbitrage • Ramp-up vs. Re-Investment vs. Amortization • Figure 2, Page 23 of Barclay’s Guide • Tranching vs. Senior/Subordinated Notes • Overcollateralization vs. Reserves • Excess Spread • Risks and Hedges (Pgs. 43-44 and Pgs. 26-27)

7. Problems and Players • Summer 2007 • Fall 2007 • Governments (Riskless Players) • Banks (Risk Arbitrage Providers) • More to Come

8. Collateralized Obligations • On Mortgages (CMOs) • On Loan Portfolios (CLOs) • On Bond Portfolios (CBOs or CDOs) • First two are generally securitizing assets held on a Bank’s Balance Sheet • Third is a structure that has a portfolio that may not have existed before CO executed

9. CMOs and CLOs • CMOs: Mortgage bonds guaranteed by FNMA, FHLMC or GNMA, then CFs split to create “tranching” and separate payment risks, • CLOs: Banks Loans made (Consumer or Commercial & Industrial) and needing removal from Bank’s balance sheet.

10. CDOs • Credit Enhance quality of standing or accumulated Bond Portfolio to split credit • AAA or AA Senior claims (low default risk) • BBB or BB Subordinated Claims (higher risk) • Equity (Credit Enhancement) (highest risk) • Essentially create riskless debt from risky debt by getting Subordinated and Equity claims to accept ALL credit risk

11. Bond Review • Intro Finance: Default-Free Bond • Price a function of expected CFs and market rate • Coupon * PVA (R,t) + Principal * PVF(R,t) • Advanced Finance: Defaultable Bond • Price a function of expected CFs and adjusted rate • Coupon * PVA (R* ,t) + Principal * PVF(R* ,t) • The question is what is the acceptable R*? • Can take market price and solve for R*, or adjust r from a comparable default-free bond.

12. Defaultable Bond • Adjust R = R* • How much return to compensate for loss? • Probability of Default • Loss given default = (1 – Recovery Rate Percentage) • R* = RNon-Default + [Prob * LGD] • Example: • Non-Default R = 5% • Probability of Default = 2%] • Recovery Rate = 30% • R* = 5% + [2% * (1 - .3)] = 6.4%

13. Structuring a Collateralized Obligation • Assume $500 million in Mortgages are held in a portfolio. No Ramp-Up or Reinvestment. • Assume 3 tranches: AAA (Sr.) $400m, BB (Subordinated) $75m and Equity (Z-tranche). • Assume AAA given 3% coupon, BB given 5%, Mortgages pay 7%, and Admin is 0.5%. • Assume Waterfall, sequential principal payment and proportional interest payment. • Assume no prepay for now.

14. How much will Equity make? • $500m in Bonds, with $475m in AAA/BB. • Equity is then $25m. • 7% Asset return. 3% on $475m, 5% on $75m debt costs. 0.5% Admin cost. • Excess Spread = Asset Return – Debt Cost – Admin cost. = 7% - ((400/500*3%) + (75/500*5%)) - 0.5%. = 3.35%

15. What does CF pattern look like? • PO/IO Spreadsheet • Assumes no Prepay. • Prepay, like default, reduces value of Equity first, then if significant enough, reduces lower-grade tranche values. • If SIV, then possible some of funding is also Commercial Paper by issuer, and if Equity held, this may also yield CP downgrade, and further Equity erosion.