Collateralized Debt Obligations

1. Collateralized Debt Obligations Fabozzi -- Chapter 15

2. Introduction to CDOs • A Collateralized Debt Obligation (CDO) - security backed by a diversified pool of one or more of the following: • Domestic investment grade and high yield bonds • Domestic bank loans • Emerging market bonds • Special situation loans & distressed debt • Foreign bank loans • Asset-backed securities • Residential & commercial mortgage-backed securities • Two Types of CDO’s • Collateralized Bond Obligation • Consists of bond-type instruments • Collateralized Loan Obligation • Consists of Bank Loans

3. Structure of a CDO • Collateral manager • Responsible for managing portfolio of debt obligations • The debt obligations collectively are called “collateral” • Individual issues within this are called “collateral assets” • Tranches • Debt obligations issued by the collateral manager including: • Senior tranches • Mezzanine tranches (Not always) • Subordinate / Equity tranches • Tranche Credit Rating • Sought for all except subordinate tranches • Senior is usually A rating minimum • Mezzanine is usually B rating minimum • Maintaining Credit Rating • Restrictions on collateral manager at time of issuance

4. Structure of a CDO - continued • Ability of Collateral Manager to make interest payments depends upon performance of collateral: • Coupon interest payments from collateral assets • Maturing of collateral assets • Sale of collateral assets • Typical Set Up • One or more tranches pays a floating rate of interest* • Interest rate swaps are used to hedge this risk • Collateral Manager pays fixed rate and receives floating rate in swap • Rating agencies require this to manage the mismatch of cash flows

5. Arbitrage vs. Balance Sheet Transactions • Type depends upon motivation of the deal sponsor • Arbitrage Transaction: • Objective is to earn a spread between yield on collateral and the payments made to the tranches • Typically Investment Banks trying make a profit • Balance Sheet transaction • Objective is to remove debt instruments (loans) from it’s balance sheet • Typically commercial banks seeking to reduce capital requirements

6. Arbitrage Transactions (Focus of this chapter) • How to determine if it’s feasible to create an arbitrage CDO • Critical factor is if it can create a competitive return for the subordinate / equity tranche • Example on Pages 351-352 in text • Analysis is done to measure: • Interest payments from the collateral vs. • Interest that must be paid to Senior and Mezzanine tranches • Remaining interest payments from collateral will be compared with the size of the subordinate tranche to determine if the return is high enough to support an arbitrage • Book example on page 352 shows a 25% return on a $10 Million subordinate tranche

7. Arbitrage Transactions - continued • Early Termination • Can occur if there is a default or events such as: • Failure to comply with covenants • Failure to meet payments to senior tranches • Bankruptcy of issuing entity of CDO • Departure of collateral management team • Arbitrage Transactions are further broken into 2 types: • Cash Flow transactions • Market Value transactions

8. Arbitrage Transactions - continued • Cash Flow transactions • Collateral manager is not free to buy & sell bonds • Restricted by credit risk considerations from rating agencies • Quality tests and Coverage tests • Quality tests measure the diversity of the assets and include: • Minimum asset diversity score • Minimum weighted average rating • Maturity restrictions • Limits on geographic exposure or emerging markets • Coverage tests include: • Par Value Tests – see page 355* • Interest coverage ratio tests

9. Arbitrage Transactions - continued • Market Value transactions • Unlike Cash Flow transactions • Collateral manager is expected to trade to improve market value • Also tries to minimize volatility • More rare than cash flow transactions • Used when cash flow is less predictable • Rating Market Value transactions: • Agencies look at collateral’s ability to generate sufficient cash flow • They look at collateral defaults and recovery rates* • Collateral manager’s focus: • Control defaults and recoveries

10. Arbitrage Transactions - continued • Overcollateralization Tests: • Based on Market Value of collateral – not par value • Advance Rates are determined based on asset types • See example on Pages 357-358* • Example using Moody’s Rating agency method • Advance rates are multiplied by market values • This determines an adjusted market value • Adjusted market values based on: • the asset type X the Advance Rate • Key to understanding the method: • The lower the credit rating sought, the higher the advance rate • Table of advance rates is determined for each credit rating

11. Synthetic CDOs • In a synthetic CDO: • The collateral itself still absorbs its typical economic risks • But collateral assets are not actually owned by collateral manager • Credit Default Swaps are required • They transfer credit risk on specified assets to a third party • Specified assets do not have to be owned but often are by one party • A CDS can be used to transfer credit risk on a pool of loans • This is done without transferring any of the loans themselves • It’s like an insurance policy • Buyer gets principal returned in case of a default or credit event • Credit events must be clearly defined and may include: • Bankruptcy • Failure to pay when due • Downgrading of an issue • Debt Repudiation • Debt restructuring