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
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).
Collateralized Debt Obligations CDOs began in 1988 with Continental Bank’s FRENDS deal, followed by NatWest’s ROSE deals 1988 198919901991199219931994199519961997199819992000200120022003 However, minimal CDO activity until 1993, when market started to take off 2002 CDO estimated issuance was $210Billion CDO estimated current “opportunity” is $350Billion
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
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
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
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
Collateralized Debt Obligations Underlying collateral affects the CDO Ramp up Collateral eligibility and profile criteria Trading and reinvestment
Collateralized Debt Obligations Global CDO issuance rose 38% YoY Collateralized Debt Obligations grew 74% YoY ($208BN) Banc Of America Securities’ 2002 CDO Data
Collateralized Debt Obligations Cash CDOs ($60.6BN): Banc Of America Securities’ 2002 CDO Data
Collateralized Debt Obligations Collateralized Debt Obligations (SCDOs): Banc Of America Securities’ 2002 CDO Data
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
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
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
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
Collateralized Debt Obligations Credit derivatives are Total Return Swaps or TRS Credit Default Swaps or CDS Credit-Linked Notes or CLNs
Basic Total Return Swap Total Return Bank pays Customer the total return on the referenced assets. Bank has reduced credit risk to reference assets, but acquires credit risk of Customer.
Basic Total Return Swap Financing Charge Customer pays Bank a specified financing charge and acquires credit risk of reference asset.
Basic Credit Default Swap Bank/Customer “buys” credit protection on a referenced entity and pays a credit spread therefor. Credit Protection
Basic Credit-Linked Note 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.
Basic Credit-Linked Note Credit Linked Note Customer purchases the note and acquires credit risk of reference asset.
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
Collateralized Debt Obligations BankCDO Class A Class B Class C CDS Notes/ Swaps Bank obtains economic and regulatory capital relief. Investors obtain credit exposure and return Balance Sheet SCDOs
Collateralized Debt Obligations IssuerCDO Class A Class B Class C CDS Notes/ Swaps Issuer reduces credit exposure Investors obtain credit exposure and arbitrage return Tranched Basket/Portfolio SCDOs
Collateralized Debt Obligations BankCDO Manager Class A Class B Class C CDS Notes/ Swaps Manager selects and manages portfolio to enhance arbitrage opportunity Managed Arbitrage SCDOs
Collateralized Debt Obligations FeatureStaticManaged 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 Comparison of Static and Managed SCDOs
Collateralized Debt Obligations FeatureStaticManaged Liquidity 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 Comparison of Static and Managed SCDOs
Collateralized Debt Obligations FeatureStaticManaged 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 Comparison of Static and Managed SCDOs
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