Collateralized Debt Obligations Fabozzi -- Chapter 15

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

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

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

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

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 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

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

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

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

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 *  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

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