4 Collateralized Debt Obligations Cash flow backed CLOs and CBOsMarket value backed CBOsSynthetic CLOs
5 Cash Flow Backed CLOs BANK (SELLER) SALE OR ASSIGNMENT Motivations: Free up capitalLower cost of fundingDistressed loan arbitrage (3rd party sponsors)BANK (SELLER)LOANSSALE ORASSIGNMENTSPECIALPURPOSEVEHICLEISSUESLOANSASSET-BACKEDCERTIFICATES
7 CLO Rating Criteria Initial Review On-Site Due Diligence Originator’s credit evaluation systemPool composition & stress testingOn-Site Due DiligenceLegal IntegrityBankruptcy-remoteness of SPVValidity of asset transfer to SPVPerfection of security interests in underlying collateralDetermining Credit Enhancement
11 Cash Flow Backed CBOs MANAGER SALE Motivation: Cash flow arbitrage (bonds have good returns relative to risk, but may be illiquid)MANAGERBONDSSALESPECIALPURPOSEVEHICLEISSUESBONDASSET-BACKEDPORTFOLIOCERTIFICATES
12 Cash Flow Backed CBOsCash flow CBOs are built around a pool of assets with predictable cash flows. As such, these structures are restricted to investments that meet minimum credit quality, tenor and expected recovery characteristics. The analysis of a cash flow deal and determination of credit enhancement is based on the expected probability of default, severity of loss, and timing of default and recovery of the assets in the pool.The ongoing market price of collateral assets is not important in a cash flow deal. Instead, it is the ability of each asset to pay scheduled principal and interest that makes these deals successful.
14 Market Value Backed CBOs Motivation:Price arbitrage (bonds are underpriced, and tradeable)BONDSMANAGERSALESPECIALPURPOSEVEHICLEISSUESBONDASSET-BACKEDPORTFOLIOCERTIFICATES
15 Market Value CBOsA market value CBO can be generally described as an investment vehicle that capitalizes on the arbitrage opportunities that exist between high yielding investments and the lower cost funds of highly rated debt. The transaction is typically capitalized with multiple classes of rated debt and a layer of unrated equity and invests in a pool of investments that is diverse in obligor, industry, and, frequently, asset class. In order to gauge the performance of the transaction, the asset manager will mark the value of each investment to market on a regular basis, usually weekly or biweekly.
16 Market Value Backed CBOs MANAGERTrades bonds to meet interest & principal needsBONDSSPVInvestorsABSflowsCashflows
17 Characteristics of Market Value CBOs Market value transactions are often collateralized by leveraged loans, high-yield bonds, mezzanine debt, distressed debt, and public and even private equity.Market value transactions are less restrictive with respect to cash flow requirements, credit quality, and maturity of the collateral.The manager can trade the securities.
18 Rating Agencies Analyze Price Volatility to Determine CE Requirements
19 Advance rates determine how much rated debt can be issued against the market value of an asset.
20 Example of Market Value CBO Asset Mix and Financing
21 Asset-Backed Securities: The Typical Structure FORD (SPONSOR)LOANS.Servicing AgreementSALE ORASSIGNMENTSPECIALPURPOSEVEHICLEISSUESLOANS.ASSET-BACKEDCERTIFICATES
22 The Alternative: Synthetic ABS DB (Originator)REFERENCEPOOL OF LOANS(Stay onbalance sheet)CREDIT SWAPAGREEMENTSPECIALPURPOSEVEHICLEISSUESTOP QUALITYASSET-BACKEDINVESTMENTSCERTIFICATES
23 Synthetic ABS or Collateralized Loan Notes CLNs are SPV debt backed by the credit of the selling bank (or better)No loans are sold to the SPVBut performance is based on the performance of a reference pool of loansIf the reference credits perform, full debt service is made on the CLNIf the reference credits default, the CLN is deemed “defaulted”and payment is halted.
24 Synthetic ABS GERMAN BANK (Originator) REFERENCE POOL OF LOANS (Stay onBalance Sheet)CREDITSWAPAGREEMENTSPECIALPURPOSEVEHICLETOP QUALITYINVESTMENTSISSUESASSET-BACKEDCERTIFICATES
25 Synthetic ABS GERMAN BANK (Originator) REFERENCE POOL OF LOANS (Stay onBalance Sheet)PROTECTION againstPOOL DEFAULTSEURIBORplus“PREMIUM”SPECIALPURPOSEVEHICLETOP QUALITYINVESTMENTSISSUESASSET-BACKEDCERTIFICATES
26 Credit Swaps in Synthetics: Doubts Problems with the collateralDebates about “events of default”Workouts and other pre-default lossesProblems with the sponsor bankObtaining title to the collateralThose “high quality investments”And all those swaps
27 Typical Credit Default Swap Arrangement BANKSPVREFERENCEPOOL OF LOANSABSDeposit andcredit guaranteeThe guarantee:Pledge of a deposit in the sponsor bankPart or all of that deposit will be forfeited if there are pool losses“Losses in the transaction are defined as amountswritten off in compliance with the bank’s usual procedures”
31 Case Study: Global High Yield Bond Trust What is the legal structure of this deal?What are the assets?What are the different classes of securities, and their terms?How do the synthetic CLOs work? (Draw a diagram)Should investors buy the subordinated tranche?