Collateralized Debt Obligations
CDOs
• A collateralized debt obligation (CDO) is an ABS backed by a pool of one or more classes of debt
o A collateralized bond obligation (CBO) has bonds and bond-like instruments as collateral o A collateralized loan obligation (CLO) has loans as collateral
• Types of debt serving as collateral in CDOs
o Debt and loans
���� Secured and unsecured ���� Any type of borrower – corporate, residential mortgage, emerging market, sovereign, etc.
o Structured Finance CDOs (CF CDOs) are backed by securitized products
���� MBS ���� ABS ���� REITs
CDOs
• Motivations
o Balance
����
for CDOs
sheet management o Arbitrage
Cash flow (ACF CDOs) ���� Market value (AMV CDOs)
•Forms of CDOs
o Cash (involving actual sale of assets to the CDO) o Synthetic (using credit derivatives to populate the collateral pool)
CDOs
• Life cycle of CDOs
o Ramp-up period (<1 year): proceeds from debt security sales are used to by a collateral manager to populate the CDO with debt assets
o Reinvestment / Revolving period (5+ years): principal received on collateral is used to finance the acquisition of new assets o Wind-down period: no new assets acquired, and collateral is either sold on the market or retired as it is paid off to fund the pay-down of outstanding liabilities
Balance Sheet CDOs
• The objective of a balance sheet CDO is balance sheet management by the owner of the assets
o The seller of the assets is a financial institution (usually a bank) that is seeking to divest certain assets from its portfolio through true sales leading to the issuance of securitized products o Usually CLOs – sometimes called “Bank CDOs” or “Bank CLOs” o Alternative to loan syndication or loan sales usually to satisfy non-bank investor appetite for bank loans as investments
Balance Sheet CDOs
• Typical features
o Bank conveys assets to master trust SPV o Typical assets:
���� Selected by the bank – no independent collateral or portfolio manager ���� 200-400 loans with total size of USD1 – 4 billion ���� Quality controlled (we’ll return to this), usually though average rating and diversity scoring
o Credit enhancements:
���� Subordination: typical balance sheet CDOs have a senior tranche, one or more subordinated mezzanine tranches, and a residual tranche – all tranches enhance the quality of those senior to them ���� A cash collateral account (CCA) funded by the seller ���� Excess spread: interest earned on collateral – interest paid on senior and subordinated tranches – fees/expenses o Averages around 0.5% per annum for many structures o In a good year, this excess spread goes to the owner of the residual tranche, the bank / seller o In bad years, the spread can be diverted to other tranches by seniority
Balance Sheet CDOs
• CLOs existing as early as 1990 • The first “traditional balance sheet CDO” is nevertheless regarded as the Rose Funding transaction done in 1996 by National Westminster Bank PLC
o $5 billion structure based on 200 loans (15%20% of NatWest’s loan portfolio) o Classes of notes included a senior revolver and senior fixed note and investors in 17 countries)
Balance Sheet CDOs
•Rose Funding provides a model for the typical structure of a balance sheet CLO:
Balance Sheet CDOs
Balance Sheet CDOs: Typical Waterfall
•Two maturities are usually issued for each class of security
o Suppose the CDO has a senior A class of securities, two classes of subordinated securities B and C, and a residual tranche D o Suppose the two maturities chosen are 3 years and 5 years o A-1, B-1, C-1, and D-1 mature in year 3, and A-2, B-2, C-2, and D2 mature in year 5
• The reinvestment period(s)
o The reinvestment period for each maturity ends a year before the securities are due o Principal payments on the collateral are reinvested at 100% from years 0-2 o From years 2-4, 50% of the principal received on the collateral goes into a cash account as it is earned to finance the eventual bullet payment of the three-year securities and the other 50% is reinvested for eventual payment of the 5-year notes
Balance Sheet CDOs: Typical Waterfall
Balance Sheet CDOs: Rating Agency Considerations
•Rating agencies pay attention to several features of CDOs • Collateral Quality • Collateral Diversification:
o Obligors are divided by industry classification o Securities across industry groups are presumed uncorrelated, whereas securities within groups are presumed perfectly correlated o A diversity score is calculated using a binomial process for defaults on each industry classification, and the collateral must meet minimum diversity requirements at all times
Balance Sheet CDOs: Rating Agency Considerations
• Likelihood of Default:
o Average rates across bonds in the portfolio are often the basis for asset quality tests o Some rating agency-specific criteria also may be used, such as Moody’s Weighted Average Rating Factor (WARF)
• Recovery Rates:
o Minimum recovery rates per asset may also be asset quality tests
• The rating agencies often ties these three variables together
o Maximum expected loss for each CDO tranche o Loss distribution tests for each CDO tranche
Balance Sheet CDOs: Rating Agency Considerations
• Asset quality tests govern the conveyance of assets into the CDO during the ramp-up and reinvestment periods • A structure may be forced to liquidate collateral and wind down early by repaying debt holders immediately if…
o the seller cannot recharge the structure during a reinvestment period o the seller is downgraded o the assets degrade so that the existing assets fail a quality test
• In addition, the CDO for rating purposes must satisfy coverage tests or the structure may terminate and wind-up early
o O/C Tests: the O/C ratio for a given tranche must exceed the O/C trigger for that tranche
���� The O/C ratio is the collateral principal allocated to a tranche divided by the total principal allocated to all tranches senior to the one in question (including the tranche being evaluated)
Balance Sheet CDOs: Rating Agency Considerations • Asset quality tests govern the conveyance of assets into the CDO during the ramp-up and reinvestment periods • A structure may be forced to liquidate collateral and wind down early by repaying debt holders immediately if…
o the seller cannot recharge the structure during a reinvestment period o the seller is downgraded o the assets degrade so that the existing assets fail a quality test
Balance Sheet CDOs: Seller/Sponsor Rationale
• The seller typically retains the residual or most deeply subordinated tranche and funds the CCA on its balance sheet • If the capital structure is such that 1% of the collateral is allocated to the residual and 1% is in the CCA, that means that the bank is funding 2% of the first risks in the structure • As long as the structure meets all its tests, the seller earns the excess spread • The real motivation for balance sheet CDOs, however, is to improve ROE by reducing regulatory capital, which is the lesser of the capital charge on the unlevered investment or 100% of the liability
Balance Sheet CDOs: Seller/Sponsor Rationale
• Example: a bank has $100 million in loans on its balance sheet earning an average interest rate of LIBOR+125 with a funding cost of LIBOR+25
o On the bank’s balance sheet, the net interest income or net spread is 100 bps o The required regulatory capital is 8% of $100 million o ROE = 1% net spread / $8 mn capital charge = 1/8 = 12.5% per annum
• Example: the bank considers selling the loans to an independent CDO
o Suppose the CDO has expenses and fees of 25 bps, so the funding cost for the loans sold to a SPE is LIBOR+50 – the net spread is now 75 bps o Suppose the bank retains a 2% residual interest in the CDO, or $2 million, which is deducted from the bank’s equity base o The capital charge is $2 million (not 8% of $2 million) o ROE = 0.75% net spread / $2 mn capital charge = .75/2 = 37.5%
Arbitrage CDOs
•The objective of an arbitrage CDO is to try and generate trading profits from perceived “arbitrage opportunities” and trading opportunities – specifically, to achieve an all-in refinancing cost on issuing securities that is below the cost of purchasing them
o There are multiple asset sellers, and the sponsor of the structure is now a professional portfolio manager – the Collateral Manager – and not the selling institution o Usually CBOs comprised of tradeable securities
•
Arbitrage CDOs
• Typical features
o Typical assets:
���� Selected by the collateral manager, which is often a commercial bank, an i-bank, or an insurance company ���� 20-100 securities with average total size of around USD150 million ���� Often specialized by type of collateral – e.g., many arbitrage CBOs are predominantly focused on high-yield debt
o Two basic flavors depending on the nature of the arbitrage or trading opportunity to be exploited
���� Cash flow arbitrage CDOs o Static o Dynamic ���� Market value arbitrage CDOs
Static Arbitrage Cash Flow CDOs (ACF CDOs)
•ACF CDOs are generally heavily influenced by rating agency criteria
o A CDO manager chooses a target rating for a tranche and then determines the credit enhancements required to support that rating o Example: Moody’s publishes a matrix that allows a CDO manager to determine what percentage of the securities can default in a tranche before a rating downgrade will occur on the corresponding class of securities – the matrix gives these percentages as a function of the WARF and diversity score of the collateral in the portfolio
•
Static Arbitrage Cash Flow CDOs (ACF CDOs) • Typical waterfall:
o Suppose the collateral manager buys 20 securities at $5 million each with an average BB rating and an average fixed yield that can be swapped for LIBOR + 300bps o A senior-sub structure is used with 20% subordination o LIBOR+100 is allocated to the senior tranche o The residual / sub tranche gets the excess spread less any default-related losses
Static Arbitrage Cash Flow CDOs (ACF CDOs)
Static Arbitrage Cash Flow CDOs Funding Problems
• Static cash flow arbitrage CDOs have two problems
o The ramp-up period during which the CDO manager is moving toward full investment is usually characterized by negative carry
���� A standard CDO is “fully funded” at closing – this means the net proceeds from issuing securities is adequate to acquire the target portfolio ���� This does not mean the target portfolio actually has been acquired ���� As managers acquire the portfolio between the closing and effective date, proceeds from the securities issue sit idly in money market instruments ���� Funding costs are excessive – significant net interest income can be lost during the ramp-up ���� Ameliorated if securities do not have to be serviced, but this can be a drawback for investors
o Time pressure to become fully invested by deadline for end of ramp-up period
Static Arbitrage Cash Flow CDOs Funding Problems
Dynamic Arbitrage Cash Flow CDOs
•Reduce excess funding costs by matching net interest obligations on liabilities with net interest income on assets (both invested and not)
Dynamic Arbitrage Cash Flow CDOs
Arbitrage Market Value CDOs (AMV CDOs)
• The basic idea behind an AMV CDO is the same as a ACF CDO, but the mechanics are a little different • In an AMV CDO, changes in the market values of the securities lead to changes in the values of the SPE’s obligations – not a pure cash flow waterfall • In an AMV CDO, the market value of the collateral times the advance rate must exceed the book value of liabilities
o The advance rate is the haircut or adjustment to the market value of assets held as collateral as a cushion against market risk o Requiring that the haircut market value exceed book value builds in a type of O/C into the structure
Arbitrage Market Value CDOs (AMV CDOs)
• In the event of a shortfall, the CDO manager must liquidate assets to bring the required O/C back up to the minimum
o One dollar of par value liquidated only reduces the shortfall by one minus the advance rate o The amount of collateral that must be liquidated to cure a shortfall thus is ()RateAdvanceShortfall−1
• Rating agencies require that a market value CDO adhere to the minimum O/C requirement, as well as meeting a minimum net worth test each quarter