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					Tranche ABX and Basis
Risk in Subprime RMBS
Structured Portfolios

Kevin Kendra
February 20, 2007
Introduction


What are structured subprime RMBS portfolios?
What is “basis risk”?
Why is “basis risk” between these structures important
now?
What are structured subprime RMBS portfolios?

>    Portfolio exposure to subprime Residential Mortgage-Backed Securities
     (RMBS) can be obtained using various structures:
       – Structured Finance Collateralized Debt Obligations (SF CDOs)
              >   Cash SF CDOs
              >   Bespoke SF CDOs
              >   Hybrid SF CDOs
       – ABX.HE Indices
       – Tranche ABX.HE (TABX) Indices




www.derivativefitch.com                                                      2
What is “basis risk”?

>    Basis risk describes the risk that offsetting investments in a hedging strategy
     will not experience cash flow or price gains in the same manner.
>    Basis risk has the potential to create an excess gain or loss and therefore is
     not directional. The amount of basis risk in a hedging strategy describes the
     how much risk is left behind due to imperfect correlation between the two
     investments.
>    Basis risk in subprime RMBS portfolios generally arises from:
       – Performance differences in the underlying portfolio assets
       – Structural differences in portfolio instruments
       – Liquidity differences in the different secondary markets
       – Timing of expected cash flows from the portfolio instruments




www.derivativefitch.com                                                                3
Why is “basis” between these structures important
now?
>    Standard tranches of the ABX.HE Index commenced trading on Feb. 14, 2007
>    Index tranches promise to provide:
       – Liquidity
       – Transparency
       – Standardization
       – Market Consensus
>    Motivations for TABX participation:
       – Hedging
       – Relative Value Trading
       – Benchmarking
       – Leveraged Market Positions



www.derivativefitch.com                                                         4
Framework for Understanding Basis Risk in
Subprime RMBS Portfolios
>    Subprime RMBS 101
>    Credit Default Swaps on Subprime RMBS
       – Credit Default Swaps 101
       – ISDA Pay-As-You-Go Template 101
       – Subprime RMBS AFC Risk
>    Typical Subprime RMBS Portfolio Structures
       – Structured Finance CDOs 101
       – ABX.HE and TABX.HE Indices 101
>    Basis Risk between TABX.HE and Other Structures




www.derivativefitch.com                                5
Subprime RMBS Overview


Subprime RMBS 101
Subprime RMBS 101

>    Typical Subprime Borrower and Loan Characteristics
       – FICO credit score 650 and below
       – Prior mortgage delinquencies are acceptable
       – Bankruptcy filing within the last 3 to 5 years are acceptable
       – Foreclosure within the last 3 to 5 years are acceptable
       – Debt-to-Income (DTI) ratios of 40% or higher
       – Loan-to-Value (LTV) ratios greater than 80%




www.derivativefitch.com                                                  7
Subprime RMBS 101

>    Typical Subprime Loan Types
       – Hybrid Adjustable-Rate Mortgages (ARMs)
              >   2/28 Mortgage is fixed for the first two years and then switches to
                  adjustable rate for the remaining 28 years
              >   Other common Hybrid ARMs 3/27 and 5/25 terms
       – Hybrid Interest Only (IO) ARMs
       – 40-Year Hybrid ARMs
       – Piggyback Second Liens
       – Limited Documentation Loan Programs




www.derivativefitch.com                                                                 8
Subprime RMBS 101

Sample Subprime RMBS Structure
                                                       Mortgage      REMIC     RMBS
              Individual Mortgages
                                                        Pools         Trust    Bonds
        M1 M2 M3 M4 M5 M6 M7 M8 M9 M10

        M11 M12 M13 M14 M15 M16 M17 M18 M19 M20

        M21 M22 M23 M24 M25 M26 M27 M28 M29 M30
                                                          2/28                  „AAA‟
        M31 M32 M33 M34 M35 M36 M37 M38 M39 M40                                 RMBS
                                                       Hybrid ARM
        M41 M42 M43 M44 M45 M46 M47 M48 M49 M50         Mortgage
                                                          Pool
        M51 M52 M53 M54 M55 M56 M57 M58 M59 M60                      Special
                                                                     Purpose
        M61 M62 M63 M64 M65 M66 M67 M68 M69 M70                      Vehicle
                                                                     (RMBS
                                                 M                               „AA‟
        M71 M72 M73 M74 M75 M76 M77 M78 . . .                         Trust)
                                                2000                            RMBS

        M1 M2 M3 M4 M5 M6 M7 M8 M9 M10                                           „A‟
                                                                                RMBS
        M11 M12 M13 M14 M15 M16 M17 M18 M19 M20                                 „BBB‟
                                                        Fixed Rate              RMBS
        M21 M22 M23 M24 M25 M26 M27 M28 M29 M30          Mortgage               „BBB-‟
        M31 M32 M33 M34 M35 M36 M37 M38 . . .                                   RMBS
                                                 M
                                                                               Residual
                                                1000




www.derivativefitch.com                                                                   9
        Subprime RMBS 101

                                                                                              $P
        Sample Subprime RMBS Payments
                                                                                 $I
        Monthly Mortgage                           REMIC                               Interest          Principal
                                                                   Accounts
           Payments                                 Trust                             Payments           Payments
M1 M2 M3 M4 M5 M6 M7 M8 M9 M10                                                                            Scheduled
                                                                                                           Principal
M11 M12 M13 M14 M15 M16 M17 M18 M19 M20                                                                        &
                                                                                                         Prepayments
M21 M22 M23 M24 M25 M26 M27 M28 M29 M30

M31 M32 M33 M34 M35 M36 M37 M38 M39 M40
                                               $                                            „AAA‟
                                                                                      L + % or Net WAC

M41 M42 M43 M44 M45 M46 M47 M48 M49 M50                                                                     „AAA‟
                                                              $I     Interest
M51 M52 M53 M54 M55 M56 M57 M58 M59 M60

M61 M62 M63 M64 M65 M66 M67 M68 M69 M70            Servicer
                                         M                                                   „AA‟
M71 M72 M73 M74 M75 M76 M77 M78 . . .                                                                       „AA‟
                                        2000                                          L + % or Net WAC
                                                                                             „A‟
M1 M2 M3 M4 M5 M6 M7 M8 M9 M10                                                                               „A‟
                                                                                      L + % or Net WAC
M11 M12 M13 M14 M15 M16 M17 M18 M19 M20                                                     „BBB‟
                                               $                                      L + % or Net WAC
                                                                                                            „BBB‟
M21 M22 M23 M24 M25 M26 M27 M28 M29 M30
                                                              $P    Scheduled               „BBB-‟
                                                                                                           „BBB-‟
M31 M32 M33 M34 M35 M36 M37 M38 . . .                                Principal        L + % or Net WAC
                                         M                               &                Residual
                                                                   Prepayments                            Residual
                                        1000                                           Excess Interest




       www.derivativefitch.com                                                                                         10
Subprime RMBS 101

>    Standard Structural Features of Subprime RMBS
       – Subordination serves as credit enhancement to account for credit risk
       – Interest rate instruments to hedge interest rate risk
       – Performance test at three year mark
              >   If test fails then the priority of payments remains unchanged with the
                  senior notes receiving all principal proceeds
              >   If test passes then principal proceeds repays subordinated notes until
                  targeted subordination is met.
       – Defaulted loans worked out by servicers
>    Each Subprime RMBS will have somewhat unique performance profiles




www.derivativefitch.com                                                                    11
Subprime RMBS 101

Principal Waterfalls
       –    Sequential pay
              > All scheduled principal and prepayments go to repay the senior bond holders
                  first until paid-in-full, then to the next senior note holder, etc.
              > Subprime RBMS are initially sequential pay for the first three years and will
                  remain sequential pay if the performance tests fail
       –    Credit Enhancement (CE) “Step Downs”, if performance tests pass
              > If overcollateralization (OC) targets have been met, the CE is stepped down by
                  repaying subordinate bond holders.
              > OC targets are set to double the original subordination, ie. If the original „AAA‟
                  bond subordination is 7.5% then the target is 15%
              > Test senior note target for compliance first and if passing then check the next
                  senior bond and so on.
              > Over periods of rapid prepayments all bonds may be meeting the OC targets,
                  then principal prepayments become inverse sequential pay.

www.derivativefitch.com                                                                              12
    Sample Principal Waterfalls
                                                            Scenario 2: Performance Test Passes the Credit
                                                            Enhancement “Steps Down” by Paying Principal
       Scenario 1: Sequential Principal Repayment                       to Subordinated Notes


                                                                             $P
                      $P
                                                                                           Principal
                                     Principal        Accounts
Accounts                                                                                   Payments
                                     Payments
                                                       Scheduled
 Scheduled                                              Principal
  Principal                                                                                   Payments
                                       Payments             &                             Before Step Down
      &                            Before Step Down   Prepayments
Prepayments
                                    After Step Down



                                                                                                „AAA‟
                                         „AAA‟




                                                                                                 „AA‟
                                          „AA‟

                                                                                                 „A‟
                                           „A‟

                                                                                                „BBB‟
                                         „BBB‟
                                                                                                „BBB-‟
                                         „BBB-‟                                            After Step Down

                                                                                              Residual
                                        Residual



   www.derivativefitch.com                                                                                   13
Subprime RMBS 101

Interest Waterfalls
       – Regular interest
              >   Paid sequentially to bonds, capped at weighted average mortgage
                  rate net of expenses (Net WAC) or available funds cap (AFC)
       – Excess Interest
              >   Excess interest is the remaining interest proceeds in the interest
                  collection account after paying bondholders regular interest above
              >   First, excess interest is used to recover realized collateral losses
              >   Second, excess interest is used to recover any interest shortfalls
                  created where Net WAC is lower than the stated bond coupon
              >   Finally, the remaining excess interest goes to the residual bond holder




www.derivativefitch.com                                                                  14
Sample RMBS Interest Waterfall
                           Step 1 – Interest   Step 2 – Excess    Step 3 – Remaining
                          Paid Sequentially       Interest to     Excess Interest to
                          to Bonds, Capped     Cover Collateral   Pay AFC Shortfalls
                                at AFC              Losses

             $I
                           Interest            Principal            Interest
Accounts                                                           Shortfalls
                          Payments             Payments
                                                 Scheduled
                                                  Principal
                                                      &
                                                Prepayments


                                „AAA‟
                          L + % or Net WAC

                                                    „AAA‟
  Interest



                                 „AA‟
                                                     „AA‟
                          L + % or Net WAC
                                 „A‟
                                                     „A‟
                          L + % or Net WAC
                                „BBB‟
                                                    „BBB‟         L + % - Net WAC
                          L + % or Net WAC
                                „BBB-‟
                                                    „BBB-‟
                          L + % or Net WAC                        L + % - Net WAC
                              Residual            Residual
                           Excess Interest        Losses                     Step 4 – Remaining
                                                                             Excess Interest to
                                                                               Residual Holder


www.derivativefitch.com                                                                           15
Subprime RMBS 101

AFC Interest Shortfall
       – AFC Shortfall is the difference between the stated bond coupon and the
         Net WAC
       – AFC Shortfalls accrue over time and may be recoverable
       – AFC Shortfalls manifest themselves in times of rising interest rates
              >   Typical subprime RMBS deals have 75% hybrid ARM mortgages
              >   RMBS bonds are generally floating rate bonds based on the London
                  InterBank Offering Rate (LIBOR)
              >   If short-term LIBOR interest rates rise during the 2- or 3-year fixed
                  rate period then the interest coupon from the mortgages is insufficient
                  to pay the RMBS bond holders LIBOR plus the stated spread
       – AFC shortfalls may be unrecoverable if excess interest is eroded.


www.derivativefitch.com                                                                     16
Credit Default Swaps on Subprime
RMBS

Credit Default Swaps (CDS) 101
ISDA Pay-As-You-Go (PAUG) Template 101
Subprime RMBS AFC Risk
Credit Default Swaps 101

Protection Seller
       – Receives CDS premium payment and reimbursement payments in
         exchange for providing protection payments if a credit event occurs.
       – CDO note holders are protection sellers in a synthetic CDO.
Protection Buyer
       – Pays CDS premium in exchange for protection payments if a credit event
         occurs.
       – CDS Swap Counterparty is the protection buyer in a synthetic CDO.
Calculation Agent
       – Determines the amount of the protection payment upon a credit event per
         the terms of the credit default swap
       – Usually the Protection Buyer serves this role


www.derivativefitch.com                                                            18
Credit Default Swaps 101

Collateral or Eligible Investment
       – Highly rated, highly liquid financial instruments purchased from the sales
         proceeds of the initial CDO notes.
       – Provides the index portion of the note coupon
       – Provides protection payments or the return of principal to note holders
Reference Entity and Reference Obligation
       – Reference entities are security issuers like a corporation or sovereign
       – Reference obligations are securities with specific debt seniority levels
              >   Reference obligations in a corporate CDS is usually informational to
                  establish the seniority of debt to be valued if a credit event occurs
              >   Reference obligations in CDS of structured finance assets or
                  leveraged loans or in total return swap structures


www.derivativefitch.com                                                                   19
Credit Default Swaps 101

Sample Credit-Linked Note (CLN) using a CDS

                  Protection                     Credit Default                           Protection
                    Buyer                           Swap                                    Seller
                                 CDS Premium                               Note Coupon
                                    (bps)                                   (L + bps)

                   CDS Swap                        Credit-Linked                           Protection
                  Counterparty                      Note Trust                               Seller
                                   Protection                              CLN Proceeds
                                  Payments ($)                                  ($)


                                                                  CLN
                                                 LIBOR          Proceeds
                                                   (L)             ($)




                   Reference                        Collateral or
                    Entity or                         Eligible
                   Obligation                       Investments




www.derivativefitch.com                                                                                 20
Credit Default Swaps 101

Credit Events
       – Applicable credit events will vary by CDS
       – Typical credit events may include:
              >   Bankruptcy
              >   Failure to Pay (FTP)
              >   Restructuring
              >   Repudiation/Moratorium, usually emerging markets and sovereigns only
              >   Obligation Acceleration, usually emerging markets sovereigns only
       – Once a credit event has been called and settled then the credit default swap
         is terminated




www.derivativefitch.com                                                               21
Credit Default Swaps 101

Settlement and Valuation Procedures
       – Protection Buyer calls a credit event by sending notice to the Protection
         Seller what credit event has occurred
       – Settlement method is determined by the CDS contract
              >   Physical settlement means the Protection Buyer gives the Seller the
                  reference obligation, or equivalent, in return for cash par amount
              >   Cash settlement means the parties look to the market value of the
                  reference obligation to determine the net protection payment
       – Fitch‟s preferred valuation process includes:
              >   Dealer poll of at least 5 dealers, not including the Protection Buyer
              >   Polls typically held 30 to 60 days after credit event notification




www.derivativefitch.com                                                                   22
ISDA Pay-As-You-Go (PAUG) Template 101

>    ISDA PAUG template is designed to replicate the cash flow profile of the cash
     bond with a credit default swap (CDS) contract
>    CDS contracts for corporate and sovereign issuers are insufficient to replicate
     the payment profile of a structured finance bond
>    ISDA PAUG template was introduced in the U.S. in XXXX 2005 for RMBS and
     CMBS securities for CDO securities in June 2006
>    Introduces the concept of “floating payments”
       – Floating payments are paid by the Protection Seller in the event of an AFC
         Interest Shortfall
       – Floating payments may be reimbursed by the Protection Buyer if the AFC
         Interest Shortfall is ultimately recovered




www.derivativefitch.com                                                                23
ISDA Pay-As-You-Go (PAUG) Template 101

Sample CLN using a PAUG CDS

                                                      Floating
                                                     Payments




                  Protection                     Credit Default                            Protection
                    Buyer                           Swap                                     Seller
                                 CDS Premium                                Note Coupon
                                    (bps)                                    (L + bps)

                   CDS Swap                        Credit-Linked                            Protection
                  Counterparty                      Note Trust                                Seller
                                   Protection                               CLN Proceeds
                                  Payments ($)                                   ($)


                                                                   CLN
                                                 LIBOR           Proceeds
                                                   (L)              ($)




                   Reference                        Collateral or
                   Obligation                         Eligible
                                                    Investments




www.derivativefitch.com                                                                                  24
ISDA Pay-As-You-Go (PAUG) Template 101

PAUG Credit Events
       – Failure to Pay (FTP) Principal
       – Writedown
       – Distressed Rating Downgrade („CCC‟ or below)
       – FTP Interest for CDO reference obligations only
PAUG Floating Amount Events
       – Interest Shortfalls
       – Principal Shortfalls
       – Writedown Amounts


>    Protection Buyers typically have an option whether to call a credit event or a
     floating amount event

www.derivativefitch.com                                                               25
ISDA Pay-As-You-Go (PAUG) Template 101

PAUG Settlement
       – The secondary market for structured finance securities is not liquid and
         therefore valuation procedures are not applicable
       – Floating payments are designed to replicate the actual loss amounts
       – If a credit event occurs then the Protection Buyer has the option to
         physically deliver all or part of the notional amount to the Seller
              >   If the entire notional is physically settled then the CDS is terminated
              >   If a portion of the notional is settled then the CDS continues on the
                  remaining amount




www.derivativefitch.com                                                                     26
ISDA Pay-As-You-Go (PAUG) Template 101

Interest Shortfalls
       – RMBS reference obligations are called AFC shortfalls
       – CMBS reference obligations are called WAC shortfalls
       – CDO reference obligations are called PIK-ing shortfalls


Interest Shortfall Cap Options
       – Fixed Cap: Floating payments are limited to the amount of the CDS premium
       – Variable Cap: Floating payment are limited to LIBOR + premium
       – No Cap: No limit to the floating rate payments
              >   Completely replicates the payments of the cash bond or total return swap
              >   May require principal to be liquidated to pay interest shortfall



www.derivativefitch.com                                                               27
Subprime RMBS AFC Risk

>    Available Funds Cap (AFC) Risk
       – REMIC law limits a floating rate RMBS bond pass-through rate to the
         lesser of:
              >   Bond spread plus some index (typically 1 month LIBOR), or
              >   Underlying mortgage collateral pool‟s weighted average coupon, net
                  of expenses (Net WAC).
       – AFC Risk varies by RMBS transaction based on:
              >   Actual prepayment speeds of underlying mortgages
              >   Effectiveness of interest rate hedges in the RMBS structure
              >   Short-term interest rate increases before Hybrid ARM mortgages
                  switch to floating interest rate payments




www.derivativefitch.com                                                                28
      Subprime RMBS AFC Risk

      >    Unrecovered AFC Interest Shortfalls can be prevalent by vintage
      >    Unrecovered AFC Interest Shortfalls can be present across all rating categories


                 RMBS Bonds that Experience Unrecovered AFC Interest Shortfalls
Initial Rating          2001       2002          2003          2004           2005       2006
    AAA                0.00%       0.00%        0.00%          0.69%         0.50%      0.00%
    AA+                0.00%       0.00%        0.00%          4.81%         0.96%      0.00%
     AA                0.00%       0.00%        0.00%          3.09%         2.24%      0.00%
     AA-               0.00%       0.00%        0.00%          6.67%         1.05%      0.00%
     A+                0.00%       0.00%        0.00%          7.46%         3.46%       0.33%
      A                0.00%       0.00%        0.93%          4.56%         3.35%       0.77%
     A-                0.00%       0.00%        6.56%          5.18%         6.71%       0.75%
   BBB+                0.00%       0.00%        4.95%         10.12%         13.51%      2.96%
    BBB                0.00%       0.00%        7.17%         10.10%         19.34%      6.67%
    BBB-               0.00%       0.00%        2.77%         16.13%         25.49%     18.17%
    BB+                0.00%       0.00%        0.00%         11.11%         23.00%     33.25%
     BB                0.00%       0.00%        0.00%          2.62%         18.04%     35.38%

     www.derivativefitch.com                                                             29
      Key Risks – AFC Risk

      >    Unrecovered AFC Interest Shortfall amounts have been small
      >    Difference in CDS premium required for No Cap protection may exceed the
           actual unrecovered AFC interest shortfalls experience in the cash bond market
             Cumulative Unrecovered AFC Interest Shortfalls as % of Bond Balance
Initial Rating          2001      2002          2003          2004           2005          2006
    AAA                0.00%      0.00%         0.00%         0.01%         0.03%      0.00%
    AA+                0.00%      0.00%         0.00%         0.04%         0.21%      0.00%
     AA                0.00%      0.00%         0.00%         0.08%         0.22%      0.00%
     AA-               0.00%      0.00%         0.00%         0.06%         0.20%      0.00%
     A+                0.00%      0.00%         0.00%         0.08%         0.27%      0.05%
      A                0.00%      0.00%         0.01%         0.05%         0.31%      0.04%
     A-                0.00%      0.00%         0.07%         0.05%         0.06%      0.05%
   BBB+                0.00%      0.00%         0.16%         0.08%         0.09%      0.04%
    BBB                0.00%      0.00%         0.18%         0.19%         0.07%      0.04%
    BBB-               0.00%      0.00%         0.64%         0.22%         0.08%      0.05%
    BB+                0.00%      0.00%         0.00%         0.34%         0.13%      0.03%
     BB                0.00%      0.00%         0.00%         0.11%         0.12%      0.03%

     www.derivativefitch.com                                                               30
Subprime RMBS Portfolio
Structures

Structured Finance CDOs 101
ABX.HE and TABX.HE 101
Structured Finance CDOs 101

>    Generic Types of SF CDOs
       – Cash SF CDOs
       – Bespoke SF CDOs
       – Hybrid SF CDOs




www.derivativefitch.com         32
Structured Finance CDOs 101

Sample Cash SF CDO Structure
                                                                CDO                         CDO
                CDO Portfolio
                                                                Trust                      Bonds
       RMBS RMBS RMBS RMBS             RMBS
       Bond 1 Bond 2 Bond 3 Bond 4     Bond 5
       RMBS RMBS RMBS RMBS RMBS
       Bond 6 Bond 7 Bond 8 Bond 9 Bond 10
                                                                          Note Coupon
        RMBS RMBS RMBS RMBS RMBS                                           (L + bps)
       Bond 11 Bond 12 Bond 13 Bond 14 Bond 15                                               „AAA‟
                                                                                              CDO
        RMBS RMBS RMBS RMBS RMBS                 Bond Coupons
       Bond 16 Bond 17 Bond 18 Bond 19 Bond 20     (L + bps)               Proceeds
        RMBS RMBS RMBS RMBS RMBS                                Special       ($)
       Bond 21 Bond 22 Bond 23 Bond 24 Bond 25                  Purpose
                                                                Vehicle
        RMBS RMBS RMBS RMBS RMBS                   Proceeds      (CDO
       Bond 26 Bond 27 Bond 28 Bond 29 Bond 30        ($)        Trust)                      „AA‟
        RMBS RMBS RMBS RMBS RMBS                                                             CDO
       Bond 31 Bond 32 Bond 33 Bond 34 Bond 35
                                                                                              „A‟
        RMBS RMBS RMBS                  RMBS                                                 CDO
                                 ...
       Bond 36 Bond 37 Bond 38         Bond 80
                                                                                             „BBB‟
        CDO    CDO    CDO    CDO        CDO                                                   CDO
       Bond 1 Bond 2 Bond 3 Bond 4     Bond 5
        CDO    CDO    CDO    CDO    CDO                                                 Preferred Shares
       Bond 6 Bond 7 Bond 8 Bond 9 Bond 10                                                  or Equity




www.derivativefitch.com                                                                                    33
Structured Finance CDOs 101

>    Cash SF CDO Asset Portfolio Highlights
       – Portfolios contain between 60 and 140 bonds
       – Assets may be diversified by market sector, however recent vintage SF
         CDOs have been concentrated in subprime RMBS
       – Assets may be diversified by risk profile (intial ratings)
       – Assets may be diversified by vintage
       – Asset acquisition and selection
              >   Asset manager warehouses bonds prior to issuing CDO notes
              >   CDO notes typically issued when asset manager has accumulated
                  approximately 60-80% of the target portfolio
              >   Initial portfolio is typically fully ramped within 6 months of CDO note
                  issuance


www.derivativefitch.com                                                                     34
Structured Finance CDOs 101

>    Managed vs Static Portfolios
       – Static portfolios are typically fully ramped at closing and principal proceeds
         are used to amortize the senior notes
       – Managed portfolios are typically partially ramped at closing and principal
         proceeds are typically reinvested for a finite period between 3 and 6 years
              >   If the portfolio experiences negative credit migration then discretionary
                  trading is limited to “maintain or improve” credit quality
              >   If the portfolio significantly under performs then the transactions may
                  shift to a static portfolio




www.derivativefitch.com                                                                     35
Structured Finance CDOs 101

>    Cash SF CDO Note Highlights
       – Credit enhancement comes from subordination and excess spread
       – Interest is paid sequentially to note holders
       – Overcollateralization (OC) and Interest Coverage (IC) performance tests
         are checked prior to distributions to subordinate notes
       – Excess interest may be used to:
              >   If tests are passing then distributed to Preferred Shares or Equity
              >   A portion may be used to repay mezzanine notes
              >   If tests are failing then distributions may be used to cure the tests
                     – Purchase new assets
                     – Pay down senior notes



www.derivativefitch.com                                                                   36
     Structured Finance CDOs 101

     Sample Bespoke SF CDO Structure
                                                                              CDO                                CDO
      Reference Portfolio
                                                                              Trust                            Structure
RMBS RMBS RMBS RMBS             RMBS
Bond 1 Bond 2 Bond 3 Bond 4     Bond 5
RMBS RMBS RMBS RMBS RMBS
Bond 6 Bond 7 Bond 8 Bond 9 Bond 10
 RMBS RMBS RMBS RMBS RMBS                                                                                       Unfunded
Bond 11 Bond 12 Bond 13 Bond 14 Bond 15                    CDS                                                 Super-Senior   Unfunded
                                                         Premium              Special                            Revolver       CDS
 RMBS RMBS RMBS RMBS RMBS
                                           CDS Swap                           Purpose
Bond 16 Bond 17 Bond 18 Bond 19 Bond 20
                                          Counterparty                        Vehicle
 RMBS RMBS RMBS RMBS RMBS                                                      (CDO
                                                         Protection
Bond 21 Bond 22 Bond 23 Bond 24 Bond 25                                        Trust)                Note
                                                         Payments
 RMBS RMBS RMBS RMBS RMBS                                                                           Coupon
Bond 26 Bond 27 Bond 28 Bond 29 Bond 30                                                            (L + bps)
                                                                                                                  „AAA‟
 RMBS RMBS RMBS RMBS RMBS                                                                                          Note
Bond 31 Bond 32 Bond 33 Bond 34 Bond 35                                                            Proceeds
                                                                                                      ($)                     Unfunded
 RMBS RMBS RMBS                  RMBS
                          ...                                                                                   First Loss
Bond 36 Bond 37 Bond 38         Bond 80                                                                                         CDS


                                                                                        Proceeds
                                                                      LIBOR
                                                                                           ($)
                                                                        (L)


                                                                         Collateral or
                                                                           Eligible
                                                                         Investments



     www.derivativefitch.com                                                                                                   37
Structured Finance CDOs 101

>    Bespoke SF CDO Asset Portfolio Highlights
       – Portfolios reference between 60 and 100 securities
       – Assets may be diversified by market sector but typically have a
         concentration in subprime RMBS
       – Assets may be diversified by risk profile (initial ratings
       – Assets may be diversified by vintage
       – Asset selection
              >   Portfolio is negotiated between the Bespoke CDO note holder and the
                  CDS Swap counterparty




www.derivativefitch.com                                                                 38
Structured Finance CDOs 101

>    Bespoke SF CDO Note Highlights
       – Attachment points define the amount of portfolio losses the structure
         needs to sustain before a protection payment would be made
       – Detachment point defines the maximum amount of protection payments
         that the notes could be required to make
       – Credit enhancement comes solely from subordination




www.derivativefitch.com                                                          39
Structured Finance CDOs 101

Sample Hybrid SF CDO Structure
                                                               CDO                         CDO
             CDS Portfolio
                                                               Trust                     Structure
     RMBS    RMBS    RMBS     RMBS    RMBS
     CDS 1   CDS 2   CDS 3    CDS 4   CDS 5
     RMBS    RMBS    RMBS     RMBS    RMBS
     CDS 6   CDS 7   CDS 8    CDS 9   CDS 10    CDS Premium              CDS Premium
    RMBS RMBS RMBS RMBS RMBS                                                              Unfunded
    CDS 11 CDS 12 CDS 13 CDS 14 Bond 15                                                  Super-Senior      Unfunded
                                                                                           Revolver          CDS
    RMBS RMBS RMBS                    RMBS       Protection              Super-Senior
                               ...                                        Protection
    CDS 16 CDS 17 CDS 18              CDS 20     Payments
                                                                          Payments
      CDO     CDO     CDO      CDO     CDO
     CDS 1   CDS 2   CDS 3    CDS 4   CDS 5                    Special
                                                               Purpose
                                                                         Note Coupon
             Bond Portfolio                                    Vehicle
                                                                          (L + bps)
                                                                (CDO                         „AAA‟
                                                                Trust)                        CDO
     RMBS RMBS RMBS RMBS              RMBS
     Bond 1 Bond 2 Bond 3 Bond 4      Bond 5                                                 „AA‟
                                                Bond Coupons                                 CDO
     RMBS RMBS RMBS RMBS RMBS
                                                  (L + bps)
     Bond 6 Bond 7 Bond 8 Bond 9 Bond 10                                                      „A‟
                                                                                             CDO           Funded
     RMBS RMBS RMBS RMBS RMBS                                                                               Notes
    Bond 11 Bond 12 Bond 13 Bond 14 Bond 15                                                  „BBB‟
                                                  Proceeds                                    CDO
     RMBS RMBS RMBS                    RMBS
                               ...                   ($)
    Bond 16 Bond 17 Bond 18           Bond 20
                                                                                        Preferred Shares
      CDO    CDO    CDO    CDO         CDO                                                  or Equity
     Bond 1 Bond 2 Bond 3 Bond 4      Bond 5                              Proceeds
                                                                             ($)



www.derivativefitch.com                                                                                               40
Structured Finance CDOs 101

>    Hybrid SF CDO Asset Portfolio Highlights
       – Portfolio assets may be in a cash or synthetic form
       – Portfolios contain between 60 and 140 bonds or CDS
       – Asset attributes similar to the cash SF CDO portfolios
       – Portfolios are typically managed
              >   Asset managers can find relative value on the same asset between
                  cash and synthetic markets
              >   Asset managers can use the synthetic market to access collateral
                  from vintages that are not available in the secondary market
              >   Asset managers can use the synthetic market to get full exposure to
                  cash bonds where they received a partial allocation




www.derivativefitch.com                                                                 41
     ABX.HE and TABX.HE Indices 101

RMBS RMBS RMBS RMBS RMBS RMBS RMBS RMBS RMBS RMBS RMBS                                               ...
                                                                                                           RMBS
  1    2    3    4    5    6    7    8    9   10   11                                                       20




 „AAA‟    „AAA‟    „AAA‟    „AAA‟    „AAA‟    „AAA‟    „AAA‟    „AAA‟    „AAA‟    „AAA‟    „AAA‟     ...    „AAA‟
 RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS             RMBS      ABX.HE.AAA




  „AA‟     „AA‟     „AA‟     „AA‟     „AA‟     „AA‟     „AA‟     „AA‟     „AA‟     „AA‟     „AA‟             „AA‟
 RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS
                                                                                                     ...    RMBS
                                                                                                                      ABX.HE.AA

  „A‟      „A‟      „A‟      „A‟      „A‟      „A‟      „A‟      „A‟      „A‟      „A‟      „A‟              „A‟       ABX.HE.A
                                                                                  RMBS
                                                                                                     ...
 RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS              RMBS             RMBS


 „BBB‟    „BBB‟    „BBB‟    „BBB‟    „BBB‟    „BBB‟    „BBB‟    „BBB‟    „BBB‟    „BBB‟    „BBB‟            „BBB‟
 RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS
                                                                                                     ...
                                                                                                            RMBS
                                                                                                                      ABX.HE.BBB

 „BBB-‟   „BBB-‟   „BBB-‟   „BBB-‟   „BBB-‟   „BBB-‟   „BBB-‟   „BBB-‟   „BBB-‟   „BBB-‟   „BBB-‟           „BBB-‟    ABX.HE.BBB-
 RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS     RMBS      ...    RMBS



Residual Residual Residual Residual Residual Residual Residual Residual Residual Residual Residual   ...   Residual




    www.derivativefitch.com                                                                                                         42
ABX.HE and TABX.HE Indices 101

>    ABX.HE Asset Portfolio Highlights
       – Portfolios reference 20 bonds
       – Assets are all subprime RMBS
       – Assets are homogenous by risk profile (intial ratings)
       – Assets are originated in a 6 month time frame
       – Asset selection
              >   Aggregate a list of the largest volume subprime RMBS issuers
              >   Select two representative transactions from each issuer
              >   Index participants vote on transactions to be included in each index




www.derivativefitch.com                                                                  43
ABX.HE and TABX.HE Indices 101

                              TABX.HE.BBB                 TABX.HE.BBB
                          Reference Obligations             Tranches

                          ABX.HE.BBB ABX.HE.BBB
                          06-2 Portfolio 07-1 Portfolio

                              „BBB‟          „BBB‟
                             RMBS 1         RMBS 1
                              „BBB‟          „BBB‟
                             RMBS 2         RMBS 2
                              „BBB‟          „BBB‟
                             RMBS 3         RMBS 3
                              „BBB‟          „BBB‟
                                                             35 – 100%
                             RMBS 4         RMBS 4
                              „BBB‟          „BBB‟
                             RMBS 5         RMBS 5
                              „BBB‟          „BBB‟
                             RMBS 6         RMBS 6
                              „BBB‟          „BBB‟
                             RMBS 7         RMBS 7
                              „BBB‟          „BBB‟
                                            RMBS 8           20 – 35%
                             RMBS 8
                                .              .             12 – 20%
                                .              .
                                .              .              7 – 12%
                                                              3 – 7%
                             „BBB‟           „BBB‟
                            RMBS 20         RMBS 20           0 – 3%



www.derivativefitch.com                                                  44
ABX.HE and TABX.HE Indices 101

>    TABX.HE Asset Portfolio Highlights
       – Portfolios reference 40 bonds from two ABX.HE indices
       – Assets are all subprime RMBS
       – Assets are homogenous by risk profile (intial ratings)
       – Assets are originated in a one year time frame




www.derivativefitch.com                                           45
Conclusions
ABX.HE and TABX.HE Conclusions

>    The ABX.HE has proven to be effective in providing market transparency in an
     otherwise opaque market
       – Allows market participant to express market views
>    The TABX.HE promises to provide similar benchmarking and relative value
     views for the Bespoke SF CDO market
>    TABX.HE will be less effective in benchmarking for cash and hybrid SF CDOs
       – Portfolios have significantly different portfolio characteristics
       – Portfolios are typically managed in SF CDOs
       – TABX.HE is equally weighted by the largest issuers whereby SF CDOs
         portfolios are typically selected by an asset manager




www.derivativefitch.com                                                             47
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