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Collateralized Mortgage Obligations

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					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 351-352 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 357-358*
            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

				
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