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Collateralized Debt Obligations

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Introduction

Collateralized debt obligations have been around for more than 25 years, market growth has accelerated and more people are coming across these instruments for the first time. This guide is an introduction to the topic. It is a simple explanation of what they are, how they work and what they are used for.

What is a Collateralized debt obligation?

In simple terms a CDO is the debt issued by a specially incorporated entity to finance the purchase of assets. Typically the assets are bonds, loans, mortgages and receiverables. The Special Purpose Vehicle, (SPV) SPVs are legal structures that include incorporated companies, master trusts and conduits. They are domiciled in tax friendly environments, (no withholding tax and minimal VAT and corporation tax). The Channel Islands, the Republic of Ireland, Delaware, Luxembourg and the Netherlands are often used.

Once established the SPV purchases the assets, (also referred to as collateral). The assets may be originated by the bank, (for example mortgages), or they can be purchased from the market place, (for example bonds).

Diagram to show The Special Purpose Vehicle

To fund these assets the SPV issues debt (liabilities). The liabilities re not all the same. They have a hierarchy or tranche structure.

The tranche structure

For collateralized debt obligations that buy cash assets, (rather than selling protection using credit default swaps), there are three distinct tranches of liability. They are:

  1. The senior tranche: rated AAA, it usually makes up the bulk of debt issued by the CDO, accounting for up to 90% of the liabilities.
  2. The mezzanine tranche: This is normally rated between Aaa and Baa2, it is the section in the middle and may account for about 5% of the liabilities.
  3. The equity: this is unrated or the "first loss piece" and may account for 5% -10% of the liabilities.
Diagram to show The tranche structure

CDO investors are buying these debt or equity tranches. Their interest and principal repayments come from the assets held in the SPV.

The investor therefore depends on the quality and diversity of these assets for the payment of interest and return of capital. Not the creditworthiness of the originating institution.

Collateralized debt obligations priority of payment

In order that the senior tranche can obtain a AAA rating there is a priority of payment. The senior tranche, has priority of payment before the mezzanine. The equity is last in the "pecking order".

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The investment return is based on risk. Provided the collateral does not experience credit losses, the equity and subordinated debt holders obtain a higher investment return than the more senior debt holders.

The sequential pay process means that the subordinated tranches, and in particular the equity, is much more at risk from defaults in the asset portfolio. This is because a small number of defaults within the asset pool will lead to the equity holders losing their principal investment. This is why many people refer to the equity as a "leveraged" investment and the senior tranche as "unleveraged". everage being a measure of the ratio of debt to equity.

Diagram to show Priority of payment

The tranching structure is slicing up the credit risks of the portfolio. Investors with different risk appetites can then decide which tranche is appropriate for them.

Although diversification of the asset portfolio can reduce investor's exposure to large losses CDOs do not turn lead into gold.

Using the principal of "what comes out must go in", the interest and principal payments, legal fees and rating agency costs all come from the collateral held.

In this respect investors need to be very clear about how their position is protected and who has priority of payment.

Ratings

Ratings are very important to collateralized debt obligations tranches. A high rating generally implies a lower risk for the investor and therefore a lower funding cost for the issuer.

Rating agencies adopt different methodologies. They can rate tranches differently and therefore one AAA tranche may be a safer investment than another AAA tranche.

When buying CDOs investors should make their own judgment of the risks involved and not just rely on the rating.

Rating agencies impose various restrictions on the manager in terms of the asset quality, the diversity and the amount of subordination. This protects the more senior investors against the risk of loss. A brief explanation of key points follows.

The AAA tranche

Even though the assets in the collateral portfolio are rated below AAA, a large proportion of the liabilities will obtain a AAA rating. Why is this?

It is because the subordinated tranches act as a cushion to the AAA tranche. The subordinated tranches experience credit losses first.

High quality diversified asset portfolios imply less risk. They therefore require lower amounts of subordination in order to obtain a AAA senior tranche.

With the level of subordination being critical the rating agencies have a very strong influence on the size of the equity, mezzanine and senior tranches.

Having a large proportion of AAA senior debt reduces the funding cost and improves the "deal economics".

Diversification

Portfolio diversification is one of the key components that reduce the possibility of large credit losses adversely affecting investors. Moodys for example measures portfolio diversification using 33 industry classification codes. The greater the spread of investment the higher the diversity score is.

In order to retain the tranche rating and protect senior investors the collateralized debt obligations manager will be required to keep the portfolio diversity score above a certain threshold.

Weighted Average Weighting Factor, (WARF)

WARFs are also used to protect investors. From a statistical perspective as the rating of an obligor deteriorates the probability of default rises rapidly.

To protect investors, the amount of risky assets in the portfolio is restricted. This is achieved by restricting most purchases to investment grade assets and also restricting the portfolio to a minimum "average rating".

This prevents the manager from loading the portfolio with too many risky credits.

The CDO manager must therefore carefully balance the selection of high quality low yielding assets with low quality high yielding assets.

Weighted Average Spread, (WAS)

Rating agencies also make further restrictions on the collateral portfolio. Additional investor protection is achieved by keeping the portfolio return above a WAS. This means that there should be sufficient cash flow to meet the interest payments as they fall due on the tranches.

More restrictions

Further restrictions regarding the collateral will also apply. These include country and currency exposures and the percentage of investment held as unrated debt, subordinated debt and asset backed securities.

Although the CDO manager has certain leeway in deciding on the assets that should be purchased, the rating process is restrictive. It stops the manager loading the portfolio with high yield, risky debt which compromises the security afforded to the AAA tranche.

Waterfalls

The purpose of the interest and principal waterfalls is to protect the seniority of the tranches.

When interest and principal payments are received by the SPV they are disbursed to the tranche holders in a strict order of priority. This disbursement is determined by the waterfall.

It is therefore very important that investors know how the interest and principal waterfalls work in relation to the tranche they hold.

In general interest payments follow the order of priority:

  1. Trustees fees
  2. Swap interest payments
  3. Asset management fees
  4. AAA interest
  5. Mezzanine interest
  6. Equity holders
  7. Holders of any excess spread or interest notes

In order to pay interest to the individual tranches an overcollaterisation, (OC), and interest coverage, (IC), test must be passed.

The OC test is designed to maintain a minimum level of subordination for each tranche. Senior tranches will have a higher OC test than the junior tranches.

Each tranche will also have a minimum IC ratio. This is the collateral interest divided by the interest on the more senior tranches plus interest on the tranche itself. The subordinated tranches have lower IC ratios than the senior tranches.

If these tests are not passed the waterfall of interest and principal is diverted. The senior tranches obtain priority and receive interest and principal payments first. This continues until the OC and IC tests are passed.

What is the attachment point?

The attachment point is the level of subordination that a particular tranche has beneath it. Attachment points are important. For an investor they show the percentage of the transaction that will absorb losses before the tranche is adversely affected.

For example suppose the tranche structure is 4% equity, 6% mezzanine and 90% senior debt. The equity has no subordination, the mezzanine debt has 4% subordination and attaches at the 4% loss level. The senior debt has 10% subordination and attaches at the 10% loss level.

How are equity returns measured?

The equity holder normally receives an annual payment once all other interest payments and fees have been paid. Then at maturity and after all other tranches are repaid any remaining cash is normally paid to the equity holder.

Equity investors normally measure the potential return on their investment as an internal rate of return (IRR) just like the yield on a bond.

Any defaults in the collateral portfolio will affect this yield because the equity holder will suffer losses first. The size of the loss will depend on the number of defaults and the assumed recovery rate.

To take into account the effect of credit losses many investors calculate the IRR using a base case default rate in the asset portfolio and then several additional default scenarios. The base case may use historic default rates implied from the collateral WARF.

The objective is to provide an estimate of the portfolio default rate. It is assumed that the historic default rate can be extrapolated forward. Whether this is an entirely appropriate way to measure the risk is a question equity investors should ask themselves.

Why has this market grown?

To understand why the collateralized debt obligations market has grown you need to consider the advantages for both, the originator of, and investor in, CDOs.

CDOs provide the following advantages for the originator:

  1. Long term funding of assets can be achieved at competitive rates of interest.
  2. Diversification of funding sources can be improved because CDO investors may not ordinarily buy the issuer's debt.
  3. Credit risk and capital usage can be reduced because the assets are normally removed from the originator's balance sheet.
  4. Banks can generate fees from originating assets like mortgages and loans, and transferring the risk to investors using CDOs.

CDOs provide the following advantages for the investor:

  1. CDOs provide investors with choice, they increase the range of investment opportunities from the very safe to the very risky. This increase in choice is what investors seem to want.
  2. Investors can find that CDOs have returns that are higher than similarly rated bonds. A shortage of suitable investments has encouraged investors to consider investing in CDOs.
  3. Many financial institutions use highly rated CDOs as investments for liquidity purposes primarily because of the relatively attractive return they generate.
  4. The equity component of a CDO is leveraged, some firms find this is attractive. In a market where credit spreads are narrow, the equity component meets the risk/return criteria of hedge funds.

Even originators that have not been able to sell all of the CDO tranches have benefited.

Under certain market conditions the equity is very difficult to sell and some banks have been left with this portion. Lower than expected default rates and narrower credit spreads have meant windfall gains for banks in this situation.

Do collateralized debt obligations have any disadvantages?

Caveat Emptor applies to this market. CDOs present investors with special difficulties and the following few paragraphs only touch on these issues.

One of the main problems is their complexity. A CDO is structured by a bank and in this respect one of the main objectives for the originator is fee income. The person who pays for this is the investor. This means that from inception the investor may not be receiving the appropriate returns for the risks being taken.

Many investors rely on ratings and do not understand the detailed mechanics of individual CDOs, for example the way the waterfall works. This means the investor may suffer much greater losses than anticipated should there be a credit downturn.

There are also concerns about the liquidity. There is little doubt that if credit risk and credit losses increased, the equity and mezzanine components of a CDO could be difficult to sell at anything like the price that the investor expected.

Obtaining regular reliable mark-to-market valuations is also a recognised problem for this product. Because of illiquidity some investors value CDO tranches using models. This has coined the term "mark-to-model". The subjective nature of some of the inputs to these models can leave accurate valuations in doubt.

Finally for banks originating CDOs there are additional concerns. There are potential conflicts of interest. Origination is not the same as distribution. Banks that retain equity portions of deals because they cannot sell them are taking risk. They may also wish to consider whether the equity is at "fair-value" or whether it is subsidising the rest of the transaction. Furthermore a bank that finances a CDO buyer may be reliant on the value of the CDO in order to obtain repayment.

The following now explains some of the terms you may encounter in the CDO market.

Cashflow collateralized debt obligations

Cash flow CDOs rely on the cash generated by the collateral to pay all the liabilities of the CDO. This means the asset selection is about the identification of sound long term credits and diversification.

Three different approaches can be taken to the management of collateral, they are:

  1. A static portfolio: no trading of the collateral portfolio is permitted.
  2. Rule based substitution: Assets may be altered provided certain rules like maximum turnover are adhered to.
  3. Managed portfolios: Assets can be bought and sold actively.

Market value, (MV CDOs)

With MV CDOs the manager is actively trading the asset portfolio. This is in contrast to cash flow structures which rely much more on portfolio diversification.

With MV CDOs the investor is protected in a different way. Instead of the assets having to meet the criteria of diversification they are regularly marked-to-market. The MTM ensures that the assets of the CDO are sufficient to repay the liabilities.

Should the value of the assets dip below a threshold the manager is required to sell the assets in order to repay the investors. This repayment follows a strict order. The senior tranche holders are paid first, the mezzanine second and the equity last.

If there is insufficient cash to repay all the liabilities the equity holders experience the first losses, followed by the mezzanine holders and finally the senior debt.

Protection is afforded to investors by various "tests" that the assets must fulfil in relation to the liabilities. These tests incorporate the use of "Advance Rates" (AR).

The market price of the asset is multiplied by the appropriate AR, (ARs vary, are less than 1.00 and depend on the quality and liquidity of the asset). The calculation shows how much debt the asset can support.

For example, if the asset has an advance rate of 0.80 then, $100m of that asset held by the CDO can support $100m x 0.80 = $80m of debt.

Therefore subordination or equity amounting to $20m will be required. Higher advance rates are associated with liquid, highly rated assets. High quality assets therefore require lower amounts of equity in the structure.

The over collateralisation test for a MV CDO uses the advance rates to determine whether there is sufficient collateral to support the tranches. If the collateral falls below this threshold the manager will need to resolve the problem or liquidate the assets of the CDO and repay investors.

To summarise MV CDOs involve trading of the assets. Investors are protected by a regular mark-to-market. If the valuation is insufficient pay down is triggered.

Balance sheet collateralized debt obligations

Sometimes these deals are called collateralised loan obligations, (CLOs). They are used where banks are securitising their loan portfolios. The two main reasons for this are:

  1. A reduction in regulatory capital usage
  2. A reduction in funding costs

In general the loan assets are sold or transferred to the SPV. The bank originator continues to service the loans. The risk is split into tranches that are sold. The tranches pay interest and principal on a sequential basis. The senior notes are rated, equity is not.

Sometimes a Master Trust (MT) structure is used, (see below). The loan assets are sold to a SPV. The SPV sells the loans to the Master Trust and receives a share in the trust. The MT then issues the tranches, these are secured on the loans held in the trust. The bank originator receives the issuance proceeds from the MT via the SPV.

The tranche holders receive interest and principal payments from the loan portfolio held by the MT. There is no recourse to the bank originator.

Diagram to show a simplified Master Trust structure

Synthetic CDOs

Synthetic CDOs use credit default swaps (CDS) to replace the cash assets. (Instead of buying cash assets, the SPV sells credit protection using CDS). The SPV receives the CDS premium for the risk that it is taking. The premium is then distributed in accordance to the tranche structure of the CDO, as are any losses experienced from the CDS trades.

Using CDS transactions to sell protection has certain advantages for the structure. The CDS market is relatively liquid, selling protection is simple, achieving the desired portfolio diversification is easier.

Furthermore CDS trades, (unlike cash assets), can precisely match the maturity of the CDO. CDS trades can also improve deal economics. Sometimes credit spreads in the CDS market can be higher than in the cash market.

Individual tranches can then receive higher returns for the risks they are taking.

Synthetic structures often rely on a tranche that is above the AAA tranche. This super senior tranche pays even lower spreads than the AAA. The super senior debt can account for the majority of the liabilities of the CDO and improves the deal economics.

Tranches of a synthetic CDO can be sold either in funded (cash) or unfunded (CDS) formats. If a tranche is sold as a funded transaction then the SPV normally holds the cash in highly rated collateral. Failure to do this would mean the senior tranches of the CDO would not obtain a sufficiently high rating. Some long dated AAA assets can still have returns that exceed Libor and in this sense the investment in AAA assets can further improve the deal economics.

Diagram to show a simplified synthetic CDO

CDO squared

A CDO squared transaction uses tranches from other CDO transactions as assets. In the example below mezzanine tranches from other CDOs are taken as assets by the SPV. Further senior, mezzanine and equity tranches are then created. The CDO squared transaction is identifying relatively cheap assets from other CDOs to improve the deal economics. But there is a cost to the investor.

The complexity of the transaction makes it a lot harder for the investor to fully identify the risks. It is possible that the collateral has increased exposure to individual credits or sectors. The investor will be reliant on the waterfalls from two different transactions. This increases the legal complexity of the transaction and makes valuation even harder. The fact that the assets themselves may have an illiquidity premium also adds to valuation difficulties.

Clarification of terminology

In this area of financial markets there are many different terms that are used to describe similar financial structures. Sometimes the description "structured finance" is used as an encompassing description.

Below are some of the frequently used terms. They are self explanatory, they refer to the assets held by the SPV or conduit. For example residential mortgage backed securities hold residential mortgages.

ABS: Asset backed security, generally backed by credit card receiverables, auto loans or lease payments.

CBO: Collateralised bond obligation

CLO: Collateralised loan obligations

CMBS: Commercial mortgage backed securities

RMBS: Residential mortgage backed securities

Synthetic: eg synthetic CLO or CDO, this is where risk transfer occurs using credit default swaps rather than the purchase and sale of funded assets like bonds and loans.

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