Collateralized debt obligations structures and analysis second edition DOUGLAS j LUCAS

In fact, with $200 billion of cash CDOs issued in 2005, another $200 billion of synthetic CDOs issued, and an incalculableamount of tranches referencing credit default swap CDS indices t

Debt Obligations

Structures and Analysis Second Edition

DOUGLAS J LUCAS LAURIE S GOODMAN FRANK J FABOZZI

John Wiley & Sons, Inc.

ffirst.frm Page vi Wednesday, April 19, 2006 2:50 PM

Debt Obligations

Structures and Analysis Second Edition

THE FRANK J FABOZZI SERIES

Fixed Income Securities, Second Edition by Frank J Fabozzi

Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L Grant and James A Abate

Handbook of Global Fixed Income Calculations by Dragomir Krgin

Managing a Corporate Bond Portfolio by Leland E Crabbe and Frank J Fabozzi

Real Options and Option-Embedded Securities by William T Moore

Capital Budgeting: Theory and Practice by Pamela P Peterson and Frank J Fabozzi

The Exchange-Traded Funds Manual by Gary L Gastineau

Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank

J Fabozzi

Investing in Emerging Fixed Income Markets edited by Frank J Fabozzi and Efstathia Pilarinu

Handbook of Alternative Assets by Mark J P Anson

The Exchange-Traded Funds Manual by Gary L Gastineau

The Global Money Markets by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry

The Handbook of Financial Instruments edited by Frank J Fabozzi

Collateralized Debt Obligations: Structures and Analysis by Laurie S Goodman and Frank J Fabozzi

Interest Rate, Term Structure, and Valuation Modeling edited by Frank J Fabozzi

Investment Performance Measurement by Bruce J Feibel

The Handbook of Equity Style Management edited by T Daniel Coggin and Frank J Fabozzi

The Theory and Practice of Investment Management edited by Frank J Fabozzi and Harry M Markowitz

Foundations of Economic Value Added: Second Edition by James L Grant

Financial Management and Analysis: Second Edition by Frank J Fabozzi and Pamela P Peterson

Measuring and Controlling Interest Rate and Credit Risk: Second Edition by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry

Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank

Short Selling: Strategies, Risks, and Rewards edited by Frank J Fabozzi

The Real Estate Investment Handbook by G Timothy Haight and Daniel Singer

Market Neutral Strategies edited by Bruce I Jacobs and Kenneth N Levy

Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J Fabozzi and Steven V Mann

Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T Rachev, Christian Menn, and Frank J Fabozzi

Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J Fabozzi, Sergio M Focardi, and Petter N Kolm

Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J Fabozzi, Lionel Martellini, and Philippe Priaulet

Analysis of Financial Statements, Second Edition by Pamela P Peterson and Frank J Fabozzi

ffirst.frm Page ii Wednesday, April 19, 2006 2:50 PM

Debt Obligations

Structures and Analysis Second Edition

DOUGLAS J LUCAS LAURIE S GOODMAN FRANK J FABOZZI

John Wiley & Sons, Inc.

Copyright © 2006 by John Wiley & Sons, Inc All rights reserved

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or oth- erwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rose- wood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4470, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Per- missions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Exhibits sourced to Moody’s Investors Service are © Moody’s Investors Service, Inc and/or its affiliates Reprinted with permission All Rights Reserved.

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ffirst.frm Page vi Wednesday, April 19, 2006 2:50 PM

CHAPTER 2

viii Contents

Conclusion 74

CHAPTER 4

Conclusion 99

PART THREE Structured Finance CDOs and Collateral Review 101 CHAPTER 5

CHAPTER 6

CHAPTER 7

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Comparing and Reconciling Structured Finance Default Rates 162

Conclusion 170

CHAPTER 8

Conclusion 198

CHAPTER 10

Conclusion 215

PART FIVE

CHAPTER 11

Conclusion 239

x Contents

CHAPTER 12

Conclusion 253

CHAPTER 13

Conclusion 262

CHAPTER 14

Conclusion 280

CHAPTER 15

Conclusion 297

PART SIX

CHAPTER 16

PART SEVEN

CHAPTER 18

Conclusion 378

PART EIGHT

CHAPTER 20

Prescription for Making Primary Issuances Conducive to

xii Contents

CHAPTER 22

Conclusion 434

CHAPTER 23

Conclusion 450

CHAPTER 24

Conclusion 473

ftoc.frm Page xii Wednesday, April 19, 2006 2:45 PM

Preface

he first edition of this book proclaimed “the market for collateralizeddebt obligations (CDOs) is the fastest growing sector of the asset-backed securities market.” Those words are still true four years later as weoffer this second edition In fact, with $200 billion of cash CDOs issued in

2005, another $200 billion of synthetic CDOs issued, and an incalculableamount of tranches referencing credit default swap (CDS) indices traded,the CDO market is probably the fastest growing financial product not only

As we also said four years ago, “there have been numerous and matic changes within the CDO market as it has evolved.” Since thatstatement, credit protections on CDOs have been tightened, high-yieldloans have replaced high-yield bond collateral, and structured financecollateral, including high-grade collateral, has come to dominate issu-ance Among synthetic CDOs, arbitrage and managed arbitraged CDOshave replaced balance sheet transactions, single-tranche CDOs havebeen created and have risen to dominance, and tranches referencingCDS indices have been created

dra-This second edition reflects the growing and evolving nature of theCDO market: It contains an additional one-third of text and three-quar-ters of the book contains new material

This book covers many different aspects of CDOs and collateralunderlying CDOs Its 24 chapters are divided into eight parts:

Below we provide an overview of each chapter

T

xiv Preface

PART ONE: INTRODUCTION TO CASH CDOs

In Chapter 1 (“Cash CDO Basics”), we first make the case that it is worthtaking the time to understand CDOs Then, to properly explain CDOs,

we break them down into their four moving parts: assets, liabilities, poses, and credit structures We explain each building block in detail andcreate a framework for understanding CDOs that puts old and new CDOvariants in context and cuts through confusing financial jargon Finally,

pur-we define the roles of the different parties to a CDO

In Chapter 2 (“Cash Flow CDOs”), we detail the cash flow creditprotection structure, explaining the distribution of cash flows to CDOtranches, the cash flow waterfall, overcollateralization tests, the restric-tions imposed on CDO managers, and key factors considered by the rat-ing agencies in the CDO debt rating process In doing so, we make use

of lots of examples from actual CDOs

PART TWO: LOANS AND CLOs

This section discusses three types of loans underlying collateralized loanobligations (CLOs): U.S broadly syndicated loans, European broadlysyndicated loans, and U.S middle market loans

The focus of Chapter 3 (“High-Yield Loans: Structure and mance”) is on U.S broadly syndicated loans We discuss the loan mar-ket, loan seniority, and lender’s control over borrowers, including loanterms and conditions that cover preservation of collateral, appropria-tion of excess cash flow, control of business risk, performance require-ments, and reporting requirements We conclude the chapter with adiscussion of loan default and recovery rates and CLO credit quality

Perfor-We begin Chapter 4 (“European Bank Loans and Middle MarketLoans”) by comparing the U.S and European markets for broadly syn-dicated loans We look at issuance by country, industry, and loan pur-pose; and at trends in leverage, spreads, and covenant protections.Given the lack of European loan default and recovery studies, the focus

of the chapter is on calibrating European loans to default and recoveryrates on U.S loans We then move on to middle market loans In theface of tighter spreads for large broadly syndicated loans, some arbi-trage CLO managers have delved into these loans to obtain higherspreads We address the characteristics of middle market loans with par-ticular focus upon their credit quality

fpref.frm Page xiv Wednesday, April 19, 2006 2:48 PM

PART THREE: STRUCTURED FINANCE CDOs AND COLLATERAL

REVIEW

In Chapters 5 and 6 we describe the collateral underlying structured

Finance Collateral: Mortgage-Related Products”) is on real estate-relatedcollateral such as residential mortgage-backed securities, mortgage-related asset-backed securities, commercial mortgage-backed securities,and real estate investment trusts Nonmortgage collateral is the focus ofChapter 6 (“Review of Structured Finance Collateral: NonmortgageABS”) and includes a discussion of credit card receivable-backed securi-ties, auto loan-backed securities, student loan-backed securities, SBAloan-backed securities, aircraft lease-backed securities, franchise loan-backed securities, and rate reduction bonds

Some of the difficulties in calculating structured finance defaults andrecoveries are described in Chapter 7 (“Structured Finance Default andRecovery Rates”) We then detail S&P’s and Moody’s default and recov-ery methodologies and results, as well as our methodology for combiningtheir results We conclude the chapter by considering the best way to use

The similarities of and differences between SF CDOs structures andhigh-yield corporate CDO structures are explained in Chapter 8(“Structured Finance Cash Flow CDOs”) A review of the relative creditquality of structured finance debt versus corporate debt as CDO collat-eral is presented We conclude the chapter by demonstrating that byusing the same criteria to rate all types of CDOs, the rating agenciesimpose an extra burden on those backed by structured finance collat-eral As a result, we argue that ratings on SF CDOs are conservative

PART FOUR: OTHER TYPES OF CASH CDOs

In Chapter 9 (“Emerging Market CDOs”), we look at CDOs backed bysovereign emerging market bonds, focusing on the differences (that mat-ter) between emerging markets and high-yield corporate deals We con-clude that the rating agencies are far more conservative in theirassumptions when rating emerging market deals than in rating high-yieldcorporate deals

Market value CDOs are the subject of Chapter 10 (“Market ValueCDOs”) While the number of market value deals is small relative tocash flow deals, they are the structure of choice for collateral where thecash flows are difficult to predict We open the chapter with an overview

of the differences between cash flow and market value structures and

xvi Preface

then examine the mechanics of market value CDOs, focusing onadvance rates An advance rate is the percentage of a particular assetthat may be issued as rated debt and is the key to protecting CDO debtholders Our investigation of market price volatility suggests that theadvance rates used by the rating agencies are conservative

PART FIVE: SYNTHETIC CDOs

In Chapter 11 (“Introduction to Credit Default Swaps and SyntheticCDOs”), we build upon a description of credit default swaps to explainthe workings of synthetic CDOs Synthetic CDOs have evolved from vehi-cles used by commercial banks to offload commercial loan risk to custom-ized tranches where investors can select the names they are exposed to, thelevel of subordination that protects them from losses, or the premium theyare paid In the chapter we also explain how the rise of standardizedtrenches on CDS indices has increased trading liquidity, thereby allowinglong-short strategies based on tranche seniority or protection tenor

In Chapters 12 and 13, we look at two types of synthetic CDO tures The basic structure and structural nuances of synthetic balancesheet CDOs, the unique challenges confronting the rating agencies in rat-ing them, and the key differences between synthetic and cash transactionsare described in Chapter 12 (“Synthetic Balance Sheet CDOs”) In Chap-ter 13 (“Synthetic Arbitrage CDOs”), we describe the advantages of thisstructure over its cash counterpart These advantages explain why syn-thetic arbitrage CDO issuance has grown dramatically and is expected to

struc-do so in the future The advantages are (1) the super-senior piece in a thetic CDO is generally not funded, (2) there is only a short ramp-upperiod, and (3) credit default swaps often trade cheaper than the cashbond of the same maturity We also demonstrate in Chapter 13 how theseadvantages impact the economics of CDO transactions

syn-We explain an empirically driven methodology that uses historicaldefault and loss-given-default data to determine how a specific tradewould have performed if entered into in the past in Chapter 14 (“AFramework for Evaluating Trades in the Credit Derivatives Market”).More specifically, we show how single name, portfolio, and CDO posi-tions would have performed had they been entered into each year from

1970 through 2000

The coverage in Chapter 15 (“Structured Finance Credit DefaultSwaps and Synthetic CDOs”) falls neatly into two topics First, the evo-lution of structured finance CDS documentation, the competing dealer,and end user templates, and the structured finance CDS terms that best

fpref.frm Page xvi Wednesday, April 19, 2006 2:48 PM

replicate the economics of owning a cash structured finance bond ond, we address the effect of structured finance CDS on SF CDOs,including managers’ newfound flexibility in accessing credit risk, thecreation of new SF CDO structures, the outlook for more tiering amongCDO managers, and the effect on SF CDO credit quality.

Sec-PART SIX: DEFAULT CORRELATION

We define default correlation, discuss its drivers, and show why CDOinvestors care about it in the first of our two chapters on default correla-tion, Chapter 16 (“Default Correlation: The Basics”) We provide pictorialrepresentations of default probability and default correlation and derivemathematical formulas relating default correlation to default probability.The difficulty of the problem becomes evident when we show that pairwisedefault correlations are not sufficient to understand the behavior of acredit risky portfolio and introduce “higher orders of default correlation.”

In the second of our chapters on default correlation, Chapter 17(“Empirical Default Correlation: Problems and Solutions”), we surveythe meager work done on historic default correlation We show thatdefault correlations within well-diversified portfolios vary by the ratings

of the credits and also by the time period over which defaults are ined But in that chapter we also devote a good deal of coverage todescribe the major problems in measuring and even thinking aboutdefault correlation The thorniest problem is that when looking at his-torical rates of default, it is impossible to distinguish default correlationfrom changing default probability We compare different approaches ofincorporating default correlation into portfolio credit analysis andopine that the approached suggested by Credit Suisse First Bostonmakes the most direct use of historical data and is the easier to under-stand, but feel that more work needs to be done on default probability

exam-PART SEVEN: CDO EQUITY

There are four reasons why investors should consider buying CDO equity:nonrecourse term financing, the forgiving nature of the cash flow CDOstructure, two optionalities CDO equity holders enjoy, and the use ofCDO equity in a defensive investment strategy We set forth these reasons

in Chapter 18 (“Why Buy CDO Equity?”)

In Chapter 19 (“CDO Equity Returns and Return Correlation”), wetake on the misguided practice of calculating CDO equity Sharpe ratios

xviii Preface

and the correlation of CDO equity returns with the returns of otherassets The calculation of these variables is so fundamentally flawed thatthe results are useless We delve into the usefulness of historical data inpredicting future CDO equity returns and present a simple approach tounderstanding the relationship between CDO equity returns and thereturns of CDO underlying asset portfolios

PART EIGHT: OTHER CDO TOPICS

In Part Eight of the book we include six chapters that cover a bord of CDO topics

smorgas-A discussion of secondary market developments and pitfalls is vided in Chapter 20 (“Analytical Challenges in Secondary-Market CDOTrading”) However, the bulk of the chapter is on how to evaluate a sec-ondary CDO offering We show what to look for in a trustee report andwhat to get out of net asset value analysis Our most important suggestion

pro-is a methodology for selecting default scenarios in cash flow modeling.The factors that structurers consider in creating CDOs are the sub-ject of Chapter 21 (“The CDO Arbitrage”) We show how to look at theCDO arbitrage and present a “quick and dirty” analysis for benchmark-ing CDO issuance and then focuses on how the arbitrage dictates dealstructure Spread configurations and the exact collateral used are impor-tant in determining optimal deal structure We explain why the practice

of simply looking at percent subordination or percent tion as an arbiter of tranche quality is misleading

overcollateraliza-In Chapter 22 (“How to Evaluate a CDO and Manage a CDO folio”), we look at evaluating CDOs individually and as part of a port-folio One of the most important points to look for in a CDO purchase

Port-is the structural protections inherent in a CDO because there Port-is a ral tension between the interest of debt holders and equity holders Buy-ers of CDO debt should look at both the incentive structures in a CDO,

natu-as well natu-as how the manager hnatu-as done on outstanding CDOs In pickingmanagers, track record cannot be taken at face value In the chapter wealso make the case that investors should buy CDOs backed by differenttypes of collateral and that low-diversity CDOs are not to be shunned

In Chapter 23 (“Quantifying Single-Name Risk Across CDOs”) wequantify the extent of collateral overlap among a sample of CLOs and

SF CDOs and propose a simple and consistent measure of single-namerisk We explain that there is little reason to be concerned about single-name risk except at the level of equity and the lowest debt tranche

fpref.frm Page xviii Wednesday, April 19, 2006 2:48 PM

In the last chapter, the rating history of 1,000 CDOs and 3,000CDO tranches across 22 types of CDOs in the United States, Europe,and emerging markets is provided In that chapter (Chapter 24, “CDORating Experience”), we compare CDOs by type and vintage and assessboth the frequency and severity of downgrades Particular attention ispaid to the severity of downgrades and a proxy CDO default study isoffered.

ACKNOWLEDGMENTS

We gratefully acknowledge the expertise and participation of UBSresearch personnel Bill Prophet, Greg Reiter, William Smith, and TomZimmerman reviewed drafts and made helpful comments Wilfred Wongand Tommy Leung contributed analysis to several chapters Vicki Ye wasinvolved in every step, from background research and data gathering toreviewing and critiquing the final product

We particularly thank the rating agencies, Moody’s Investors vice, Standard & Poor’s, and Fitch Ratings, for allowing us to drawupon the wealth of data and expertise they provide to CDO investors.Most specifically, we incorporated material on their rating methodolo-gies, default and recovery studies, and rating transition studies into thisbook Special thanks also to S&P LCD, for the variety of loan data andanalysis they allow us to use

Ser-Douglas J LucasLaurie S GoodmanFrank J Fabozzi

fpref.frm Page xx Wednesday, April 19, 2006 2:48 PM

About the Authors

Douglas J Lucas is an Executive Director at UBS and head of CDO

CDO research at JPMorgan, co-CEO of Salomon Swapco, and analyst atMoody’s Investors Service While at Moody’s he authored the ratingagency’s first default and rating transition studies, quantified the expectedloss rating approach, and developed the rating methodologies for collat-eralized debt obligations and triple-A special purpose derivatives dealers

He is known for doing some of the first quantitative work in default relation Currently Chairman of The Bond Market Association’s CDOResearch Committee, Douglas has a BA magna cum laude in Economicsfrom UCLA and an MBA with Honors from the University of Chicago

cor-Laurie S Goodman is cohead of Global Fixed Income Research and ages U.S Securitized Products (RMBS, ABS, CMBS, CDO) and Treasury/Agency/Swap Research at UBS As a mortgage analyst, Laurie has long

categories 30 times over the last eight years In 1993, Laurie founded thesecuritized products research group at Paine Webber, which merged withUBS in 2000 Prior to that, Laurie held senior fixed income research posi-tions at Citicorp, Goldman Sachs, and Merrill Lynch and gained buy-sideexperience as a mortgage portfolio manager She began her career as aSenior Economist at the Federal Reserve Bank of New York Laurie holds

a BA in Mathematics from the University of Pennsylvania, and MA andPhD degrees in Economics from Stanford University She has publishedmore than 160 articles in professional and academic journals

Frank J Fabozzi is an Adjunct Professor of Finance and Becton Fellow inthe School of Management at Yale University Prior to joining the Yalefaculty, he was a Visiting Professor of Finance in the Sloan School at MIT.Frank is a Fellow of the International Center for Finance at Yale Univer-sity and on the Advisory Council for the Department of OperationsResearch and Financial Engineering at Princeton University He is the edi-

xxii About the Authors

the City University of New York in 1972 In 2002 Frank was inductedinto the Fixed Income Analysts Society’s Hall of Fame He earned the des-ignation of Chartered Financial Analyst and Certified Public Accountant

He has authored and edited numerous books in finance

flast.frm Page xxii Wednesday, April 19, 2006 2:49 PM

One

Introduction to Cash CDOs

p01 Page 2 Monday, March 6, 2006 11:10 AM

CHAPTER 1

3

Cash CDO Basics

Yet it was only in 1998 that annual issuance broke $100 billion As

of 2005, $1.1 trillion of CDOs were outstanding, making CDOs thefastest-growing investment vehicle of the last decade This growth is atestament to their popularity among asset managers and investors

A CDO issues debt and equity and uses the money it raises to invest in

a portfolio of financial assets such as corporate loans or mortgage-backedsecurities It distributes the cash flows from its asset portfolio to the hold-ers of its various liabilities in prescribed ways that take into account therelative seniority of those liabilities This is just a starting definition, wewill fill in the details for this definition over the next few pages

In this chapter, we first make the case that it is worth taking thetime to understand CDOs Then, to properly explain CDOs, we breakthem down into their four moving parts: assets, liabilities, purposes,and credit structures We explain each building block in detail and cre-ate a framework for understanding CDOs that puts old and new CDOvariants in context and cuts through confusing financial jargon Next,

we define the roles of the different parties to a CDO

WHY STUDY CDOs?

Before we tell you more about CDOs, you should know why it is worthyour time to take notice There are three compelling reasons:

total amount of CDOs outstanding is $1.1 trillion Of course, the merefact that there is a lot of something is not a recommendation But the

C

4 INTRODUCTION TO CASH CDOs

most desirable thing in the world is not very useful if you cannot getyour hands on it The fact that the supply of CDOs is large and grow-ing means that there are a wide variety of different structures to choosefrom

investors can gain exposures that they could not otherwise obtain, such

as investment-grade risk to grade assets or grade risk to investment-grade assets Investors can get levered expo-sure to an asset portfolio, or the exact opposite, loss-protected expo-

leverage The debt a CDO issues provides higher spreads than similarlyrated instruments Certain types of CDOs provide upside potentialwith a limit on downside risk Others provide a surety of constantreturns

Reason #3: They can improve the return profile of an existing

would not acquire on their own, thereby improving portfolio diversity.CDOs come with built-in diversification and most come with built-inasset management CDO returns have low correlation to returns ofother assets

UNDERSTANDING CDOs

“Collateralized debt obligations,” “arbitrage cash flow CDOs,” and

“collateralized loan obligations” are similar phrases that could refer tothe same type of CDO or to very different types of CDOs “Structuredfinance CDOs,” “ABS CDOs,” and “resecuritizations” are three distinctnames all referring to the same type of CDO The phraseology getsworse with idioms such as “CDO squared” and the perfectly logicalexpression (once you understand it) “the CDO issues CDOs.” Like mostfinance terms, the emphasis of CDO nomenclature is to distinguish newproducts from existing products This often happens at the expense oflogical categorization

Any CDO can be well described by focusing on its four importantattributes: assets, liabilities, purposes, and credit structures Like anycompany, a CDO has assets With a CDO, these are financial assets such

as corporate loans or mortgage-backed securities And like any pany, a CDO has liabilities With a CDO, these run the gamut of pre-ferred shares to AAA rated senior debt Beyond the seniority and

com-c01-Introduction Page 4 Monday, March 6, 2006 11:11 AM

subordination of CDO liabilities, CDOs have additional structural

differ-ent types of assets CDOs hold, the differdiffer-ent types of liabilities CDOsissue, the two different credit structures CDOs employ, and at the threepurposes for which CDOs are created

Assets

CDOs own financial assets such as corporate loans or mortgage-backedsecurities A CDO is primarily identified by its underlying assets.The first CDOs created in 1987 owned high-yield bond portfolios

In fact, before the term “CDO” was invented to encompass an broadening array of assets, the term in use was “collateralized bondobligation” or “CBO.” In 1989, corporate loans and real estate loanswere used in CDOs for the first time, causing the term “collateralizedloan obligation” or “CLO” to be coined Generally, CLOs are com-prised of performing high-yield loans, but a few CLOs, even as far back

ever-as 1988, targeted distressed and nonperforming loans Some cever-ash CLOscomprised of investment-grade loans have also been issued

Loans and bonds issued by emerging market corporations and eign governments were first used as CDO collateral in 1994, thus “emerg-ing market CDO” or “EM CDO.” In 1995, CDOs comprised of residentialmortgage-backed securities (RMBS) were first issued CDOs comprised ofcommercial mortgage-backed securities (CMBS) and asset-backed securi-ties (ABS), or combinations of RMBS, CMBS, and ABS followed but theyhave never found a universally accepted name In this book, we use “struc-tured finance CDO” or “SF CDO.” However, Moody’s champions theterm “resecuritizations” and many others use “ABS CDO,” even to refer toCDOs with CMBS and RMBS in their collateral portfolios

sover-It is noteworthy that the collateral diversity we have described sofar, between 1987 through 1995, occurred while annual CDO issuanceaveraged $2 billion and never exceeded $4 billion As shown in Exhibit1.1, CDO issuance only really took off in 1996 Issuance jumped to $38billion in 1996, $82 billion in 1997, and $139 billion in 1998

The decline in CDO issuance in 2001 and 2002 was due to a difficultcorporate credit environment As a result, corporate bond and loan-backed CDO issuance fell 50% from $100 billion in 2000 to $50 billion

in 2002 Since 2002, the steady annual increases in CDO issuance hasbeen fueled by high-yield loan-backed CLOs and SF CDOs As shown inExhibit 1.2, these collateral types underlie 91% of CDOs issued thus far

6 INTRODUCTION TO CASH CDOs

c01-Introduction Page 6 Monday, March 6, 2006 11:11 AM

in 2005 Also shown in Exhibit 1.2 is the distinction between mezzanineassets—BBB– and A rated SF—and high-grade AA– and AAA rated SFassets While mezzanine SF securities have been used in CDOs in quantity

as far back as 1998, higher rated SF securities debuted in CDOs in 2003.The majority of the “other” category in the exhibit is comprised of capitalnotes from banks and insurance companies CDOs backed by these assetswere first issued in 2000 Emerging market debt and high-yield bondsmake up most of the remainder of the “other” category in Exhibit 1.2.The CDO market is opportunistic in the way it drops collateraltypes that are out of favor with investors and picks up collateral typesthat are in favor with investors The best example of this is the switchout of poor-performing high-yield bonds and into well-performing high-yield loans between 2001 and 2003 Also, certain types of ABS present

in SF CDOs from 1999 through 2001 disappeared from later vintages:manufactured housing loans, aircraft leases, franchise business loans,and 12b-1 mutual fund fees All of these assets had horrible perfor-mance in older SF CDOs In their place, SF CDOs have recently focusedmore on RMBS and CMBS

Liabilities

Any company that has assets also has liabilities In the case of a CDO,these liabilities have a detailed and strict ranking of seniority, going upthe CDO’s capital structure as equity or preferred shares, subordinated

equity are commonly labeled Class A, Class B, Class C, and so forthgoing from top to bottom of the capital structure They range from themost secured AAA rated tranche with the greatest amount of subordina-tion beneath it, to the most levered, unrated equity tranche Exhibit 1.3shows a simplified tranche structure for a CLO

Special purposes entities like CDOs are said to be “bankruptremote.” One aspect of the term is that they are new entities without

Tranche

Percent of

8 INTRODUCTION TO CASH CDOs

previous business activities They therefore cannot have any legal ity for sins of the past Another aspect of their “remoteness from bank-ruptcy” is that the CDO will not be caught up in the bankruptcy of anyother entity, such as the manager of the CDO’s assets, or a party thatsold assets to the CDO, or the banker that structured the CDO

liabil-Another, very important aspect of a CDO’s bankruptcy remoteness,

is the absolute seniority and subordination of the CDO’s debt tranches

to one another Even if it is a certainty that some holders of the CDO’sdebt will not receive their full principal and interest, cash flows from theCDO’s assets are still distributed according to the original game plandictated by seniority The CDO cannot go into bankruptcy, either volun-tarily or through the action of an aggrieved creditor In fact, the needfor bankruptcy is obviated because the distribution of the CDO’s cashflows, even if the CDO is insolvent, has already been determined indetail at the origination of the CDO

Within the stipulation of strict seniority, there is great variety in thefeatures of CDO debt tranches The driving force for CDO structurers is

to raise funds at the lowest possible cost This is done so that the CDO’sequity holder, who is at the bottom of the chain of seniority, can get themost residual cash flow

Most CDO debt is floating rate off LIBOR, but sometimes a fixedrate tranche is structured Avoiding an asset-liability mismatch isanother reason why floating-rate high-yield loans are more popular inCDOs than fixed-rate high-yield bonds Sometimes a CDO employsshort-term debt in its capital structure When such debt is employed, theCDO must have a standby liquidity provider, ready to purchase theCDO’s short-term debt should it fail to be resold or roll in the market ACDO will only issue short-term debt if its cost, plus that of the liquidityprovider’s fee, is less than the cost of long-term debt

Sometimes a financial guaranty insurer will wrap a CDO tranche.Usually this involves a AAA rated insurer and the most senior CDOtranche Again, a CDO would employ insurance if the cost of thetranche’s insured coupon plus the cost of the insurance premium is lessthan the coupon the tranche would have to pay in the absence of insur-ance To meet the needs of particular investors, sometimes the AAA

Some CDOs do not have all their assets in place when their ties are sold Rather than receive cash the CDO is not ready to invest,tranches might have a delay draw feature, where the CDO can call forfunding within some specified time period This eliminates the negativecarry the CDO would bear if it had to hold uninvested debt proceeds incash An extreme form of funding flexibility is a revolving tranche,where the CDO can call for funds and return funds as its needs dictate

liabili-c01-Introduction Page 8 Monday, March 6, 2006 11:11 AM

CDOs are created for one of three purposes:

balance sheet, (2) reduce required regulatory capital, (3) reducerequired economic capital, or (4) achieve cheaper funding costs Theholder of these assets sells them to the CDO The classic example ofthis is a bank that has originated loans over months or years and nowwants to remove them from its balance sheet Unless the bank is verypoorly rated, CDO debt would not be cheaper than the bank’s ownsource of funds But selling the loans to a CDO removes them from thebank’s balance sheet and therefore lowers the bank’s regulatory capitalrequirements This is true even if market practice requires the bank tobuy some of the equity of the newly created CDO

and management fees Investors wish to have the expertise of an assetmanager Assets are purchased in the marketplace from many differentsellers and put into the CDO CDOs are another means, along withmutual funds and hedge funds, for an asset management firm to pro-vide its services to investors The difference is that instead of all theinvestors sharing the fund’s return in proportion to their investment,investor returns are also determined by the seniority of the CDOtranches they purchase

capital Here, the example is a large number of smaller-size banks

issuance of its own liabilities The bank capital notes would not beissued but for the creation of the CDO to purchase them

Three purposes differentiate CDOs on the basis of how they acquiretheir assets and focus on the motivations of asset sellers, asset managers,and capital note issuers From the point of view of CDO investors, how-ever, all CDOs have a number of common purposes, which explain whymany investors find CDO debt and equity attractive

One purpose is the division and distribution of the risk of theCDO’s assets to parties that have different risk appetites Thus, a AAAinvestor can invest in speculative-grade assets on a loss-protected basis

Or a BB investor can invest in AAA assets on a levered basis

or-der of repayment.

10 INTRODUCTION TO CASH CDOs

Source: UBS, Salomon Yield Book.

For CDO equity investors, the CDO structure provides a leveragedreturn without some of the severe adverse consequences of borrowingvia repo from a bank CDO equity holders own stock in a company andare not liable for the losses of that company Equity’s exposure to theCDO asset portfolio is therefore capped at the cost of equity minus pre-vious equity distributions Instead of short-term bank financing, financ-ing via the CDO is locked in for the long term at fixed spreads to theLondon interbank offered rate (LIBOR)

For CDO debt investors, CDOs offer spreads that are usually higherthan those of alternative investments, particularly for CDOs rated below

AA, as shown in Exhibit 1.4 And finally, the CDO structure allowsinvestors to purchase an interest in a diversified portfolio of assets.Often these assets are not available to investors except through a CDO.Exhibit 1.5 summarizes the CDO purposes that we have discussed

CREDIT STRUCTURES

Beyond the seniority and subordination of CDO liabilities, CDOs haveadditional structural credit protections, which fall into the category of

explain, since it is analogous to an individual’s margin account at a

the amount that can be borrowed against that asset Advance rates arenecessarily less than 100% and vary according to the market value vola-tility of the asset For example, the advance rate on a fixed rate B ratedbond would be far less than the advance rate on a floating rate AAA-rated bond Both the rating and floating rate nature of the AAA bond

Home Equity

Credit Card

Manf House

indicate that its market value will fluctuate less than the B rated bond.Therefore, the CDO can borrow more against it The sum of advancerates times the market values of associated assets is the total amount theCDO can borrow.

The credit quality of a market value CDO derives from the ability ofthe CDO to liquidate its assets and repay debt tranches Thus, the mar-ket value of the CDO’s assets are generally measured every day, advancerates applied, and the permissible amount of debt calculated If thiscomes out, for example, to $100 million, but the CDO has $110 million

of debt, the CDO must do one of two things It can sell a portion of itsassets and repay a portion of its debt until the actual amount of debt isless than the permissible amount of debt Or the CDO’s equity holderscan contribute more cash to the CDO If no effective action is taken, theentire CDO portfolio is liquidated, all debt is repaid, and residual cashgiven to equity holders The market value credit structure is analogous

to an individual being faced with a collateral call at his (or her) age account If he does not post additional collateral, his portfolio is atleast partially liquidated

Balance

Provide asset sellers with cheap funding

or regulatory capital relief or economic

capital relief

X

Provide asset managers with assets under

management and CDO investors with

asset management services

X

Provide banks and insurance companies

with cheap equity-like capital

X Divide and distribute the risk of the CDO

assets to parties with differing appetites

for risk

Provide equity investors with leveraged

exposure to the CDO’s assets with

non-recourse term financing

Provide debt investors with high

ratings-adjusted yields

Provide investors with a diversified

invest-ment portfolio, perhaps of

hard-to-access assets

12 INTRODUCTION TO CASH CDOs

assets is expected to cover debt tranche principal and interest with somedegree of certainty Obviously, the certainty that a AAA CLO tranche,with 23% subordination beneath it, will receive all its principal andinterest is greater than the certainty a BB CLO tranche, with only 8%subordination beneath it, will receive all its principal and interest.All cash flow CDOs have a feature that improves the credit quality

of their senior tranches In the normal course of events, if defaults arenot “too high” (a phrase we will shortly explain in detail), cash couponscome in from the CDO’s asset portfolio These dollars are first applied

to the CDO’s administrative costs, such as those for its trustee and itsmanager, if it has one Next, these moneys are applied to interestexpense of the CDO’s senior-most tranche Next, moneys are applied tointerest expense on the CDO’s second most senior tranche and succes-sively moving down the capital structure until all interest on all debttranches is paid If the CDO has a manager, an additional fee to thatmanager might be paid next Finally, left over, or residual, cash flow isgiven to the CDO’s equity holders

What if defaults are “too high” (as we promised earlier to explain)?Also, how do we know whether defaults are too high? There are two series

of tests, the most important of which is shown below The key to these tests

is that defaulted assets are excluded or severely haircut (counted at a tion of their par amount) in the definition of “asset par.”

frac-Class A par coverage test = Asset par/frac-Class A parClass B par coverage test = Asset par/(Class A par + Class B par)Class C par coverage test = Asset par/(Class A par + Class B par + Class C par)

… and so on, for all the debt tranches

To pass these tests, par coverage must be greater than some number,perhaps 120% for the Class A par coverage test, perhaps only 105% forthe Class C par coverage test The more defaulted assets a CDO has, themore likely it will be to fail one or more of these tests Failure of a parcoverage test requires that cash be withheld from paying interest onlower-ranking debt tranches Instead, cash must be used to pay downprincipal on the CDO’s senior-most debt tranche If enough cash isavailable to pay down the senior-most tranche so that the par coveragetest is in compliance, remaining cash can be used to make interest pay-ments to lower-ranking tranches and on down the line to the CDO’s

c01-Introduction Page 12 Monday, March 6, 2006 11:11 AM

equity holders We discuss the cash flow credit structure in much moredepth in Chapter 2

A CDO STRUCTURAL MATRIX

Exhibit 1.6 shows the four CDO building blocks and a variety ofoptions beneath each one Any CDO can be well described by askingand answering the four questions implied by the exhibit:

This way of looking at CDOs encompasses all the different kinds ofCDOs that have existed in the past and all the kinds of CDOs that arecurrently being produced For example, the first CDO ever created, back

in 1987, had high-yield bond assets, fixed rate debt, a market value

make further use of this CDO classification system as we turn to themost common types of CDOs offered today

under-written by Drexel Burnham, and rated by S&P.

Credit Structure

14 INTRODUCTION TO CASH CDOs

CDOs BEING OFFERED TODAY

In Exhibit 1.2, we showed that 91% of CDOs issued so far in 2005 arebacked by high-yield loans and structured finance (ABS, CMBS, RMBS)assets Most of these CDOs, as well as the comparatively few CDOsbacked by high-yield bonds, investment-grade bonds, and emergingmarket bonds, use the cash flow credit structure and were done for arbi-trage purposes Exhibit 1.7 shows 2005 CDO issuance by purpose,credit structure, and assets Note that 81% of CDOs issued in 2005have been arbitrage cash flow CDOs backed by various types of assets.This is clearly the dominant structure

PARTIES TO A CDO

A number of parties and institutions contribute to the creation of aCDO We conclude this introductory chapter with a discussion of themost important roles

CDO Issuer and Co-Issuer

A CDO is a distinct legal entity, usually incorporated in the CaymanIslands Its liabilities are called CDOs, so one might hear the seemingly cir-cular phrase “the CDO issues CDOs.” Offshore incorporation enables theCDO to more easily sell its obligations to United States and internationalinvestors and escape taxation at the corporate entity level When a CDO islocated outside the U.S., it will typically also have a Delaware co-issuer.This entity has a passive role, but its existence in the structure allowsCDO obligations to be more easily sold to U.S insurance companies

c01-Introduction Page 14 Monday, March 6, 2006 11:11 AM

Asset Manager (Collateral Manager)

arbitrage CDO and manage it according to prescribed guidelines

balance sheet CDO of distressed assets to handle their workout or sale

A variety of firms offer CDO asset management services including hedgefund managers, mutual fund managers, and firms that specialize exclu-sively in CDO management

Asset Sellers

retain its equity In cash CDOs, the assets involved are usually sized loans extended to smaller-sized borrowers In the United States,these are called “middle market” loans and in Europe these are called

smaller-“small and medium enterprise” (SME) loans

Investment Bankers and Structurers

asset seller to bring the CDO to fruition They set up corporate entities,shepherd the CDO through the debt rating process, place the CDO’sdebt and equity with investors, and handle other organizational details

A big part of this job involves structuring the CDO’s liabilities: their sizeand ratings, the cash diversion features of the structure, and, of course,debt tranche coupons To obtain the cheapest funding cost for the CDO,the structurer must know when to use short-term debt or insured debt

or senior/junior AAA notes, to name just a few structural options.Another part of the structurer’s job is to negotiate an acceptable set ofeligible assets for the CDO These tasks obviously involve working withand balancing the desires of the asset manager or seller, different debtand equity investors, and rating agencies

Insurers/Guarantors

the senior-most tranche in a CDO Often, insurance is used when a CDOinvests in newer asset types or is managed by a new CDO manager

Rating Agencies

per-form due diligence on the asset manager and the trustee, and rate thevarious seniorities of debt issued by the CDO Usually two or three ofthe major rating agencies (Moody’s, S&P, and Fitch) rate the CDO’s

16 INTRODUCTION TO CASH CDOs

debt DBRS is a recent entrant in CDO ratings and A M Best has rated

CDOs backed by insurance company capital notes

Trustees

Trustees hold the CDO’s assets for the benefit of debt and equity

hold-ers, enforce the terms of the CDO indenture, monitor and report upon

collateral performance, and disburse cash to debt and equity investors

according to set rules As such, their role also encompasses that of

col-lateral custodian and CDO paying agent

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