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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

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Collateralized debt obligations

Collateralized Debt Obligations

Fabozzi -- Chapter 15

Introduction to cdos
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
    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
    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
    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
    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
    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 continued1
    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 continued2
    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 continued3
    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
    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