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Global CDO Market Update. Richard Gugliada Managing Director +1-212-438-2474 richard\[email protected] S&P’s Global CDO Rated Transactions by Region (1996-2002). # o f D E A L S. S&P’s Global CDO Rated Transactions by Region (1996-2002). EVOLUTION OF CDOs. Leveraged Loans.

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richard gugliada managing director 1 212 438 2474 richard gugliada@sandp com
Global CDO

Market Update

Richard GugliadaManaging Director+1-212-438-2474 [email protected]

slide2
S&P’s Global CDO Rated Transactions

by Region (1996-2002)

#

o

f

D

E

A

L

S

slide4
EVOLUTION OF CDOs

Leveraged

Loans

Trust Preferred

Private Equity

Hedge Funds

Municipal Bonds

Correlation Trades

Other

ABS

MBS

REITs

Distressed Debt

Synthetic CDOs

HY DEBT

cash flow cdos
Cash Flow CDOs
  • Interest and principal for Corporate obligations are used to pay down the investors.
  • Liabilities are subordinated to provide different levels of credit protection.
  • Assets  SPV  Class A “AAA”

Class B “BBB”

Equity NR

cash flow cdo structure
Cash Flow CDO Structure

Market /

Sponsor

SPV

Loan/Bond Portfolio

Class A

Class B

Class C

Equity

notes

cash

cash

synthetic cdo
Synthetic CDO
  • Investors sell credit protection to 3rd party on a referenced pool of obligations.
  • SPV holds the money in Eligible Investments (EI)
  • Investors get interest from EI and 3rd party.
  • If an obligation in the pool defaults, SPV pays 3rd party from EI, based on an agreed upon settlement process to value the defaulted obligation.
synthetic cdo8
Synthetic CDO

Eligible Investments

Assets

cash

Class A

Class B

Class C

Equity

Sponsor/

Protection Buyer

SPV

fee

notes

contingent payment

cash

Reference

portfolio

global rated cdo volume 2001 vs 2002
Global Rated CDO Volume:2001 vs. 2002

* Excludes 11 US re-pack deals

Source: S&P Global Deal List

** Rounded two decimal places

slide13
Economic Backdrop
  • HY issuance remains relatively low
  • Severe pool-level ratings migration
  • Stigma of Record Corporate Defaults
  • Too much liquidity to certain sectors (e.g., telecom and healthcare)
  • Depressed recoveries
  • Corresponding negative correlation
  • All contribute to poor performance in certain

sub-sectors of CDO market

  • But, fixed income market sell-off creating

relative buy opportunities

slide14
U.S. SPECULATIVE GRADE ISSUANCE*

(1992 – Aug. 25, 2003)

(US$ Billions)

Industrials

Telecommunications

Utility

Financials

140

120

100

80

60

40

20

0

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

* = Includes all public and rule 144a issuance of straight, convertible, floating-rate,

and medium-term notes issued into U.S. marketplace by financial and non-financial entities.

Source: Standard & Poor's Global Fixed Income Research, Thomson Financial

annual default rates investment grade speculative grade
Annual Default RatesInvestment Grade & Speculative Grade

Source: Standard & Poor's Risk Solutions CreditPro® 6.4

source standard poor s risk solutions creditpro 6 4
Source: Standard & Poor's Risk Solutions CreditPro® 6.4

Quarterly Default Rates

Speculative Grade

slide17
Standard & Poor’s LossStatsTM

Recovery Rates Based on Pre-Default Interest

1988 – 2003 Q2*

1998 – 2003 Q2**

* 1741 observations

** 868 observations

current regulatory driven issues impact on investor appetite
Current Regulatory-Driven Issues Impact on Investor Appetite
  • FIN 46 / FAS 140
  • EITF 99-20
  • Traditional non-US investors under increased regulatory scrutiny
  • Efficiency of holding downgraded assets for portions of CDO investorbase(e.g., conduits, SIVs, insurance companies, etc.)

All combine to create buying opportunities

But ramp-up difficult

most downgrades are caused by these problems
Most Downgrades Are Caused By These Problems:
  • Credit migration – reduction in the credit quality of the performing assets within the collateral pool
  • Par erosion – reduction in the par value of the collateral pool securing the rated notes
  • Spread deterioration – reduction of the weighted average coupon or weighted average spread generated by the performing assets within the collateral pool
  • Hedging issues – mismatch between the fixed rate of interest received off the assets in the collateral pool and the floating rate of interest paid on the liabilities
slide21
Global CDO* 1997 to 2002

Average One-Year Transition Rates (%)

*includes all CDO segments

slide22
U.S. CDO* versus U.S. Corporate

2002 One-Year Transition Rates (%)

CDOs

CORPORATES

*includes all CDO segments

slide23
European CDO* versus European Corporate 2002 One-Year Transition Rates (%)

CDOs

CORPORATES

*includes all CDO segments

slide25
Cash Flow CBO Rating Transitions:Ten Collateral Managers with the Most Downgraded Senior Tranches (HY and IG CBO transactions only)*

*as of Aug. 31, 2003

slide26
Leverage via Par-Building Trades

EXAMPLE 1:

Before a payment date in 2000, Manager X purchased two bonds at discounted prices (i.e., 14% and 17%), even though the obligors were rated “B” and “B-” and on credit watch negative. Net result was a gain of $5mm in par because assets carried at 100%. Class B O/C ratio to pass by 80 bps. Two weeks after the payment date one defaults. Manager X insists not credit risk when purchased.

EXAMPLE 2:

Transaction has a 5% CCC bucket. Manager Y continued to purchase CCC-rated assets, even after bucket exceeded. Through discounted trades (e.g., 28.5% and 30%) increased par by more than $200mm since closing. Several assets defaulted less one month after purchase.

EXAMPLE 3:

Immediately prior to pay date, Manager Z purchases several heavily discounted securities in 2 CLOs it manages because “they are dollar good” (e.g., 6% rated “B-” watch negative). Carrying those assets at par allows monies to pay subordinate management fee and an equity distribution (n.b., some equity held by Manager Z). Direct proceeds to Manager Z from both deals exceeded $1.5mm. Assets subsequently downgraded to “CC”. Despite conference call, Manager Z does similar (but less egregious) trade last month.

slide27
Striking a Balance is Key

Bondholders vs. Equityholders

BONDHOLDERS

Timely Interest

Ultimate Principal

EQUITYHOLDERS

Current Income

Upside Relative to Risk Profile

Structural Mitigants

Compromising to Build Rainy Day Cushion

slide29
Static versus Managed Transactions
  • Lessons Learned by looking at Corporate Static Pools
  • Flexibility to Move In and Out of Credits Based on Market
  • Conditions Comes at a Cost and Increases Risk / Leverage
  • Collateral Mangers’ True Added Value Difficult to Gauge
  • Mandatory Redemptions Following Breach of Coverage Tests Make Meaningful Comparisons to Most Indexes Difficult
  • Certain Structures Incentives Gaming
  • Adverse Selection versus Rational Decisions to Avoid Shutting Down Deal Given Constraints
s p s cdo manager focus
S&P’s CDO Manager Focus
  • A comprehensive report of a CDO Manager’s capabilities & track record developed through in-depth site visits & transaction evaluation
  • Manager capability report focuses on Manager & team depth, coverage & expertise; organizational support; investment process; credit evaluation practices & CDO structural management
  • Transaction evaluation addresses managers’ results relative to their peers by evaluating default rates; covenant breaches; par erosion trends; sales & purchase prices; portfolio credit quality & diversification of their outstanding CDO’s
slide31
NEW INITIATIVES FROM S&P

INCREASED TRANSPARENCY

  • Pre-Sale Reports Globally
  • Post-Sale Reports Globally
  • CDO Manager Focus Reports
  • CDO Explorer – Collateral Info

Expanding CDO Indices

CDO BENCHMARKS

  • CDO Evaluator version 2.2 just out
  • Roll-Out ROC Performance Tool
slide32
Structural Mitigants address non-rating related issues
  • Notching Assets on Credit Watch
  • Haircut Low-Rated Collateral
  • Additional Credit Risk Disclosure / Purchase Discounts
  • Applying Additional Defaults to Reinvested Monies
  • Modeling Defaults After Breach of Traditional
  • Coverage Tests, Absent Additional Coverage or
  • Other Reinvestment Tests
  • Treating All Monies from Defaulted Securities as Principal
  • Limitation on Pass-Through of Trading Gains
slide33
1 2 3 4 5
  • Since ROC speaks to the stability of the current rating it is necessary to show ROC for original rating to demonstrate relative decline or improvement

2. Current ROC levels

3. Change on last month in basis points – this shows ‘collateralisation shifts’ – relative dollar values for rating migration.

4. Average Notional of Pool = Pool Balance / # of Entities

  • Rating Loss Threshold = Dollar loss the deal can sustain at each tranche level given current tranche rating. This is equal to (100%-ROC) * Portfolio Balance.

 For one (average sized) default CCC+ will be maintained on the C notes if 1 - (6.35 / 19.148)

recoveries are achieved. i.e. 1 - (33%) = 67% Recoveries are required given average default.

S&P CDO Benchmarks

Dissecting a Sample ROC Report

slide34
What’s Hot and What’s Not
  • Excessive leverage
  • Unrealistic equity returns
  • Diversity for diversity’s sake
  • Discretionary trading
  • Difficulty in replacing collateral managers
  • Abandoning transactions
  • Cosmetic structural mitigants
  • Inadequate staffing
  • Lack of drill-down technology
  • Restructuring
  • Style drift
  • Money market tranches
  • Structural mitigants
  • Marks in lieu of ratings
  • ROC and other performance measures
  • Single-tranche correlation trades
  • Retranchings
  • CDO squared technology
  • Additional transparency
  • Template to address FIN 46
  • CDOs of alternative assets
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