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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