Structure of Collateralized Debt Obligations(CDO)

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Collateralized Debt Obligations(CDOs) are one of the most interesting innovations of the se­curitization market in the 90s.

Structure of Collateralized Debt Obligations

Collateralized Debt Obligations(CDOs) are one of the most interesting innovations of the se­curitization market in the 90s. They create new, customized asset classes, by allowing various investors to share the risk and return of an underlying pool of debt obligations. The attrac­tiveness to investors is determined exactly by the underlying debt and the rules for sharing the risk and return.

A CDO is a securitization in which a portfolio of securities is transferred to a special purpose vehicle (SPV). The SPV in turn issues tranches of debt securities (notes) of different seniority and equity to fund the purchase of the portfolio. Securitization is considered a reallocation of the risk. It is a process of converting assets into securities backed by those assets, in order to lower funding costs, access the capital markets, generate management fees and reach some accounting purposes.

A Collateralized Bond Obligation (CBO) involves mostly bonds, while a Collateralized Loan Obligation (CLO) involves mostly loans.

The CDOs borrow their structural template from Collateralized Mortgage Obligations. A CDOs can hold mortgage-backed securities, asset-backed securities, real-estate investment trusts (REITS) and even other CDOs.

Figure 1 - CDO Diagram

I have set up a typical CDO structure in Figure 1.1. The assets are transferred to the SPV that funds these assets, from cash proceeds of the notes it has issued.

The CDO structure allocates interest income and principal repayment from a pool of different debt instruments to a prioritized collection of securities notes called tranches. They are typically rated based on portfolio quality, diversification, and structural subordination. There are always at least two tranches.

The losses in interest or principal to the collateral are absorbed first by the lowest level tranche and then in order to the next tranche and so on. The mechanism for distributing the losses to the various tranches is called waterfall. Senior notes are paid before mezzanine and lower rated notes. Any residual cash flow is paid to the equity piece. This makes the senior CDO liabilities significantly less risky than the collateral.

The market classifies CDOs into two broad categories

Market value structures and cash flow structures. The two categories are not completely disjoint. There are examples of CDOs which have characteristics of both classes. In any case, all CDOs have an investment manager who manages the collateral. He must follow the rules set out in the offering circular.

On every payment date, equity receives cash distributions after the scheduled debt payments and other costs have been paid off. The equity is also called the first-loss position in the collateral portfolio, because it is exposed to the risk of the first dollar loss in the portfolio.

Losses occur when there is some kind of credit event. A credit event is usually either a default of the collateral, or a credit downgrade of the collateral. In either case, the market value of the collateral drops. The lowest tranche is the riskiest and is called the equity tranche. All the tranches except the equity tranche have credit ratings. The highest tranche is usually rated AAA.

The CDO rating is based on its ability to service debt with the cash flows generated by the underlying assets. The debt service depends on the collateral diversification, subordination and structural protection (credit enhancement and liquidity protection).

As we move down the CDOs capital structure, the level of risk increases. The equity holders bear the highest risk.

The typical CDO consists of a ramp-up period, during which the collateral portfolio is formed, a reinvestment period, during which the collateral portfolio is actively managed, and an unwind period, during which the liabilities are repaid in order of seniority, using collateral principal proceeds.

In the repayment period, excess interest payments gradually decrease as the collateral portfolio principal proceeds are used to repay the debt in order of seniority. After all the debt classes have been redeemed, the remaining principal payments pass to the equity.

Figure 2 - CDO Capital Structure

displays an example of capital structure, where the high yield bonds collateralize CDO liabilities.

Arbitrage and Balance Sheet CDOs

Most CDOs can be placed into either of two main groups: arbitrage and balance sheet trans­actions.

Figure 3 – CDO Structure

shows the conceptual breakdown between the two structures.

Cash flow CDOs

A cash flow CDO is one where the collateral portfolio is not subjected to active trading by the CDO manager. The uncertainty concerning the interest and principal repayments is determined by the number and timing of the collateral assets that default. Losses due to defaults are the main source of risk.

Market value CDOs

A market value CDO is one in which the CDO tranches receive payments based essentially on the mark-to-market returns of the collateral pool, as determined in large part by the trading performance of the CDO manager.

Balance sheet cash flows CDOs

Balance sheet deals are structures for the purpose of capital relief, where the assets se­curitized are low yielding debt instruments. The capital relief reduces funding costs or increases return on equity, by removing from the balance sheet the assets that take too much regulatory capital.

These transactions rely on the quality of the collateral that is represented by guaranteed bank loans with a very high recovery rate. In the majority of the cases, the sold assets are loan-secured portfolios.

Arbitrage CDOs

An arbitrage CDO, often underwritten by an investment bank, is designed to capture an arbitrage between yield on collateral acquired in the capital markets (largely sub­investment grade) and investment-grade notes issued to investors.

Arbitrage market value CDOs

Arbitrage market value CDOs go through a very extensive trading by the collateral man­ager, necessary to exploit perceived price appreciations.

This type of CDO relies on the market value of the pool securitized, which is monitored on a daily basis. Every security traded in capital markets, with an estimated price volatility, can be included in this type of CDO. During the revolving period, the collateral manager can increase or decrease the funding costs that changes the leverage of the structure.

Arbitrage cash flow CDOs

Most collateral assets are bonds. As arbitrage deals, the collateral assets can be refinanced by re-tranching the credit risk and funding cost in a more diversified portfolio. Unlike arbitrage market value CDOs, the collateral assets are not traded very frequently.

Credit enhancement in cash flow transactions

Senior notes in cash flow transactions are protected by subordination, over-collateralization and excess spread. The senior notes have a priority claim on all cash flows generated by the collateral, therefore, non-senior notes performance is subordinated to the good performance of senior notes.

Over-collateralization(OC) provides a further protection to senior notes by imposing a minimum collateral value with two coverage tests: par value and interest coverage tests.

The par value test requires that the senior notes (and subsequently the other notes) are at least a certain percentage of the underlying collateral (for example 115%).

The par value test is applicable to lower rated notes (mezzanines). In this case, the trigger percentage below that fails the test is selected at a lower rate (for example 105%).

An interest coverage test is applied to ensure that collateral interest income is sufficient to cover losses and still make interest payment to the senior notes. This credit support is also known as excess spread.

Credit enhancement in market value transactions

Advance rates are the primary form of credit enhancement in market value transactions. It is defined as the maximum percentage of the market rate that can be used to issue debt. Rating agencies assign different advance rates to different types of collateral. They depend on the volatility of the asset return, and on the liquidity of the asset in the market. Assets with a higher return volatility and lower liquidity are given lower advance rates.

A collateral manager must ensure that the advance rate test is not violated due to fluctuations in the underlying prices. When a breach of the test happens, the collateral manager must remedy it within a cure period by either selling securities with a lower advance rate and buy ones with a higher advance rate, or by selling securities with a lower advance rate and repay the debt starting with the most senior notes.

The Minimum Net Worth Test is also designed to offer credit protection to the senior notes holders in market value transactions, by creating an equity cushion. This is achieved by impos­ing that the excess market asset value, minus the debt notes is equal or greater than the equity face value, times a percentage.

In cases where the test is breached, the manager has a cure period to bring the CDO into compliance, by either redeeming part or all of the senior notes, or by generating enough capital gains through selling of some assets.

The Manager

The manager of the CDO is responsible for the credit performance of the collateral portfolio and for ensuring that the transaction meets the diversification, quality and structural guidelines specified by the rating agencies. In return for managing the collateral portfolio, the manager receives a fee. During the reinvestment period, the CDO manager continuously evaluates the state of the collateral portfolio and of the overall market. He trades out positions at risk for credit deterioration, and takes advantage of appreciation opportunities.

The key to a successful market value CDO is the manager’s ability to generate high risk-adjusted returns through research, market knowledge and trading ability. The return performance of CDO equity depends hugely on the long-horizon returns of the underlying portfolio realized by the manager.

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