CDO transactions structural basics.

• Author: Khakee, Nik

CDO structures contain various covenants and mechanisms that dictate the composition of the collateral portfolio, define the trading activities permitted, allocate cash proceeds to the rated notes and equity, and aim to protect noteholders by paying down debt if certain triggers are tripped. This section will focus on the features common to most CDOs, outline considerations and risks associated with each, and highlight Standard & Poor's criteria developed to address such concerns.

1. CASH FLOW CDOS COLLATERAL DEBT SECURITIES/ELIGIBILITY CRITERIA

   CDO technology allows for the accumulation of collateral across a wide range of assets. For example, the portfolio might include bonds, loans or synthetic securities, corporate securities, structured finance securities, assets denominated in U.S. dollar or other currencies, and investment- grade or noninvestment-grade securities. Absent constraints, investors and rating agencies would have great difficulty identifying the risks in the CDO as each type of assets introduces different cash flow characteristics and risk sensitivity factors.

   The trading mechanism included in most transactions further complicates the issue as the risk profile of the portfolio may change during the reinvestment period. Constraints on the types of collateral and concentration limits are established through the definition of collateral debt securities and eligibility criteria to alleviate this concern. Such parameters define the types of assets the manager can purchase and place limits on the concentration of assets across characteristics such as type, issuer, credit rating, and industry to create diversity. These constraints might take the form of "buckets" that set maximum limits, outright exclusion on the purchase of certain assets, or a maximum/ minimum range for assets.

   The collateral eligibility constraints typically cover the following:

   * Types of assets eligible for inclusion in the transaction (e.g. corporate, ABS, synthetics);

   * Form of the assets (loans, bonds, derivatives, etc.)

   * Payment terms (frequency, interest, currency);

   * Credit quality (investment-grade, high-yield, rating concentrations); and

   * Aggregate pool characteristics (minimum coupon, recovery rates, concentrations).

   For example, typical constraints found in corporate cash flow CDOs include:

   * List of permitted asset types;

   * List of permitted or excluded corporate industries;

   * Range of bonds and loans as a percentage of total par;

   * Range of fixed interest rate and floating interest rate assets as a percentage of total par;

   * Buckets for assets such as structured finance securities, synthetic securities, and guaranteed securities;

   * Buckets for assets that have unstable cash flows such as interest-only securities and assets that have the ability to defer or capitalize interest obligations;

   * Limits on assets with bivariate or multivariate risk such as assets issued by foreign obligors, synthetic securities, and loan participations;

   * Buckets to control concentration in single issuers or issuances;

   * Limits on non-U.S. dollar-denominated assets;

   * Prohibition by investors on purchasing credit-risk securities and defaulted securities; and

   * Buckets for assets such as convertible bonds or bonds with attached warrants that introduce market value risk into the cash flow structure.

   Typically such limitations and constraints are specified by the sponsor, banker, and collateral manager based on their perceptions of what the investor community wants and can be comfortable with. At certain times, investors also may request additional constraints to address specific concerns that they may have.

   In its assessment of collateral debt security and eligibility criteria, Standard & Poor's takes into consideration items such as the experience of the collateral manager along asset types and across the credit spectrum, the feasibility of adequately modeling cash flows, and the introduction of atypical risks. When warranted, Standard & Poor's highlights collateral characteristics that increase risks.

   A general trend among transaction arrangers is to want to include buckets for all different types of collateral. The belief is that this will give the collateral manager greater flexibility to manage the transaction. While in general this is true, if the collateral manager has no experience with such collateral and does not intend to use it, this flexibility might actually cost the transaction. Why allow a 20% emerging markets bucket in a transaction when the collateral manager has no experience with managing such debt and does not intend to purchase such? Recoveries on emerging markets corporate debt are very low, and by having such a bucket, the weighted average recovery for the transaction will suffer, since Standard & Poor's will assume that the bucket will be used. Sponsors and transaction arrangers are encouraged to consider the consequences of including such buckets if the collateral manager will not use them.

   Since, for most transactions credit support is sized through cash flows, the CDOs ability to adequately cover its principal and interest obligations under various stress scenarios is a key component of Standard & Poor's analysis. Assets that introduce variability in cash flows and cannot be effectively modeled therefore require added scrutiny. Payment-in-kind (P/K) assets, which have the ability to defer or capitalize interest as shortfalls arise, are one such example. Modeling the behavior of these assets proves difficult due to the scarcity of empirical data on the likelihood and timing of payment shortfalls. This concern is typically addressed by limits to the inclusion of PIK securities and/or through the use of a liquidity facility to cover shortfalls in the payment of interest on the senior class of liabilities resulting from deferred interest on the PIK assets.

   Convertible bonds, exchangeable bonds, and bonds with warrants attached introduce other risks. These instruments are convertible, and are allowed in transactions only if such convertibility is not mandated by the issuer of such debt hut rather only by the holder of the debt. Prior to conversion or exchange, convertible and exchangeable bonds that meet collateral eligibility guidelines will be permitted in collateral valuation and coverage tests. After conversion, if the securities are not eligible as transaction assets, these securities are no longer considered eligible collateral debt securities, and should not be included in the coverage tests. Furthermore, the collateral manager must consider the effect that such conversion has on the transaction prior to exercising the conversion option.

   For example, since equity is not given credit (either as principal or interest) in these types of transactions, converting eligible debt to equity weakens the transaction. The collateral managers should only exercise this option if they are certain that they can sell the equity and reinvest to maintain or improve the transaction tests. Equity warrants can remain attached to bonds in the collateral pool, hut should not themselves be assigned any value in the collateral tests. As a result, bonds with equity warrants are generally constrained. Furthermore, certain debt having equity convertibility features might be considered margin stock, as in the United States, and subject the transaction to specific regulations should certain concentrations of this debt be held by the transaction. Transaction sponsors and organizers are strongly urged to consider all such implications before proposing inclusion of convertible instruments.

   Interest-only securities are another example of assets with relatively volatile cash flow streams. These assets may be first loss pieces covered by excess spread from several structured finance products such as CMBS and RMBS. As first loss pieces, their ability to provide cash flow is highly susceptible to voluntary and involuntary prepayments of the underlying collateral. These securities are typically limited to 5% of the collateral pool in conventional corporate CDO transactions, and a "haircut" is applied in the modeling of cash flow.

   A growing number of CDO structures are including "baskets" for assets with bivariate credit risk. These baskets can enhance yield, or expand the eligible collateral universe, especially later in the reinvestment period when a collateral manager's asset maturity profile contracts. Bivariate risk arises when the probability of default on an asset is the combination of the probabilities of default of two obligors or counterparties. These "bivariate risk assets" include loan participations, credit-linked notes (CLNs) or credit derivatives, securities loans, and corporate debt from obligors domiciled in countries rated lower than 'AA'. Standard & Poor's does not limit bivariate exposure in transactions because it has the analytical tools to size such risks, typically resulting in a higher level of required credit support. The "basket" limitations are driven by the investors and bankers that want to constrain certain risks.

   A payment default may occur on a participation if either the borrower, the lending bank selling the participation, or both default. A credit derivative, such as a CLN, in which a counterparty promises payment based on performance of an underlying reference obligor or security, can default if either or both parties default. Similarly, securities can default if the counterparty (cash borrower and collateral pledgor), the obligor on the underlying collateral securities held by the lender, or both default. Finally, emerging market debt denominated in a foreign currency (for example, U.S. dollar-denominated assets from corporate obligors domiciled outside the U.S.) may default if the corporate obligor defaults, if the sovereign government actions adversely affect the ability of the obligor to make timely payment on its obligations, or both the sovereign and the obligor default.

   Not only is the risk...