CBO, CLO, CDO: a practical guide for investors.

• Author: Melennec, Olivier

The CDO market has been developing rapidly since 1996, reaching an issuance volume of USD l00bn in 1999, i.e. approximately twice the securitisation volume of US credit cards, the most mature market segment. MBS (Mortgage Backed Securities) and CDO are the 2 categories of ABS (Asset Backed Securities) which are growing fastest in Europe (see Exhibit 1). MBS are very standardised transactions which are very easy to compare with one another. However, CDO are harder to understand as there are many different structures, types of underlying assets and management rules. This article provides six reference structures for CDO: three "balance sheet" structures and three "arbitrage" structures. (1)

1. HOW TO ANALYSE A CDO?

   CDO stands for "Collateralized Debt Obligation". A CDO is an ABS-type securitisation where the underlying portfolio is comprised of securities (a CBO or "Collateralized Bond Obligation") or loans ( a CLO or "Collateralized Loan Obligation") or possibly a mixture of securities and loans.

   A CDO typically comprises of a limited number of commercial borrowers (from 20 to 500), as opposed to "traditional" ABS portfolios of between 500 and 100,000 individual debtors (mortgages and retail trade receivables). The majority of CDO assets are generated through the banking system: bond portfolios or commercial loans where the borrowers are large companies.

   In terms of risk analysis, when there are a limited number of debtors, credit rating agencies carry out an issue-by-issue study of the portfolio, as opposed to the purely statistical analysis of traditional securitisations. This implies that the credit rating agencies estimate each underlying debtor's credit rating. This analysis is greatly facilitated if some of the underlying credits are already rated.

   1. Two Main Categories

      CDO can be broken down into 2 main types of transaction, depending whether the transaction is to enhance the seller's balance sheet or carry out an arbitrage transaction.

      1. Balance sheet CDO

         The seller is a financial institution which seeks to deconsolidate a debt portfolio: loans to companies, securities portfolio, etc.

         This type of transaction is developing very fast, mainly in banks seeking to reduce their regulatory capital to meet growing ROE (Return On Equity) requirements. This transaction involves transferring the risks traditionally taken by the banking system to the final investors.

         As in the majority of cases, portfolios sold are loansecured portfolios, the term CLO is often associated with balance sheet management CDO, (even though balance sheet management CBO also exist).

      2. Arbitrage CDO

         The aim of the transaction is no longer to pay up regulatory capital, but to carry out a market arbitrage. The idea is to buy a portfolio which will act as collateral for a securitisation, possibly with tranches for the various levels of risk, more suited to the profiles sought by investors, so that the cost of refinancing the portfolio is lower than the asset purchase price.

         By its very nature, the underlying asset of an arbitrage CDO is an asset which has been purchased and is therefore a negotiable asset. Often these are securities and therefore the term CBO is often associated with arbitrage CDO (even though it is possible to have arbitrage CLO).

         Balance sheet management CDO are generally sizeable (USD 2bn) as the deconsolidated portfolio must be large enough to have an impact on the ROE of the selling bank. Conversely, arbitrage CDO are often private transactions associated with portfolios comprising several dozen illiquied lines with a total volume of approximately USD 150m.

         Therefore, even though there are many transactions, arbitrage CDO account for a much lower market share in liabilities than balance sheet management CDO. This difference is even more marked in Europe where many banks issue balance sheet management CDO, while the majority of arbitrage CDO consist of US assets (High-Yield for example).

   2. How to Find One's Feet?

      The main difficulty, for an investor used to standard US credit card type transactions or European MBS transactions, is to assess the value of a CDO, without spending much more time than would be required for analysing a traditional ABS.

      This is actually quite simple, if before embarking on a detailed study, one takes the time to ascertain which type of CDO one is dealing with. In this document, we will divide CDO into six separate structures: in Section II of the document, balance sheet CDO will be broken down into three classic structures and in Section III, arbitrage CDO will be broken down into three classic structures.

      After this preparatory work, it is simpler to make a more traditional type of analysis of securitisations. The article "Investor's guide to ABSs" (Securitization Conduit, Vol.2, issue 1) provides a five-step breakdown: underlying assets, credit enhancement, cashflow mechanics, legal structure and links with the seller.

2. BALANCE SHEET CDO

   This type of CDO, also known as "Bank CDO" or "Bank CLO" is by far the most common in Europe. There are 3 main classic structures: "traditional Master Trust", "Synthetic" and "Leveraged".

   1. Structure 1: "Traditional CLO"

      This structure was used for the first time by Nations Bank in 1997, then by LTCB (PLATINUM), IBJ (PRIME), Sumitomo (WINGS) Bankboston (BANKBOSTON), Bank of Montreal (LAKESHORE), Sanwa (EXCELSIOR), SG (POLARIS), and more recently by Credit Lyonnais (LEAF) and Paribas (LIBERTE). All of these structures are very similar as they constitute the most direct application of the securitisation principle: the bank sells a homogenous commercial loan portfolio to a SPV, refinanced by the issuance of the most standard securities possible to attract the maximum number of investors.

      The SPV is structured as a Master-Trust in order to enable the bank to sell another subsequent portfolio whilst keeping the same structure.

      1. Underlying assets

         They comprise 200 to 400 loans (often syndicated) to US companies with a total volume of USD 1 to 4bn. As the credit rating agencies carry out an issue-by-issue analysis of the debtors, at the same time as their statistical analysis, most of the debtors must already be rated (or they must at least benefit from a scoring system of the seller).

         As most rated loans are on the books of the US branches of major banks, almost all transactions involve portfolios of US syndicated loans with Average Ratings ranging from BB to BBB, with a Diversity Score of 50 to 70.

         If the transaction entails a Reinvestment Period, the addition of further loans in the pool is controlled by continual monitoring of the overall quality of the portfolio: Average Rating and minimum Diversity Score. There are also eligibility criteria for each loan: minimum rating: B, maximum concentration per debtor: 2% and per business sector: 8%.

      2. Credit support

         These transactions have two constraints: minimising the overall cost of the securities issued, and minimising the size of the subordinated tranche kept by the seller. However, as the underlying assets are similar, all the transactions have more or less the same refinancing structure: 92% tranche AAA, 3% tranche A, 1.5% tranche BBB, 1.5% tranche BB, 1% subordinated tranche, and finally 1% cash deposit by the seller, subordinated to all the other tranches called Cash Collateral Account (CCA). Each tranche benefits from credit support from all tranches with a lower rating. By keeping the subordinated tranche and the CCA, the seller keeps the first loss of portfolio up to 2%.

         The second credit support is the Excess Spread, i.e. the difference between the cashflows collected by the SPV and the management costs and return of securities. Under normal circumstances, this amount of around 0.50% per year is paid to the bearers of the first risk, i.e. the selling bank. However, in the event of the quality of the structure worsening, the entire amount may be used to refund the securities issued, according to their seniority.

      3. Credit risk analysis

         The level of credit support for each tranche is comparable to data relating to historical net losses of the underlying portfolio. In general, the investor possesses data relating to net losses on the seller's portfolio for the past 4 or 5 years. It is possible to gain a broader view by obtaining past data from credit rating agencies. For example, the blue curve in Exhibit 2 represents the default rates after one year of a pool of Ba-rated securities, since 1970 (0.68% per year on average). These figures include all the existing Ba's, including for example LBOs (Leveraged Buy Out), responsible for the crisis in 90-91, and therefore greatly exaggerates the risk of the portfolio selected which does not contain this type of loan.

         In this type of analysis, care should be taken to compare like for like: the majority of bank CLO use the drawing of revolving loans as assets. If the average duration of a drawing is one year, the performance of the portfolio is comparable to the default rate after one year. If the average duration of the portfolio loans was 5 years, it would be necessary to compare it with the cumulated default rates over 5 years (available from the rating agencies).

      4. Cashflow mechanics

         The selling bank retains the commercial relationship and continues to collect the cashflows on behalf of the SPV, and to select the new assets to be sold to the SPV, during the reinvestment period (Exhibit 3). The above is carried out within the clearly defined framework of the legal documentation relating to the transaction. In general, to reach the maximum number of investors, each Class is broken down into 2 maturities: 3-year (tranches A1, B1, C1 and D1) and 5-year (tranches A2, B2, C2 and D2). The structure includes a reinvestment period which finishes approximately one year before the repayment date. This means that the payments are reinvested at 100% between year 0 and 2. Between year 2 and 4, 50% of the payments are reinvested in eligible loans and the other...