Collateralized debt obligations (CDOs): identity crisis.

Author:Hurst, R. Russell
 
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The term CDO is relatively new, coined by the rating agencies and others in late 1997 to describe asset-backed securities (ABS) backed by a broad variety of collateral mixes with a variety of structures introduced into the market. A collateralized loan obligation (CLO) is a CDO backed only by bank loans. A collateralized bond obligation (CBO) is a CDO backed only by bonds. Just to make things interesting, the term CDO can also refer specifically to a CDO subclass that has a mixture of loan and bond collateral or a CDO subclass with other types of fixed income collateral, such as mortgages.

  1. OVERVIEW

    The term CDO is relatively new, coined by the rating agencies and others in late 1997 to describe asset-backed securities (ABS) backed by a broad variety of collateral mixes with a variety of structures introduced into the market. A collateralized loan obligation (CLO) is a CDO backed only by bank loans. A collateralized bond obligation (CBO) is a CDO backed only by bonds. Just to make things interesting, the term CDO can also refer specifically to a CDO subclass that has a mixture of loan and bond collateral or a CDO subclass with other types of fixed income collateral, such as mortgages. The typical structure of a CDO is shown in Exhibit 1.

    A CDO is an ABS backed by various types of fixed income securities, bank loan collateral or a mixture of both. Varying senior/subordinated classes of passthrough debt (or certificates) and a modest amount of equity are issued by the special-purpose vehicle (SPV) that purchases the collateral from the seller. The collateral is held in trust and pledged to secure the repayment of the CDO. The SPV is a bankruptcy-remote entity and does not engage in any other business than managing the collateral. The SPV will engage an asset manager to manage the debt and this is usually an affiliate of the seller. To place a particular CDO in its proper category, the following items must be known:

    1. Issuer motivation (balance sheet or arbitrage).

    2. Underwriting approach (cash flow, synthetic or market value).

    3. Whether the ratings of the CDO are linked to the seller or de-linked.

    4. Credit quality of the underlying collateral.

    5. Mix of collateral by type (bank loan, corporate bonds or percentage combination).

    6. Geographic mix of collateral (U.S. domestic, non-U.S., emerging market or percentage combination).

    This information distinguishes one CDO from another and, together with other details such as average life, rating and the experience of the asset manager, is needed to properly price a CDO and to determine its relative value.

  2. COMPOSITION AND BRIEF HISTORY OF THE MARKET

    The asset-backed market has grown dramatically over the past four years. This growth has been presented in Exhibit 2 in a slightly different fashion that more appropriately depicts the sources of growth and how the market has changed during this period. Most investors have focused on U.S. public ABS market volumes to gauge growth and the potential for increased liquidity in the market.

    It is easy to see that the increased growth in the repackaged market (which includes CBOs and mortgage CBOs) and the international market more than offset the slowing of growth in the U.S. public and U.S. private markets. Some argue that repackaged ABS do not represent new issuance but merely refinance existing product. In some respects this may be true, however, the repackaged market has for the most part taken securities from other nonasset-backed markets (e.g., high yield bonds, loans and the mortgage markets) and offered new product to the asset-backed market, thereby providing liquidity to the market where the assets were originated. Also, from a truistic perspective, all asset-backed issuance represents the repackaging of financial assets.

    In this regard, total growth in the asset-backed market is more accurately portrayed by including international and repackaged product, which shows total asset-backed issuance increasing 17% to $372 billion in 1998 from $319 billion in 1997 (Exhibit 2). If growth was measured by issuance in the U.S. public and private markets, the annual percentage increase would be only 11% to $267 billion in 1998 from $240 billion in 1997. Perhaps the most worrisome aspect of using just the U.S. numbers as a barometer for growth is the sheer size of the international and repackaged market, which reached $107 billion of new issuance in 1998 or 28.6% of the total market. This amount is up from only $12 billion in 1995, which accounted for less than 10% of the market.

  3. ISSUER MOTIVATION (BALANCE SHEET OR ARBITRAGE)

    There are two basic motivations for CDO issuance. The first is to transfer the collateral off the balance sheet of the issuer to achieve regulatory capital relief or manage the credit risk profile of the issuer's balance sheet (balance sheet motivated). Balance-sheet-motivated CDOs have been done mostly by banks. The second is a leveraged arbitrage of the high-yielding collateral by insurance companies and asset-management companies (arbitrage motivated) to generate asset-management fees and/or share in the attractive returns generated by the equity ownership.

  4. UNDERWRITING APPROACH (CASH FLOW, SYNTHETIC OR MARKET VALUE)

    Cash flow, synthetic structures (credit-linked notes and default swaps) and market value are the three fundamental approaches used to structure CDOs. Cash flow and synthetic structures in the CDO market are similar in that the analysis of the collateral depends heavily on the expected loss. Meaningful analysis of the expected loss of leveraged loans and corporate bonds was made possible when Moody's Investors Service, Inc., and Standard and Poor's Corp. began publishing detailed histories of defaults on their respective rating universes. Moody's study, for example, includes all bonds ever rated by the agency and dates from the 1920s. Because the universe of rated issuers was so large and could easily be categorized by industry, it was statistically relevant to use these average default levels by rating category to predict what losses might be expected by a similar portfolio of bonds over a defined time horizon.

    The key to this analysis is that the portfolios be "similar," and the rating agencies therefore required initial and ongoing industry and issuer diversification, so that loss experience would be "similar." Because the future expectation of losses is based on historical analysis, active management of a portfolio would invalidate the underwriting assumptions. We have labeled this approach as "passive portfolio management," or "buy and hold," and the rating agencies for this reason also limit discretionary reinvestment, or turnover, in the CDO collateral. Selling of investments is, however, allowed when the credit quality of an issuer or the average rating of the portfolio as a whole deteriorates outside original underwriting parameters. Proceeds from any sale of collateral are reinvested or used to retire the senior-most class.

    In a cash flow structure, the cash flow net of losses is sized around the liability structure so sufficient cash flow is available to each class of security in the CDO to achieve the desired rating. The structure is then stressed in many different ways to ensure that the default expectation of the newly created CDO classes is consistent with the rating assigned by the rating agencies. The stress scenarios are patterned after historical worst-case economic situations. Some scenarios are based on historical experience and others are fictional but intended to attack the weakest point of the cash flows. For example, after running the cash flow stress scenarios, expected losses to the AAA tranche would be nil, which is consistent with the loss expectation of an investor in a AAA security. A typical structure may have a large AAA tranche, followed by subordinated tranches rated A, BBB and BB. A cash flow structure will pass through the principal and interest payments of the bond and loan collateral sequentially to the CDO certificate holders, less expenses (such as asset management fees and net losses due to the payment default of loans and bonds).

    Synthetic structures have become an effective and useful tool for managing balance sheet risk and isolating credit risk. As with cash flow structures, performance of the issue depends on the default-and-loss experience of the collateral, which in this case is a "reference" portfolio. The synthetic CDO issuance is much smaller than the reference collateral, and the payment of principal and interest on the "new money" does not depend on cash flow from the reference pool.

    There have been two approaches so far to synthetic execution--default swaps and credit-linked notes. Both obviously exploit the technology developed in the burgeoning credit derivatives market. All this sounds complex but, in fact, it is straightforward. The amount of capital raised by the CDO issuance covers the "expected loss" of the reference pool. In the case of default swaps, an ongoing fee is paid to the SPV for the portfolio default swap contract by the "seller," which in this case is the beneficiary of the default swap. The swap contract stipulates that at the end of a defined period (equal to the bullet maturity of the CDO issue), the SPV or trust is obligated to pay any net loss (par amount of the reference pool less any recoveries) that occurs less a first-loss deductible. The first-loss position is comparable to the equity provided in a traditional cash flow CLO. Issues to date have had 3- and 5-year maturities. The cash raised is invested in Treasuries or other high-quality current coupon (AAA) s ecurities with maturities prior to the term of the issue. The current income from the Treasuries, together with the default swap fees, is used to pay the current interest when due on the various classes of the CDO issuance. The classes are tranched in the same manner they would be for a CLO.

    To date, the reference pool has exceeded...

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