Structural and collateral considerations.

• Author: Albulescu, Henry C.

This section highlights the credit support and payment features of CDOs, and their effect on the CDO transactions.

1. CREDIT SUPPORT AND PAYMENT STRUCTURES

   1. SUBORDINATION

      One of the most common forms of credit enhancement in CDOs is subordination of junior tranches. In the multi-tranche or senior/subordinated CDO the subordinated or junior tranches support the senior tranches. The issuance proceeds from debt and equity are used to purchase collateral (assets) generally with a principal balance equal to the rated debt amounts (liabilities) plus the equity share. Since the equity is not typically rated, the asset pool supporting the rated liabilities is greater than the rated liability amounts. Thus, there is a loss amount that the assets can sustain without immediately affecting any of the rated liabilities.

      The payment priority waterfall in the transaction prioritizes the payments to each class of debt holders. In CDO payments are typically paid sequentially for the senior to the more subordinated tranches. Thus, holders of the senior debt tranche have priority of payment over the holders of any junior debt tranche. As a result of their subordinated status, the junior debt tranches generally are rated lower than the senior debt. However, the junior debt holders are compensated for the additional risk by being paid a higher interest rate.

   2. OVERCOLLATERIZATION

      Instead of using subordination, the senior liability class in the structure can also be supported by overcollateralization. In this structure, the rated class is supported by an excess of assets. The overcollateralization amount covers the estimated level of credit losses that the structure is expected to withstand without causing a loss to the holders of the rated senior tranche, in accordance with the risk expectations of the senior tranche rating.

      Consider, for example, a cash flow transaction involving the issuance of $80 million of rated senior debt supported by a collateral pool with a total par value of $100 million. This "80/20" liability structure consists of 80% rated senior debt, and 20% unrated supporting debt or equity. The senior overcollateralization ratio (O/C ratio) equals 125% (100/80), which is defined as the ratio of assets over rated liabilities. The funds used for the purchase of surplus assets ($20 million in this example) are typically raised by the issuance of unrated equity.

      The same level of credit protection for the senior class could have been provided through subordination by issuing $80 million of senior notes, $10 million of class B subordinated notes, $5 million of class C subordinated notes, and $5 million of unrated equity. If the transaction allocated losses from the equity tranche up, in all likelihood the class B and class C notes could have been given some rating lower than the rating of the senior class. This would likely lower the interest rate needed for payment on these tranches to less than if they were all part of the $20 million unrated equity. The rate would be lower because the class B is protected from losses by class C, and class C is protected from losses by the equity. If they were all part of the $20 million unrated equity, all investors would have faced a loss after the first default. Hence, creating different tranches in a structure with different payment priorities allows the issuer to create different risk/reward profiles. This is the concept behind CDOs, where the lowest class in the structure takes the first loss. By segregating the risk/reward profile of the portfolio, the senior tranches of the CDO can be rated higher than the average rating of the pool. However, because the equity investors take on the first loss risk, they demand high rates of return.

   3. PAYMENT ALLOCATIONS

      The manner in which collateral principal payments and losses are allocated among classes has a large impact on the level of credit support each tranche has over time. All payment structures represent different trade-offs between paydown and support of the senior class, versus return of cash to the junior debt and equity holders. There are several types of payment structures, of which the most commonly used are sequential pay, pro rata, and fast pay/ slow pay. It is worth noting that though this discussion mentions three different payment structures, the sequential payment structure with fast pay features is by far the most common structure used in CDOs.

   4. SEQUENTIAL PAY

      These structures require payment of senior debt in full before the payment of junior debt. In the 80/20 example discussed earlier, the $20 million subordinated class would remain outstanding until the entire $80 million senior class was retired. Clearly, as the $80 million senior notes pay down, the effective senior O/C ratio builds to well above 125%. In such structures that pay senior debt first, senior debt holders benefit from an increase in credit enhancement as the portion of subordinated debt grows in relation to total debt.

   5. PRO RATA PAYDOWN

      In this structure, available funds are allocated to pay down principal on the rated debt in proportion to the size of each tranche. Thus, the degree of overcollateralization is maintained at the same percentage, until retirement of the senior class. In the example above, the overcollateralization would be maintained at the 80%/ 20% level, assuming no losses occur. Subordinated investors will be paid out at the same time as the senior investors assuming no losses occur and there are no credit support floors in the deal. Thus the hard dollar amount of credit support to senior noteholders decreases as time goes on. If losses are incurred, the loss amount is allocated to the lowest tranche first. Thus in the example, the lowest tranche would receive less than 20% of the principal collections.

      Given that collateral pools are lumpy and defaults can occur at any time, the pro rata paydown does not protect senior noteholders as well as sequential paydown. Assume in the previous example that there were only $20 million in assets outstanding with no defaults having occur. At that point, 80% of the debt would be senior ($16M), and 20% would be subordinated ($4M), the same proportions as at the start of the transaction. If at that point the transaction would incur a $5 million dollar loss, only $4 million would be allocated to the subordinated tranche, and the senior tranche would lose $1 million. If the transaction had paid down scquentially, however, the senior class would have been retired once only $20 million of assets were outstanding, and would have not suffered any loss. For this reason, pro rata structures are not optimal for CDOs and typically must have hard dollar floors of credit support.

   6. FAST PAY/SLOW PAY STRUCTURES

      This structure pays down both classes, but pays down senior debt faster than the junior debt and at a higher rate than pro rata. Like sequential pay structures, these structures typically require a "minimum par value overcollateralization ratio," in which the ratio of assets over liabilities must be maintained at a minimum level, for example, of at least 125%. If this test is breached due to defaults or trading losses, a higher percentage or all of the collateral cash flow will be used to pay senior debt until compliance is restored. If excess funds are available after meeting senior and junior debt service and coverage requirements, they may be used to pay down junior debt, even before senior debt maturity.

      A variation on the fast pay structure is a turbo paydown of junior notes with excess interest proceeds when the coverage tests for the senior notes are satisfied and the coverage tests for the junior notes are not satisfied. In this structure, excess interest is used to pay down the most costly debt, and in effect substitutes overcollateralization for subordination, since the par amount of assets does not decrease as the subordinate class is paid down. While these structures do provide some benefits, in general they may be harder to model since transition between triggers is difficult to accurately predict.

2. OTHER CREDIT SUPPORT

   1. CASH COLLATERAL OR RESERVE ACCOUNTS

      Cash collateral or reserve accounts are another form of credit enhancement. Excess cash is held in highly rated and liquid investments that provide security to the debt holders, generally in an account under the control of a trustee or custodian. Cash reserves are often used in the ramp-up phase of a cash flow transaction. During this phase, cash proceeds from the sale of CDO securities can be used to purchase the underlying collateral and to fund reserve accounts.

      Cash reserves may not be the most efficient form of credit support because of the relatively low assumed interest rate earned on the eligible investments held in the reserve...