Choudhry. Fixed Income Securities Derivatives Handbook

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282 Selected Cash and Derivative Instruments

❑ The bank has detailed information on the loans that enables it to

manage effectively the risk it retains.

❑ Having a ﬁ nancial interest in the performance of the loan portfo-

lio, the bank remains motivated to service it.

❑ The return required by a potential purchaser of the equity tranche

may be too high.

Structuring a conventional CDO may give rise to signiﬁ cant issues.

For instance, the transfer of assets into the SPV may have adverse tax,

legal, and regulatory impacts, depending on the jurisdiction in which the

transfer of assets takes place and the details of the legislation pertaining

to that jurisdiction. Another issue is reinvestment risk: in a conventional

CDO, the originator receives cash, and if the main objective of the trans-

action is to transfer credit risk or to acquire protection for credit risk, this

cash must be reinvested in other assets.

The multitranche structure, with its prioritization of cash ﬂ ow pay-

ments to investors, provides the CDO with a credit enhancement. To

enhance the credit of the senior notes, the originating bank may also use

other mechanisms, such as credit insurance on the underlying portfolio,

known as a credit wrap, and reserve accounts that absorb a loss before the

equity tranche.

FIGURE 15.2

Conventional CDO Structure

Notes

Cash flows

Fees

Transfer of

assets

Originator

underlying

asset pool

SPV

Investors

FundsFunds

Hedging

counter-party

Manager/

Investment adviser

Collateralized Debt Obligations 283

Synthetic CDO Structures

As with conventional CDOs, the main motivation for issuing synthetic

CDOs is the desire to hedge or transfer credit risk, in order to achieve

regulatory-capital relief or to obtain credit protection on an underly-

ing asset pool. In a synthetic CDO structure, such as that illustrated

FIGURE 15.3, the reference pool of assets remains on the originator’s

balance sheet. In place of an asset transfer, the originator enters into a

credit-default swap with the SPV that covers any losses in the underlying

asset pool. This transfers the credit risk of the asset portfolio to the SPV.

If its regulatory authority recognizes the credit-risk offset, this allows the

bank to release regulatory and economic capital. In return for the credit

protection, the originator bank pays the SPV a premium, typically in the

form of a regular fee.

Notes issued in synthetic structures are organized by tranche. With the

proceeds from the notes it issues to investors, the SPV purchases high-quality

(AAA) liquid securities—for example, U.S. Treasuries, bank asset-backed

paper such as credit card ABS, and German bonds, such as Pfandbriefe

—to serve as collateral. This collateral will generate LIBOR-related interest

and principal cash ﬂ ows that the SPV passes on to the investors together

with the swap premium, which creates an additional credit spread on the

notes. The cash ﬂ ows from the collateral may not match the payments

due on the issued notes—for example, the bonds used as collateral may

pay a ﬁ xed rate and the issued notes a ﬂ oating one. To remedy this, the

FIGURE 15.3

A Synthetic CDO Structure

Principal and

interest and fee

Principal and

interest

Cash to buy

collateral

Fee

SPV Issuer

Investors in

AA tranche

Investors in

BBB tranche

Equity

Cash

Payout on default

of credits in portfolio

AAA-rated

(Collateral)

Asset

pool

284 Selected Cash and Derivative Instruments

SPV usually enters into an interest rate swap. The swap counterparty may

also sell the SPV other derivative instruments, such as interest rate caps, to

manage possible cash ﬂ ow risk. Such risk-exposure management requires

careful attention, since the SPV’s risk proﬁ le can have a signiﬁ cant impact

on the credit risk of the notes issued to investors. In an unleveraged trans-

action, the size of the issue is equivalent to the credit protection the SPV

offers on the reference pool of assets. For example, if the credit default

swap is on a nominal of $300,000, the nominal value of the notes issued

will be $300,000.

The notes issued to investors are linked to the credit risk of the port-

folio through the credit-default swap—which usually has the same term

to maturity as the notes—and to the credit derivative counterparty. The

notes are therefore credit linked.

The payout from the credit-default swap is triggered by a credit event.

The precise deﬁ nition of credit event is important, since it may affect the

notes’ returns. It usually includes bankruptcy and failure to pay off the

underlying credit. In a failure to pay, a grace period may be speciﬁ ed, so

that default is not triggered if the payment is delayed for technical rea-

sons, such as information technology issues. The International Swaps and

Derivatives Association’s deﬁ nitions for a credit derivative transaction

refer to restructuring, as a credit event. Its inclusion in the credit deﬁ ni-

tions of default swaps in synthetic CDO transactions depends on whether

it would affect the regulatory-capital-relief treatment of the underlying

asset pool. Restructuring refers to the process when the loan liabilities of a

borrower are restructured, in terms set by its lenders, in times of ﬁ nancial

difﬁ culty.

If a credit event occurs, the SPV usually pays out a cash amount equal

to the par value of the underlying assets covered by the credit default swap,

less their post-default price. Less commonly, the SPV physically settles the

credit-default swap by purchasing the defaulted assets at par value. The

credit loss is then passed on to the investors according to the priority of

the tranches they hold.

Motivation Behind CDO Issuance

Different types of institutions have different motives for originating

CDO transactions. The main ones are to optimize regulatory capital, to

obtain funding, to engage in arbitrage, or, on occasion, a combination

of all three.

Collateralized Debt Obligations 285

Balance Sheet–Driven Transactions

In a balance sheet–driven CDO the originating bank is trying to obtain

off–balance-sheet treatment for existing assets to which bank capital has

been allocated. This enables the originator to manage capital constraints

and to improve its return on capital.

The originators in these situations are mainly commercial banks. The

underlying asset pool may include commercial loans, both secured and

unsecured, guarantees, and revolving credits. Although there is usually no

intention to trade these assets, the pool may be subject to substitutions or

replenishments over the life of the structure. The originating bank usually

acts as investment adviser with respect to such changes, to maintain the

underlying asset pool’s quality and protect the note holders. In this regard,

the rating agencies often require that the average credit quality of the asset

pool be maintained.

Investor-Driven Arbitrage Transactions

In a CDO whose purpose is arbitrage, the underlying asset pool includes

not only instruments that generate investment income but also some that

provide the opportunity to generate value from active trading. The lat-

ter may be existing positions or may be acquired expressly for the CDO.

The potential for trading proﬁ ts depends on the quality and expertise of

the CDO manager, who is usually the investment adviser. The aim is to

proﬁ t from the spread between the investment- and subinvestment-grade

markets. CDOs allow lower-rated debt to be repackaged as higher-rated

notes, exploiting the fact that spreads between the two grades of debt are

often greater than justiﬁ ed by the credit difference. The originator thus

earns more on the risky debt than it pays to securitize it and to enhance

its credit rating.

The proﬁ tability of an arbitrage-driven CDO depends on such factors

as the following:

❑ the return required by the holders of the issued tranches

❑ the return of the underlying asset pool

❑ the expenses of managing the SPV

If the underlying portfolio performs well and its loss proﬁ le is more at-

tractive than projected, because of better-than-expected default and recov-

ery rates, the return to the equity holder after payments to the senior and

junior tranche will be higher than expected. If, however, the underlying

portfolio performs poorly and default and recovery rates are worse than

projected, perhaps because of adverse economic conditions, the tranche

returns will be lower than expected. Poor investment management will

also have an adverse impact on the return to investors.

286 Selected Cash and Derivative Instruments

Fund managers create arbitrage CDOs from pools of high-yield bonds

since this enables them to increase the size of their assets under manage-

ment with comparatively small levels of equity. Their objective is to set

up the CDO so that the return generated by the underlying pool of high-

yield bonds is sufﬁ cient to pay off investors and provide them with a proﬁ t

on the equity tranche on top of their management fee.

Analysis and Evaluation

A number of factors are important to consider when analyzing, evaluating,

or rating a CDO. The basic ones are discussed in this section.

Portfolio Characteristics

The credit quality of the underlying asset pool is critical, since it determines

the structure’s credit rating. It is common to allocate an average rating to the

initial reference pool. A constraint in structuring the transaction may be that

any permitted changes to the pool should not lower the average rating. The

portfolio’s credit quality and its possible variability are used to project the

pool’s default frequency and loss rates. In some cases, the bank’s own system

for determining the credit risk of borrowers is a key part of the rating pro-

cess. Particularly for unrated assets, investors should determine the internal

rating system’s accuracy by mapping it onto the rating agency’s system.

The diversity of the reference pool plays a part in determining its credit

risk. Diversity is measured in terms of the portfolio’s concentration by in-

dustry group, obligor, and sovereign country. Broadly speaking, the greater

the diversiﬁ cation, the lower the credit risk. A portfolio is assigned a diver-

sity score based on its weighted average credit score. Each incremental credit

exposure in the underlying asset pool gets a marginal score determined by

the makeup of the entire credit portfolio. If the portfolio is concentrated

in one category—say, an industry group—the marginal score attributed to

the marginal credit is reduced to reﬂ ect the lack of diversity. As a result, an

asset pool with a wide range of credit exposures has a higher diversity score.

Change in the underlying asset pool may be constrained by a requirement

that a minimum diversity score be maintained for the life of the CDO.

Cash Flow Analysis and Stress Testing

The cash ﬂ ow proﬁ le of a CDO depends on the following issues:

❑ The spread between the interest earned on the collateral and the

coupon paid on the securities issued

❑ The frequency of defaults in the underlying asset pool and their

severity, in terms of recovery rate, plus the impact of losses on investors’

principal

Collateralized Debt Obligations 287

❑ The principal-repayment proﬁ le and expected amortization of the

underlying loans

❑ The contingent payments under any credit-default swap used to

transfer credit risk from the originator to another party, such as the SPV or an

OECD bank. Under Basel I rules, if an investor takes out credit protection on

a loan, and the protection is provided by a OECD bank, his capital charge

changes from 100 percent to 20 percent.

❑ The contingent cash ﬂ ows from any credit wrap or credit insurance

on the underlying asset pool

❑ The cash ﬂ ows receivable from or payable to a hedge counterparty

under swap agreements or derivative contracts

❑ The premium received from the credit default swap counterparty

❑ Fees and expenses

The cash ﬂ ows are tested to see how they are affected in both normal

and stressed scenarios. The types of stress scenarios tested depend on the

underlying asset pool.

Originator’s Credit Quality

The impact of the originator’s credit quality on the rating of the notes is-

sued depends on the CDO structure. In a conventional structure, where

the underlying assets are transferred from the originator to the SPV, the

credit quality of the CDO notes is “delinked” from that of the originator,

depending solely on the portfolio performance and the credit enhance-

ment. In a synthetic structure, in contrast, the underlying asset pool

remains on the originator’s balance sheet. Investors, therefore, may be

exposed to both the originating bank’s credit quality and the portfolio

performance. The rating of such a credit-linked CDO is capped by that

of the originator, whose ﬁ scal soundness determines the reliability of the

interest and principal payments.

The senior tranches of a synthetic CDO, however, may be delinked

from the bank’s rating by using AAA-rated collateral and default swaps, as

described above. The ﬁ nal rating is inﬂ uenced by the credit rating of the

default-swap provider and the extent to which the cash ﬂ ows to investors

are exposed to the risk of default by the asset pool.

Operational Aspects

In market value transactions, the portfolio manager’s ability is key, since

the performance of the underlying portfolio is critical to the structure’s

success. The originator’s procedure for reviewing credit approvals of the

borrowers of the underlying loans and monitoring the loans is another

factor to consider. The better the credit-assessment and monitoring proce-

288 Selected Cash and Derivative Instruments

dure, the more comfortable investors can be with the integrity and quality

of the underlying asset portfolio.

Review of Credit-Enhancement Mechanisms

Credit enhancements include reserve accounts, subordinated tranches,

credit wraps, and liquidity facilities. Investors should consider the im-

pact of the particular enhancements a structure uses. This will usually be

observed by subjecting the CDO to stress scenarios that are designed to

determine the effect on the cash ﬂ ows.

Subordination. Each tranche’s rights to and priority in receiving

interest and principal payments are set out in an issue’s offering circular,

which provides a detailed description of the notes and their legal structure.

In allocating cash ﬂ ows, typically, fees and expenses are subtracted from

the cash ﬂ ows, then the most senior tranches are serviced, followed by the

junior tranches, and ﬁ nally the equity tranche. This method of cash ﬂ ow

is sometimes referred to as a cash ﬂ ow waterfall.

Credit wrap. As explained above, the originating bank may buy credit

insurance on the debt instruments of the underlying portfolio, to improve

its credit quality.

Reserve accounts. The banks may also set aside cash reserves from

the note proceeds in accounts, usually managed by the servicing agent or

a specialized cash manager, which provide ﬁ rst-loss protection to investors

by absorbing losses before the equity tranche.

Liquidity facility. A facility is an arrangement to provide a borrower

with credit support. In the case of a CDO, this arrangement involves the

originating bank ensuring that, should the underlying asset pool experi-

ence a temporary cash shortfall, the notes’ interest and principal payments

will still be made.

Legal Structure of the Transaction

A typical CDO structure is described in several legal agreements that

formalize the roles played by the various counterparties to the deal. In

addition to the offering circular, which presents the transaction details to

investors, these documents include the following:

❑ The trustee agreements, which set out the responsibilities for ad-

ministration and maintenance of books and records

❑ The sale agreement or credit-default swap agreement used to trans-

fer credit risk

❑ The hedging agreements, such as interest rate or cross-currency

swaps and other derivative contracts

❑ Guarantees or insurance, such as credit wraps on the underlying

asset pool

Collateralized Debt Obligations 289

Before the deal is closed, the SPV’s incorporation documents are also

reviewed, to ensure that it is bankruptcy remote and established in a tax-

neutral jurisdiction.

Expected Loss

Rating a CDO involves a detailed analysis of its structure, including the

elements discussed above. It also encompasses a quantitative assessment.

This is often based on the expected loss (EL) to note holders. The expected

loss calculated for each tranche is mapped to a table of expected losses and

their corresponding rating to assign the tranche an appropriate rating. The

tranche’s credit rating is a key determinant in its pricing and marketability.

Expected loss is calculated using equation (15.1).

EL p L

()

∑

(15.1)

where

= the loss on the notes under scenario x

= the probability of the scenario x occurring

Note holders’ expected losses are determined by considering the im-

pact on their cash ﬂ ows of the credit losses—losses from loan defaults—

occurring in various scenarios, taking into account how such losses are

allocated to the issue’s tranches. The cash ﬂ ows to the note holders depend

on whether a default has occurred and the size of the resulting loss. The

severity of the loss equals the par value of the note less the recovery rate.

The probability of default may be inferred from the rating of the under-

lying credit exposures. Expected losses are calculated using Monte Carlo

techniques, which simulate thousands of scenarios and cash ﬂ ows and so

require sophisticated computational models.

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291

Selected Market

Trading Considerations

PART THREE

Part Three presents the author’s insights into trading, based on

his experiences working as a gilt-edged market maker and ster-

ling-bond proprietary trader. The topics covered include implied

spot and market zero-coupon yields, yield-curve spread trading,

and butterﬂ y spreads.

291