Figure 3.5 shows the TROR transacted between the bank and the institution. This arrangement is financially the same as being ‘long’ the asset in the individual cases. However a significant advantage is now conferred, providing the asset and the BB institution have a low default correlation.
Finally Figure 3.6 illustrates the ‘synthetic’ asset for each counter- party. The institution has an unfunded asset as in Figure 3.4, but the periodic financing is five basis points cheaper. While the bank has a high- quality credit on its books; with a higher rating than the original asset.
The phrase CDO is a generic expression applied to any securitization backed by a pool of debt, usually bonds and/or loans. There are two main categories, the cash flow and the arbitrage.1 The distinction is made on the basis of collateral backing and motivation. CDO issuance constitutes a major activity within continental Europe, indeed compara- ble to other varieties of ABS. The term arbitrage arises because a vehicle is established in order to benefit from the funding gap which may tem- porarily exist between the assets, typically high-yield bonds and the liabilities, typically investment grade bonds. This has to be positive for the viability of the vehicle.
The cash flow CDO is employed by banks to remove assets from their balance sheet. The backing consists of loans no longer profitable because of regulatory reasons. The arbitrage CDO is issued by a portfolio manager purchasing backing in the secondary market. The resulting structure is typically sold to institutional investors. There are many advantages to the manager including the ability to grow assets under management.
Both CDOs have similar structures consisting of asset backing, the creation of a bankruptcy remote vehicle (SPV) and the structuring of the liabilities appealing to the net end investor. When the backing is mainly bonds the CDO is referred to as a CBO, with loans the term CLO is used.
These arrangements are addressed in Section 7 within the chapter on securitization. We also give examples of the synthetic CLO, where credit derivatives are employed by banks wishing to seek regulatory relief. In this section we wish to focus on the use of credit derivatives within the investment management community.
An important development in the market has been the inception of the investment grade CDO. This represents a new type of mandate for the investment manager. The phraseology is misleading because the collateral is a combination of assets including investment grade bonds or loans. The benefits are considerable, and in common with the trad- itional arbitrage variety include the opportunity to grow assets and consequently the fee base but further to leverage the existing expertise.
There are three alternatives: traditional ‘cash flow’ CDO’s using invest- ment grade bonds as the collateral; a fully synthetic market value CDO which instead of having a tangible instrument backing the indenture rely on the cash flows from credit derivatives and finally a market value hybrid consists of a combination of credit derivatives and cash bonds
1The arbitrage CDO is further divided into the cash flowand market valuecategories.
The basis of distinction is that cash flows are used to pay principal in the former while receipts from sales on the collateral provide the principal repayments in the latter. This implies that the manager can freely trade the backing in the market.
to supply the backing. Having swallowed these details the reasoning for the mushrooming of styles will be now be elaborated upon.
The advantages of the traditional arbitrage CDO must be balanced with the obvious shortcoming represented by the somewhat fleeting nature of the arbitrage and yet another piece of phraseology coined the
‘ramp up period’. This sounds intimidating and it refers to the period when the physical assets that will be contained in the vehicle are col- lected. Due to these constraints managers often plump for the synthetic deal type, in particular they do not suffer from any ‘ramp up’ exposures because assets do not have to be physically assembled. Furthermore the arbitrage is easier to maintain, they do however require familiarity with the credit derivatives marketplace. Also the risks may be more than pure default risk.
The majority of investment grade deals have an average credit qual- ity of around A to BBB for collateral consisting of corporate bonds.
We discussed above, because of the difficulty of capturing arbitrage for any extended period, additional asset classes must be included.
Figure 3.7 shows a typical breakdown by asset category.
The choice of collateral is not straightforward and will generally be made with due consideration to at least three major factors including the amount of diversity the asset class can introduce, its liquidity and possibly the outlook for the sector. Diversity is key to the performance of the resulting securities that are issued; otherwise a seemingly isol- ated credit event could cause premature repayment, or worse, if the portfolio is inadequately constructed. It is part of the task of the rating agencies to assess and quantify this aspect of the deal. Liquidity is also very important given the short-term nature of the arbitrage. It is necessary to have the ability to exit at all times. We can examine each of the asset categories in these contexts; high yield is a much smaller marketplace in Europe, issuance is quite small and furthermore it also suffers from being quite concentrated towards the telecom sector. This places strong reservations on the appropriateness. Leveraged loanson
Investment grade loans Investment grade bonds High yield bonds CDS
ABS SME loans Leveraged loans
Figure 3.7 Backing for European CDO in 2002. Source:Dresdner Kleinwort Wasserstein.
the other hand are much more diverse and enjoy a better spread for a comparative rating. They are usually difficult to source and reinvestment into an equivalent asset could pose a challenge. Asset-backed secur- ities also offer good diversity but suffer from a lack of a developed sec- ondary market within Europe. Emerging market paper is quite broad in terms of credit quality but has restricted European denominated issuance. Unfortunately this sector suffers from a contagion factor.
Bank capital is a distinct source, enjoying a yield pick up relative to senior bank debt but is less liquid usually denominated in small trad- ing sizes of less than 10 million Euros.
A typical managed CDO structure
Instead of taking a standard approach and drawing lots of arrows we attempt to explain the operation of the CDO illustrated in Figure 3.8 by discussion. Firstly the ‘asset manager’ will contract with the equity provider (or the ‘investor’) in the above diagram. Usually this is arranged through the investment banking community who also undertake the hedging arrangement, that is the ‘hedge provider’. At an opportune moment in the market the manager starts collecting assets initiating the ‘ramp up period’, the risk of this period is held by the ‘investor’ and
Custodian Hedge provider Investor
Asset manager Trustee
Reporting
Equity AAA notes Invest. grade
€700–800 million
High yield bonds/loans
€100–200 million
AAnotes SPV
Assets Liabilities
Figure 3.8 A managed CDO structure. Source:Dresdner Kleinwort Wasserstein.
is purchased with a bridge loan from the arranger. After the assets are collected, they are transferred into the ‘company’ which is a separate legal entity and held by the custody bank. Securities are then issued into the marketplace and the equity is issued. The certificates are held by the Trustee, who deals with the administrative aspects of the com- pany. At this point the loan is paid off to the bank from the proceeds.
Finally because the assets are usually fixed coupon and represent a potential currency exposure, there will be an interest rate (and possibly forex) hedge between the vehicle and the ‘hedge provider’.
The synthetic CDO
We can introduce a synthetic deal into the context of this discussion.
The basic organizational arrangement remains the same but the struc- ture of the company or trust alters, we can examine this in Figure 3.9.
Effectively the ‘physical’ collateral has been replaced by a set of credit derivatives, usually default swaps on the underlying credits. The stream of protection premia flows into the partially funded indenture. This means that the investor does not have to supply capital. There are a distinct number of advantages to this arrangement including the com- parative rapidity of the time to market and the ease which the positions
Equity AAA notes
unfunded
Traditional assets CDS portfolio
AAnotes unfunded SPV
Assets Liabilities
Figure 3.9 A synthetic CDO.
can be traded. Consequently there is a movement towards managed synthetic CDOs, although at present most are static. The example dis- played in Figure 3.9 is more relevant to the types of structure involving the fund management community. It is increasingly common for banks to take out protection on each of the individual tranches and manage the risk accordingly.
Collateral quality
Examining the collateral is one of the critical ingredients to the success of a managed CDO. We begin by presenting the characteristics of a typ- ical pool.
The measure that will require a little elaboration is the concept of the diversity score which is widely used within the industry, so it is worth the effort and is discussed in detail in Section 6.7.
Consider the portfolio, in Table 3.5, and assume for one moment that the one hundred assets are independent and consequently have cor- relation of zero, what would be the default characteristics of the port- folio? It turns out to have an expected loss of the default probability multiplied by the recovery rate and loss distributed binomially around this average. Increasing the correlation both ‘skews’ and creates more losses in the ‘tail’. In the extreme case where all the assets are 100 per cent correlated, the portfolio either defaults or it does not. Thus the distribution is composed of two spikes. In Figure 3.10 we illustrate the effect this has on each tranche consisting of a junior taking the first 10 per cent of the losses, a mezzanine the next 10 per cent and a senior receiving the final 80 per cent.
Table 3.5 The characteristics of the collateral.
Characteristic Value
Pool size €1 000 000 000
Number of assets 100
Number of obligors 100
Moody’s diversity score 47
Average pool rating A–
Average life of pool 6 years
Average pool spread 181 bps
Largest single obligor 1%
Largest industry concentration 12% Utilities 10% Telecoms 9% Construction
When no correlation is present, the losses are entirely contained within the equity tranche, which can be very high depending on the size of the equity tranche and the credit quality of the portfolio. In our example with backing having default probability of 14 per cent and recovery value of 50 per cent corresponds to an expected loss of 7 per cent, thus in the case of zero correlation up to 70 per cent of the equity would be lost. At the other extreme of all assets fully correlated, the portfolio behaves as just one asset. However the senior debt is differentiated by having a claim on the recovery value. If this is high then it implies the
0 20 40 60 80
0 20 40 60 80 100
Correlation
Expected loss (%)
Equity Mezzanine Senior
Figure 3.10 Tranche loss as a function of default correlation. Source:Lehman Brothers.
ROBECO CSO III SPV
Funded AAA (21.3%) Trustee
Unfunded super senior CDS (70%)
Funded Aa2 (1.55%)
Funded N/R (4%) Funded
Baa1 (3.15%) ABS
Collateral
CDS counterparty
CDS counterparty Robeco Asset
Management Contingent
Principal Regular
Figure 3.11 Robeco III structure diagram. Source:JP Morgan/Chase.
expected loss is very low as a fraction of its notional. In our example the maximum loss is restricted to 30 per cent of the senior tranche and a correspondingly lower fraction of the face value.
The mezzanine portion is more difficult to evaluate, and a model of default is required. We give an example of such a structural-based model in Section 4.9.
In Figure 3.11 we display a managed synthetic CDO. This is repre- sentative of a ‘third generation’ CDO in the sense of mixing both cash and synthetic assets. In this particular example the backing partially consisted of asset-backed securities serving as collateral on the senior notes. Additionally there is an interest guarantee arrangement taken out through a third party. The additional ‘assets’ consist of the premia from credit default swaps. The underlying references are freely traded by the manager. The other noteworthy point is that the resulting liabil- ities consist of funded notes, listed in Table 3.6. The unfunded portion is referred to as a ‘super senior CDS’ consisting of a credit default swap.