CollateralizedDebtObligation (CDO)

FixedIncomeSecurities&DebtMarkets

Faculty:Dr.MeeraSharma
Course:PTMBA20092012|IIIYear|TermVII|FINANCEDiv.B Assignmentsubmittedby:Group7 RollNo. StudentName

107 110 129 142 162

VatsalDhandhukia MukundGhumara VivekParulekar AashikaShah SunilObhan

September4,2011

CollateralizedDebtObligations

Contents

1. Introduction......................................................................................................................................................3 2. HowCDOworks?............................................................................................................................................4 3. WhyCDO?..........................................................................................................................................................8 4. CDOStructures................................................................................................................................................9 5. TypesofCDO.................................................................................................................................................13 . 6. Transactionparticipants..........................................................................................................................14 7. CDOLifeCycle...............................................................................................................................................15 8. Pros&Cons....................................................................................................................................................16 9. CDOMarketGrowth...................................................................................................................................16 .

CollateralizedDebtObligations

1. Introduction
The basic principle behind a CDO involves the re-packaging of fixed income securities and the division of their cash flows according to a strict waterfall structure. A Collateralized Debt Obligation (CDO) is a credit derivative that creates fixed income securities with widely different risk characteristics from a pool of risky assets. The coupon and principal payments of these securities are linked to the performance of the underlying pool. These fixed income securities are known as tranches and are divided into senior, mezzanine and subordinated/equity tranches. Each of these tranches has a different level of seniority relative to the others in the sense that a senior tranche has coupon and principal payment priority over a mezzanine tranche, while a mezzanine tranche has coupon and principal payment priority over an equity tranche. It is important to note that a CDO only redistributes the total risk associated with the underlying pool of assets to the priority ordered tranches. It neither reduces nor increases the total risk associated with the pool. A CDO is similar to a regular mutual fund that buys bonds. However, unlike a mutual fund, most of the securities sold from a CDO are themselves bonds, rather than shares. In simplest terms, a CDO is an arrangement that raises money primarily by issuing its own bonds and then invests the proceeds in a portfolio of bonds, loans, or similar assets. Payments on the portfolio are the main source of funds for repaying the CDO's own securities. CDOs had become a notable feature of the financial landscape from 2000 to 2007. Average global CDO issuance has exceeded $161.7 billion per year, for each of the past ten years.

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2. How wCDOwor rks?

CDOs vary in stru s ucture and u underlying a assets, but th basic prin he nciple is the same. A CD is a type of DO e as sset-backed security. To create a CD a corporate entity is constructed to hold ass as colla o DO, s d sets ateral and to sell pa ackages of c cash flows to investors. A CDO is co o onstructed as follows: s

Figure21ExampleofaCDOStructure

A special purpose ve ehicle (SPV or specia purpose e V) al entity (SPE) is designe to acquir a ) ed re ing assets. Common u underlying assets held include m mortgage-bac cked portfolio of underlyi securities, commercial real estate b l bonds and co orporate loan ns.

The SPE issues bonds to investors in exchang for cash, which is use to purcha the portf i s s ge ed ase folio of underly ying assets. The bonds issued are in layers w different risk charac with t cteristics ca alled tranches. Senior tranc S ches are paid from the cash flows from the un nderlying as ssets before the junior secu urities and e equity securi ities. Losses are first bor by the eq rne quity securit ties, next by the y junior tran nches, and fin nally by the senior tranc ches.
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One analogy is to think of the cash flow from the CDOs portfolio of securities (say mortgage payments from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, then junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranche investors face the losses first. The risk and return for a CDO investor depends directly on how the tranches are defined, and only indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all asset-backed securities, enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated. The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This explains why some CDO became entirely worthless, as the equity layer tranches were paid last in the sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of which defaulted) to trickle down to the equity layers.

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Capital Structure A typical CDO might have an underlying portfolio of roughly 100 corporate bonds with an average rating of single-B-plus (Moody's B1, S&P B+). If the total size of the portfolio is $300 million, the CDO might issue six classes of securities as follows:
Table21ExampleofBasicCDOStructure

Class ClassA ClassB ClassC ClassD ClassE Equity

Amount ($millions) 243 13.5 10.5 9 9 15

%ageofDeal 81 4.5 3.5 3 3 5

Ratings (Moody's/S&P) Aaa/AAA Aa2/AA A2/A Baa2/BBB Ba2/BB notrated

In buying and selling assets for the portfolio, the manager would be required to maintain an average portfolio rating of single-B-plus or higher. If the average rating of the portfolio slips lower, the terms of the deal might curtail the manager's discretion in managing the portfolio. In addition, the rating agencies might downgrade the securities. Naturally, investors demand higher yields on classes exposed to greater credit risk. In the example above, the Class A securities would command the lowest yield because they carry the highest ratings. Conversely, the equity class would command the highest yield because of its station at the bottom of the deal's capital structure.

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Figure22Hiera archyofDebtse ecuritiespackag ging

The T collatera for cash CDOs includ al C de: Struct tured finance securities ( e (mortgage-ba acked securi ities, home e equity asset-backed secu urities, comm mercial mortg gage-backed securities) d Lever raged loans Corpo orate bonds Real e estate investm trust (R ment REIT) debt Comm mercial real estate mortgage debt (inc e cluding who loans, B n ole notes, and M Mezzanine de ebt) Emerg ging-market sovereign d debt Projec finance de ct ebt Trust preferred securities
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3. WhyCDO?
The ability to enhance overall market liquidity for an asset class is a key value proposition of CDOs. This feature alone secures CDOs a critical role in the global financial marketplace. The barriers that CDOs help investors overcome are not limited to providing diversified asset class access alone. More fundamentally, they provide a means to diversify into an asset class with the optional benefit of expert advice. Although static portfolios (and more recently indexation-based portfolios) can be constructed, most CDOs formally contract an asset manager with a unique specialization in the targeted asset class to administer the portfolio. Another service a CDO affords investors is an ability to select the degree of risk an investor takes to an asset class (and, if applicable, the asset manager) depending on where in the CDOs capital structure the investor invests. Companies have different reasons for creating or sponsoring CDOs. For example, some CDOs are created by investment advisory firms (i.e., money management firms). Such a firm earns fees based on the amount of assets that it manages. By creating a CDO, the firm can increase its income by increasing its assets under management. This kind of CDO is usually called an arbitrage CDO because of the (hopefully) positive spread between the yield that the CDO earns on its portfolio and the yield that it must pay out on its own debt securities. In many cases, the profit goes mostly to the holder of the equity class, with some portion going to the manager as a performance-based fee. Other CDOs are created by banks as a way to remove assets from their balance sheets. A bank can remove assets from its balance sheet by creating a CDO and transferring assets to the CDO's portfolio. Such a CDO is called a balance sheet CDO. Removing assets from its balance sheet can be advantageous for a bank when it calculates its regulatory capital requirement.

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4. CDOStructures
CDO is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follow: Source of funds cash flow vs. market value Arbitrage CDOs can be further broken down into cash flow and market value categories. Focus: In a cash flow issue, the structure uses cash generated by a pool of corporate loans and bonds to satisfy its payment obligations. Since cash flow CDOs will hold assets with varying terms, the portfolio manager must ensure that payment obligations can be satisfied with incoming cash flows. In contrast, a market value CDO portfolio manager focuses on the pool's prospects for appreciation and high yield. Strategy: A cash flow portfolio manager's strategy will typically be buy-and-hold (essentially matching asset flows with liability flows), whereas a market value CDO's portfolio manager actively trades the pool to enhance total return. Rating agencys perception: In addition, rating agencies review and monitor each structure differently. In a cash flow CDO, rating agencies will monitor overcollateralization (excess asset value) by comparing the present value of the pool's cash flows to the present value of the trust's obligations. A rating agency monitors overcollateralization in a market value CDO by considering the portfolio's market or liquidation value versus the trust's obligations. Fundingcash vs. synthetic Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a special purpose vehicle) issuing the CDOs tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006.
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Figure41CashCDOMechanism[So ource:BionicTur rtle.com]

Synthetic CD do not own cash as DOs o ssets like bon or loans. Instead, sy nds ynthetic CDO gain cred exposure to a Os dit po ortfolio of fixed incom assets w me without owni ing those assets throug the use of credit de gh efault swaps, a de erivatives in nstrument. (Under such a swap, th credit pr ( h he rotection sel ller, the CD receives periodic c DO, s cash pa ayments, cal lled premium in excha ms, ange for agre eeing to assu ume the risk of loss on a specific as in the ev k sset vent th asset exp hat periences a default or oth credit ev d her vent.) Like c cash CDO, th risk of loss on the CD portfoli is he DOs io di ivided into t tranches. Lo osses will fir affect the equity tran rst e nche, next th mezzanin tranches, and finally the he ne se enior tranche Each tranc receives a periodic p e. che s payment (the swap prem mium), with the junior tr ranches offer ring hi igher premiu ums. A syn nthetic CDO tranche ma be either funded or unfunded. U O ay r Under the s swap agreem ments, the C CDO co ould have to pay up to a certain amo o ount of mon in the event of a cred event on the referenc obligation in ney dit ce ns th CDOs ref he ference portf folio. Some of this credi exposure i funded at the time of investment b the inves it is by stors in funded tran n nches. Typic cally, the jun tranches that face th greatest r of exper nior s he risk riencing a lo have to f oss fund
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at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in highquality, liquid assets or placed in a GIC (Guaranteed Investment Contract) account that offers a return that is a few basis points below LIBOR. The return from these investments plus the premium from the swap counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit event occurs and a payout to the swap counterparty is required, the required payment is made from the GIC or reserve account that holds the liquid investments. In contrast, senior tranches are usually unfunded since the risk of loss is much lower. Unlike cash CDO, investors in a senior tranche receive periodic payments but do not place any capital in the CDO when entering into the investment. Instead, the investors retain continuing funding exposure and may have to make a payment to the CDO in the event the portfolio's losses reach the senior tranche. Funded synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time to create. Cash assets do not have to be purchased and managed, and the CDOs tranches can be precisely structured.

Figure42SyntheticCDOMechanism[Source:BionicTurtle.com]

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Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional assets. A portion of the proceeds from the funded tranches is invested in cash assets and the remainder is held in reserve to cover payments that may be required under the credit default swaps. The CDO receives payments from three sources: the return from the cash assets, the GIC or reserve account investments, and the CDO premiums. Single-tranche CDOs The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke CDOs) where the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches are never sold but held by the dealer based on valuations from internal models. Residual risk is delta-hedged by the dealer.
Table41ComparisonbetweenSingleTrancheSyntheticCDOsandTraditionalSyntheticCDOs

Single-Tranche Synthetic CDO Synthetic risk transference via single name credit default swaps is used to create the underlying collateral pool. Usually between 50 and 100 high-grade names in the collateral pool. Only one tranche is placed with an investor. The remaining tranches are retained by the dealer and the associated risk is actively managed (delta hedged). Bilateral contract between protection buyer and protection seller. No reliance or dependence on equity tranche investor or other parties as in traditional CDOs. Client has ultimate flexibility in determining the underlying portfolio, investment size, tranche structure and desired rating. Investor-driven, single-investor.

Multi-Tranche Synthetic CDO Synthetic risk transference via single name credit default swaps is used to create the underlying collateral pool. Typically around 100 high-grade names in the collateral pool. Majorities of the tranches are placed with different investors and hedging is more straightforward than in single tranche deals. Syndication may be involved. Different investors will be attracted to different tranches depending on risk/ return preference. Less flexibility in determining underlying collateral pool depending on the type of investor.

Issuer-driven in traditional securitization or equity investor/portfolio manager driven in case of arbitrage CDO. Potentially faster execution than full capital structure Typically slower execution as all tranches need to be deals, allowing the investor to capitalize on arbitrage placed. Deals can collapse if the entire capital opportunities between the CDS and cash markets, as structure cannot be placed. well as sweet spots in the capital structure.
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5. TypesofCDO
CDOs, which first appeared in the late 1980s, are considered to be the most important innovation in the structured finance market in the past two decades. There are many types of CDOs available in the market. A) Based on the underlying asset: Collateralized loan obligations (CLOs) CDOs backed primarily by leveraged bank loans. Collateralized bond obligations (CBOs) CDOs backed primarily by leveraged fixed income securities. Collateralized synthetic obligations (CSOs) CDOs backed primarily by credit derivatives. Structured finance CDOs (SFCDOs) CDOs backed primarily by structured products (such as asset-backed securities and mortgage-backed securities). Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans, and only less than 10% of CDOs were backed by fixed income securities. B) Other types of CDOs include: Commercial Real Estate CDOs (CRE CDOs) backed primarily by commercial real estate assets Collateralized bond obligations (CBOs) CDOs backed primarily by corporate bonds Collateralized Insurance Obligations (CIOs) backed by insurance or, more usually, reinsurance contracts CDO-Squared CDOs backed primarily by the tranches issued by other CDOs. CDO^n Generic term for CDO3 (CDO cubed) and higher, where the CDO is backed by other CDOs/CDO2/CDO3. These are particularly difficult vehicles to model due to the possible repetition of exposures in the underlying CDO.

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6. Transactionparticipants
Investors: have different motivations for purchasing CDO securities depending on which tranche they select. Underwriter: typically an investment bank, acts as the structurer and arranger of the CDO. Working with the asset management firm that selects the CDOs portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche. The asset manager: plays a key role in each CDO transaction, even after the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDOs portfolio. The manager can maintain the credit quality of a CDOs portfolio through trades as well as maximize recovery rates when defaults on the underlying assets occur. The trustee and collateral administrator: The trustee holds title to the assets of the CDO for the benefit of the investors. In the CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and distributes note-holder reports, performs various compliance tests regarding the composition and liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall models. Accountants: The underwriter typically will hire an accounting firm to perform due diligence on the CDOs portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread, of each collateral security. In addition, the accountants typically calculate certain collateral tests and determine whether the portfolio is in compliance with such tests. Attorneys: Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction documents. Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory requirements to disclose certain information to investors.
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7. CDOLifeCycle
It is useful to view a CDO as having a lifecycle that consists of several phases. The first phase is the ramp-up phase, when the manager uses the proceeds from issuing the CDO to purchase the initial portfolio. The CDO's governing documents generally specify parameters for the initial portfolio but not the exact composition. For example, the terms of the CDO might require that the initial portfolio have a minimum average rating, a minimum average yield, a maximum average maturity, and a minimum degree of diversification. During the ramp-up phase, the manger must select assets so that the portfolio satisfies all the parameters. The second phase is the revolving period, during which the manager actively manages the portfolio and reinvests cash flow from the portfolio. The reinvestment phase allows a CDO to remain outstanding without amortization of the CDO's own bonds even though the assets in the underlying portfolio reach their maturity dates. The third period is the amortization phase. During the amortization phase, the manager stops reinvesting cash flow from the portfolio. Instead, the manager must apply the cash flow toward repaying the CDO's debt securities. A manager generally is required to follow certain rules in managing the portfolio. The rules protect investors by somewhat limiting the manager's discretion. For example, one rule might require the manager to maintain the average yield or spread on the managed assets above a certain level. Another rule might require the manager to maintain the average maturity of the assets within a certain range.

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8. Pros&Cons
Advantages: Different Tranches allow Investors to customize their Credit Risk exposure Efficient Mechanism for taking Diversified Credit Exposure Attractive Spreads relative to similarly rated Assets

Disadvantages: Pricing is based on Rating Agency assigned default probabilities which may not reflect True Underlying Risk Expenses Origination & Management Fees reduce the economies to Investors

9. CDOMarketGrowth
The first CDO was issued in 1987 by bankers at Drexel Burnham Lambert Inc. and a decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, and then declined back under $20 billion by Q1 2008.
Table91GlobalCDOIssuance[Source:sifma]

GlobalCDOIssuance($billions)
500 450 400 350 300 250 200 150 100 50 0
456 430

251 158 68 78 83 87 62 4 8 3

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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In 200 ICICI ha structured India's mai 02, ad d iden CDO fo its corpora loans, bu failed to a or ate ut attract invest tors. There has no been muc growth in India's CD market t T ot ch n DO thereafter (R 1,900 cro and Rs 2 Rs ore 2,600 crore) in ), co ontrast to th phenomen growth in the retail loan securitization ma he nal l arket from a about Rs 1,3 crore to Rs 300 o 25 5,600 crore b between 200 and 2005 (ICRA). 02 CDOs have been in the limeli s ight after the subprime c e crisis - the c collapse of fi financial inst titutions and the d pr resent econo omic turmoil. Many qu uestions hav been rais about th future of these instr ve sed he f ruments. Th hese qu uestions ran from regu nge ulatory issue to attackin the very basis of issu es ng uance of CD DOs. Credit d derivatives h have be blamed for whatever ills are trav een r velling aroun the marke today. nd et class of asse that CDO falls into needs to be looked int from a re ets Os o to egulatory an ngle - to ens sure The c gr reater transp parency in th pricing an trading of these produ he nd f ucts. Also, th extent to which instru he uments actu ually tr ransfer risk s should be in nvestigated i detail and brought on balance sheets and p in d nto public disclo osures of ba anks an public-tra nd aded compan nies. The fir law of ris managem rst sk ment says: Risk is neither created nor destroyed; just r r re epackaged an redistribu nd uted. CDOs n need to be te ested against this golden rule. t n

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