Collateralized Debt Obligations

Making High-Yield Assets Safe

By: Jason Nelson

Sept. 11, 2000 (SmartPros) — Many investors believe that junk

bonds died with the Michael Milken era. Actually, junk bonds are very
much alive and are more appropriately known to fixed income
professionals as "high-yield bonds."

In fact, Financial Securities Data reports that high-yield issuance totaled over $50
billion in 1999. Of course, savvy investors are familiar with the direct relationship
between risk and return. So how can investors play the high-yield market while
minimizing the inherent risk? The answer: collateralized debt obligations (CDOs).

How Did Collateralized Debt Obligations Originate?

Collateralized debt obligations are privately placed securitizations that were created
in the late 1980s. A securitization, in abstract terms, is a reallocation of risk.
Securitization is the process of converting assets into securities backed by those
assets and is used for:

• Lower funding costs

• Accounting purposes
• Accessing the capital markets
• Generating fees—servicing and underwriting

CDOs borrowed their structural template from another structured product—

collateralized mortgage obligations (CMOs). The CMO structure was established in
the 1970s and proved readily adaptable to different collateral types because of its
ability to repackage and redistribute risk, thereby achieving equivalent returns
through higher-rated securities.

In short, this structuring technique creates a special-purpose entity (SPE) to hold

underlying collateral. The SPE then issues securities backed by the underlying
collateral pool. The underlying collateral's cash flows are then used to pay interest
and principal on the issued securities.

The subsequent securities' higher credit quality is due in part to a fundamental

concept in portfolio management theory—diversification. However, diversification is
only part of the story.

Tranching
Diversification redistributes risk by "pooling" numerous underlying collateral risk-
return profiles, thereby creating a single risk-return profile on the underlying
collateral pool (the assets). Securitizations go one step further and seek to
redistribute liability risk through a process known as tranching—taking the underlying
collateral cash flow and dividing it among numerous tranche interest and principal
components.
In layman's terms, this means creating different classes of securities (the liabilities),
each of which carry a different risk component defined by its payment priority and
timing. Tranching creates multiple securities that appeal to different investors given
the investor's risk-return threshold.

For example, highly-rated securities will have a lower return and can appeal to
institutional investors like pension funds. Lower-rated securities will have a higher
return and can appeal to hedge fund managers who are willing to sacrifice safety for
the juicier yields (up to 30 percent annually). Thus, the underlying collateral pool's
single risk-return profile (created through diversification) is transformed into multiple
risk-return profiles on the newly created securities (liabilities).

In the end, a less attractive investment on the collateral side—even though risk is
mitigated through diversification—is transformed into a more attractive investment
opportunity by tranching.

CDO tranches do not resemble their underlying collateral in credit quality or

performance. Each newly-created note tranche offers unique payment
characteristics.

What Are the Types of CDOs?

CDOs come in a variety of flavors but generally employ one of the following
structures:

• Cash Flow Structure: ongoing cash flow from the underlying collateral pool
serves as the repayment of interest and principal on the securities; or
• Market Value Structure: ongoing cash flow proceeds from the sale of
underlying collateral serves as the repayment of interest and principal on the
securities.
Cash flow structures are the dominant CDO form in terms of issuance volume. These
are commonly broken down into arbitrage and off-balance sheet transactions.
Arbitrage structures are the most common cash flow form and capture the positive
spread between a portfolio of high-return, high-risk assets and lower-cost, highly-
rated securities (liabilities) issued to purchase the underlying collateral portfolio.

The second cash flow structure -- off-balance sheet transactions -- was created to
reduce regulatory capital constraints by securitizing balance sheet assets. However,
off-balance sheet CDOs are now used to increase lending capacity and lower funding
costs. Market value structures -- as opposed to cash flow structures -- trade the
underlying collateral to realize positive gains for the payment of liability interest and
principal. Market value structures are "trading portfolios."

What is CDO Collateral?

The following definitions are helpful before reading further:

• Collateralized Bond Obligation (CBO): backed by a portfolio of bonds.

• Collateralized Loan Obligation (CLO): backed by a portfolio of loans.
• Collateralized Debt Obligation (CDO): backed by a portfolio of bonds, loans
and other assets.

Because almost all transactions created today contain a mix of several collateral
types, CDO is generally the most applicable term. CDO collateral may be comprised
of the following assets (this list is not exhaustive):

CDO Collateral Types

Debt Corporate
Securities Loans
Bonds (Senior,
Unsecured, or Term Loans
Subordinated) Revolving Loans
Distressed/Non- Secured &
Performing Unsecured
Junk Bonds Syndicated
Emerging Loans
Market Bilateral Loans
Structured Distressed/Non-
Finance (ABS, Performing
CBO/CLO, Loans
CMBS, REIT and Unfunded
RMBS) Commitments to
Project Finance Lend
Forfeiting Paper
Synthetic
Securities

What are the Motivations for CDOs?

CDOs are attractive because the structure reduces risk through diversification and
tranching. It is important to note that these are not the only risk management tools
used in CDOs but are highlighted here for entry-level understanding. CDOs employ
many credit enhancement features including:
 • Overcollateralization;
• Cash collateral/reserves;
• Excess spread/interest;
• Amortizing and insured tranches; and
• Hedges (interest rate swaps).

The motivation for each party in a CDO transaction can be very different. These are
summarized in the table below.

CDO Motivations
Investor
Issuer Motivations
Motivations

Yield
premium
opportunity

Participate in
Arbitrage: deversified
Realize positive spread high-yield
Increase assets under management portfolio via
Generate stable management fees investment
Participate in equity upside grade
structure
Balance Sheet:
Capital relief Select credit
Enhance lending capacity exposure loss
Lower funding cost position
Diversification of Funding sources
Increase ROE

Sample CDO Transaction

The flow chart below depicts the parties involved in a typical CDO transaction.
Ongoing CDO Management
CDOs are complex financial structures that can quickly go awry without established
portfolio-management guidelines. These guidelines can be presented under many
structural forms depending upon the overall purpose of the issuance.

Regardless of the contractual form, the contract itself can be thought of as a

"rulebook" for the CDO. This rulebook specifies:

• Collateral quality and coverage testing parameters for the portfolio;

• Acceptable collateral types;
• Performance metrics;
• Trading parameters;
• Payment distribution priority waterfall; and
• Default and liquidation triggers.

Summary
Structured products -- including CDOs -- continue to evolve. At their genesis in the
late 1980s, the primary CDO collateral types were high-yield bonds and loans. Today,
CDOs hold mortgage-backed securities, asset-backed securities, real-estate
investment trusts (REITS) and even tranches of other CDOs. Thus, even though
2000 high-yield issuance is off its blistering 1999 pace, the addition of these new
collateral types signals even more asset choices for the future.

The result: a more complicated financial product for the rating agencies to contend
with but continued yield for investors. Given the fact that only 1.2 percent of all
CDOs have been downgraded and there has never been a default, there is no end in
sight for this type of securitization.

Notes
"Global CBO/CLO Criteria," Standard and Poor's Structured Finance (1999.)
Harris, Dandra, Kitto, Thomas, Nelson, Soody, Tesher, David and Widemik, Anna, "An Introduction to Cash Flow
CBOs/CLOs and Market Value Transactions," Standard and Poor's Conference, Miami, Florida (April 1999).

Hurst, R. Russell, "The Myth and Reality of Collateralized Debt Obligations -- Growth and Stability Continue," First
Union Securities, Inc., Asset-Backed Research (October 1999).

Lee, Dan and Chen, Wei, "Securitization: An Overview of Arbitrage and Tranching," The Securitization Conduit,
Vol. 1, No. 1 (1998).

"New Assets are Tweaking Old Vehicles Amid Dearth of High-yield Bonds," Wall Street Journal (June 12, 2000).

For additional reading on CDOs, see the following Web sites:

Fitch IBCA, Duff & Phelps (www.fitchibca.com)

Moody's Investors Service (www.moodys.com)
Standard and Poor's (www.standardandpoors.com)