collateralized debt obligation - report

8/4/2019 Collateralized Debt Obligation - Report

1/17

Collateralized Debt Obligation

(CDO)

Fixed Income Securities & Debt Markets

Faculty: Dr. Meera Sharma

Course:PTMBA20092012|IIIYear|TermVII|FINANCEDiv.B

Assignmentsubmittedby:Group7

RollNo. StudentName107 VatsalDhandhukia

110 MukundGhumara

129 VivekParulekar

142 AashikaShah

162 SunilObhan

September4,2011


2/17

Collateralized Debt Obligations

Contents1. Introduction ...................................................................................................................................................

2. How CDO works? .........................................................................................................................................

3. Why CDO? .......................................................................................................................................................

4. CDO Structures .............................................................................................................................................

5. Types of CDO ..................................................................................................................................................

6. Transaction participants ..........................................................................................................................

7. CDO Life Cycle ...............................................................................................................................................

8. Pros & Cons ....................................................................................................................................................

9. CDO Market Growth ....................................................................................................................................


3/17


1. IntroductionThe basic principle behind a CDO involves the re-packaging of fixed income securities and the divis

of their cash flows according to a strict waterfall structure. A Collateralized Debt Obligation (CDO) is a cre

derivative that creates fixed income securities with widely different risk characteristics from a pool of ri

assets.

The coupon and principal payments of these securities are linked to the performance of the underly

pool. These fixed income securities are known as tranches and are divided into senior, mezzanine a

subordinated/equity tranches. Each of these tranches has a different level of seniority relative to the others in

sense that a senior tranche has coupon and principal payment priority over a mezzanine tranche, whil

mezzanine tranche has coupon and principal payment priority over an equity tranche. It is important to note t

a CDO only redistributes the total risk associated with the underlying pool of assets to the priority orde

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

securities sold from a CDO are themselves bonds, rather than shares. In simplest terms, a CDO is

arrangement that raises money primarily by issuing its own bonds and then invests the proceeds in a portfolio

bonds, loans, or similar assets. Payments on the portfolio are the main source of funds for repaying the CD

own securities. CDOs had become a notable feature of the financial landscape from 2000 to 2007. Aver

global CDO issuance has exceeded $161.7 billion per year, for each of the past ten years.


4/17

C

a

p

ollateralize

2.HoCDO

set-backed

ackages of c

Debt Oblig

CDOwovary in str

security. T

ash flows t

A special

portfolio

securities,

The SPE i

of underl

tranches.

junior sec

junior tran

tionsks?

ucture and

create a C

investors.

purpose v

of underlyi

commercial

ssues bonds

ing assets.

Senior tranc

rities and e

ches, and fi

nderlying a

O, a corpo

CDO is c

Figure21

hicle (SPV

ng assets.

real estate

to investor

The bonds

hes are pai

quity securi

ally by the

ssets, but t

rate entity i

nstructed a

ExampleofaC

) or specia

Common

onds and c

s in exchan

issued are

d from the

ties. Losses

senior tranc

e basic pri

constructe

follows:

DOStructure

l purpose

nderlying

orporate loa

e for cash,

in layers w

cash flows

are first bo

hes.

ciple is the

d to hold as

ntity (SPE)

assets held

ns.

which is us

ith differen

from the u

ne by the e

same. A C

ets as colla

is designe

include m

d to purch

risk chara

derlying a

uity securit

O is a typ

teral and to

d to acqui

ortgage-bac

se the portf

teristics ca

sets before

ies, next by

o

l


5/17


One analogy is to think of the cash flow from the CDOs portfolio of securities (say mortgage payme

from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, th

junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient c

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 o

indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods u

to define the risk and return of the tranches. CDOs, like all asset-backed securities, enable the originators of

underlying assets to pass credit risk to another institution or to individual investors. Thus investors m

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 ea

management fees during the life of the CDO. The ability to earn substantial fees from originating CDO

coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volu

rather than loan quality.

In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by ot

CDOs. This explains why some CDO became entirely worthless, as the equity layer tranches were paid las

the sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of wh

defaulted) to trickle down to the equity layers.


6/17


Capital Structure

A typical CDO might have an underlying portfolio of roughly 100 corporate bonds with an aver

rating of single-B-plus (Moody's B1, S&P B+). If the total size of the portfolio is $300 million, the CDO mi

issue six classes of securities as follows:

Table21ExampleofBasicCDOStructure

ClassAmount

($millions)%ageofDeal

Ratings

(Moody's/S&P)

ClassA 243 81 Aaa/AAA

ClassB 13.5 4.5 Aa2/AA

ClassC 10.5 3.5 A2/A

ClassD 9 3 Baa2/BBB

ClassE 9 3 Ba2/BB

Equity 15 5 notrated

In buying and selling assets for the portfolio, the manager would be required to maintain an aver

portfolio rating of single-B-plus or higher. If the average rating of the portfolio slips lower, the terms of the d

might curtail the manager's discretion in managing the portfolio. In addition, the rating agencies mi

downgrade the securities.

Naturally, investors demand higher yields on classes exposed to greater credit risk. In the exam

above, the Class A securities would command the lowest yield because they carry the highest ratin

Conversely, the equity class would command the highest yield because of its station at the bottom of the de

capital structure.


7/17

C

T

ollateralize

he collater

Structcomm

Lever Corp Real Com Emer Proje Trust

Debt Oblig

l for cash

ured financ

ercial mort

aged loans

rate bonds

state invest

ercial real

ing-market

t finance d

preferred se

tions

DOs inclu

securities (

age-backed

ment trust (

state mortg

sovereign d

bt

curities

Figure22Hier

e:

mortgage-b

securities)

EIT) debt

age debt (in

ebt

rchyofDebts

acked securi

luding wh

curitiespackag

ties, home

le loans, B

ing

quity asset-

notes, and

backed secu

ezzanine d

rities,

bt)


8/17


3. WhyCDO?The ability to enhance overall market liquidity for an asset class is a key value proposition of CD

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 cl

access alone. More fundamentally, they provide a means to diversify into an asset class with the optional ben

of expert advice. Although static portfolios (and more recently indexation-based portfolios) can be construc

most CDOs formally contract an asset manager with a unique specialization in the targeted asset class

administer the portfolio.

Another service a CDO affords investors is an ability to select the degree of risk an investor takes to

asset class (and, if applicable, the asset manager) depending on where in the CDOs capital structure

investor invests.

Companies have different reasons for creating or sponsoring CDOs. For example, some CDOs

created by investment advisory firms (i.e., money management firms). Such a firm earns fees based on

amount of assets that it manages. By creating a CDO, the firm can increase its income by increasing its ass

under management. This kind of CDO is usually called an arbitrage CDO because of the (hopefully) posit

spread between the yield that the CDO earns on its portfolio and the yield that it must pay out on its own d

securities. In many cases, the profit goes mostly to the holder of the equity class, with some portion going to

manager as a performance-based fee.

Other CDOs are created by banks as a way to remove assets from their balance sheets. A bank

remove assets from its balance sheet by creating a CDO and transferring assets to the CDO's portfolio. Suc

CDO is called a balance sheet CDO. Removing assets from its balance sheet can be advantageous for a b

when it calculates its regulatory capital requirement.


9/17


4. CDOStructuresCDO is a broad term that can refer to several different types of products. They can be categorized

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 sati

its payment obligations. Since cash flow CDOs will hold assets with varying terms, the portfolio manager m

ensure that payment obligations can be satisfied with incoming cash flows. In contrast, a market value CD

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 as

flows with liability flows), whereas a market value CDO's portfolio manager actively trades the pool to enhan

total return.

Rating agencys perception: In addition, rating agencies review and monitor each structure differently. I

cash flow CDO, rating agencies will monitor overcollateralization (excess asset value) by comparing the pres

value of the pool's cash flows to the present value of the trust's obligations. A rating agency monit

overcollateralization in a market value CDO by considering the portfolio's market or liquidation value ver

the trust's obligations.

Fundingcash vs. synthetic

Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities

mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a spec

purpose vehicle) issuing the CDOs tranches. The risk of loss on the assets is divided among tranches in reve

order of seniority. Cash CDO issuance exceeded $400 billion in 2006.


10/17

C

S

p

d

p

t

d

s

h

c

t

i

ollateralize

ynthetic C

ortfolio of

rivatives i

ayments, ca

at asset ex

ivided into

nior tranch

igher premi

A sy

uld have to

e CDOs re

funded tra

Debt Oblig

Os do not

fixed inco

strument.

led premiu

eriences a d

ranches. L

. Each tran

ms.

thetic CD

pay up to

erence port

ches. Typi

tions

Figur

own cash as

e assets w

Under such

s, in excha

efault or ot

sses will fi

he receives

tranche m

certain am

olio. Some

ally, the ju

e41CashCDO

sets like bo

ithout owni

a swap, t

nge for agr

er credit e

rst affect th

a periodic

y be eithe

unt of mon

of this credi

ior tranche

Mechanism[So

ds or loans

ng those a

e credit p

eing to ass

ent.) Like c

equity tra

ayment (th

funded or

ey in the ev

t exposure i

s that face t

urce:BionicTur. Instead, sy

ssets throu

otection se

me the risk

ash CDO, t

che, next t

e swap pre

unfunded.

ent of a cre

s funded at

e greatest r

tle.com]nthetic CD

h the use

ler, the C

of loss on

e risk of lo

he mezzani

ium), with

nder the s

it event on

the time of

isk of exper

s gain cred

of credit d

O, receive

specific a

ss on the C

e tranches,

the junior tr

wap agree

the referenc

investment

iencing a l

it exposure

fault swap

periodic

set in the e

Os portfoli

and finally

anches offe

ents, the C

e obligation

y the inves

ss have to f

t

s

r

t

u


11/17


at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in hi

quality, liquid assets or placed in a GIC (Guaranteed Investment Contract) account that offers a return that

few basis points below LIBOR. The return from these investments plus the premium from the sw

counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit event occurs

a payout to the swap counterparty is required, the required payment is made from the GIC or reserve acco

that holds the liquid investments. In contrast, senior tranches are usually unfunded since the risk of loss is m

lower. Unlike cash CDO, investors in a senior tranche receive periodic payments but do not place any capita

the CDO when entering into the investment. Instead, the investors retain continuing funding exposure and m

have to make a payment to the CDO in the event the portfolio's losses reach the senior tranche. Fund

synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time

create. Cash assets do not have to be purchased and managed, and the CDOs tranches can be precis

structured.

Figure42SyntheticCDOMechanism[Source:BionicTurtle.com]


12/17


Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio o

hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional ass

A portion of the proceeds from the funded tranches is invested in cash assets and the remainder is held

reserve to cover payments that may be required under the credit default swaps. The CDO receives payme

from three sources: the return from the cash assets, the GIC or reserve account investments, and the CD

premiums.

Single-tranche CDOs

The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke CDOs) wh

the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches

never sold but held by the dealer based on valuations from internal models. Residual risk is delta-hedged by

dealer.

Table41ComparisonbetweenSingleTrancheSyntheticCDOsandTraditionalSyntheticCDOs

Single-Tranche Synthetic CDO Multi-Tranche Synthetic CDO

Synthetic risk transference via single name credit

default swaps is used to create the underlyingcollateral pool.

Synthetic risk transference via single name cre

default swaps is used to create the underlycollateral pool.

Usually between 50 and 100 high-grade names in thecollateral pool.

Typically around 100 high-grade names in collateral pool.

Only one tranche is placed with an investor. Theremaining tranches are retained by the dealer and theassociated risk is actively managed (delta hedged).

Majorities of the tranches are placed with differinvestors and hedging is more straightforward thansingle tranche deals. Syndication may be involved.

Bilateral contract between protection buyer andprotection seller. No reliance or dependence on equitytranche investor or other parties as in traditionalCDOs. Client has ultimate flexibility in determining

the underlying portfolio, investment size, tranchestructure and desired rating.

Different investors will be attracted to differtranches depending on risk/ return preference. Lflexibility in determining underlying collateral pdepending on the type of investor.

Investor-driven, single-investor. Issuer-driven in traditional securitization or equinvestor/portfolio manager driven in case of arbitrCDO.

Potentially faster execution than full capital structuredeals, allowing the investor to capitalize on arbitrageopportunities between the CDS and cash markets, aswell as sweet spots in the capital structure.

Typically slower execution as all tranches need toplaced. Deals can collapse if the entire capstructure cannot be placed.


13/17


5. TypesofCDOCDOs, which first appeared in the late 1980s, are considered to be the most important innovation in

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-bac

securities and mortgage-backed securities).

Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans,

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 ot

CDOs/CDO2/CDO3. These are particularly difficult vehicles to model due to the possible repetition

exposures in the underlying CDO.


14/17


6. TransactionparticipantsInvestors: 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

asset management firm that selects the CDOs portfolio, the underwriter structures debt and equity tranches. T

includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality te

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 experien

manager is critical in both the construction and maintenance of the CDOs portfolio. The manager can maint

the credit quality of a CDOs portfolio through trades as well as maximize recovery rates when defaults on

underlying assets occur.

The trustee and collateral administrator: The trustee holds title to the assets of the CDO for the benefit of

investors. In the CDO market, the trustee also typically serves as collateral administrator. In this role,

collateral administrator produces and distributes note-holder reports, performs various compliance te

regarding the composition and liquidity of the asset portfolios in addition to constructing and executing

priority of payment waterfall models.

Accountants: The underwriter typically will hire an accounting firm to perform due diligence on the CD

portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread

each collateral security. In addition, the accountants typically calculate certain collateral tests and determ

whether the portfolio is in compliance with such tests.

Attorneys: Attorneys ensure compliance with applicable securities law and negotiate and draft the transact

documents. Attorneys will also draft an offering document or prospectus the purpose of which is to sati

statutory requirements to disclose certain information to investors.


15/17


7. CDOLifeCycleIt is useful to view a CDO as having a lifecycle that consists of several phases. The first phase is

ramp-up phase, when the manager uses the proceeds from issuing the CDO to purchase the initial portfo

The CDO's governing documents generally specify parameters for the initial portfolio but not the ex

composition. For example, the terms of the CDO might require that the initial portfolio have a minim

average rating, a minimum average yield, a maximum average maturity, and a minimum degree

diversification. During the ramp-up phase, the manger must select assets so that the portfolio satisfies all

parameters.

The second phase is the revolving period, during which the manager actively manages the portfolio

reinvests cash flow from the portfolio. The reinvestment phase allows a CDO to remain outstanding with

amortization of the CDO's own bonds even though the assets in the underlying portfolio reach their matur

dates.

The third period is the amortization phase. During the amortization phase, the manager st

reinvesting cash flow from the portfolio. Instead, the manager must apply the cash flow toward repaying

CDO's debt securities.

A manager generally is required to follow certain rules in managing the portfolio. The rules prot

investors by somewhat limiting the manager's discretion. For example, one rule might require the manager

maintain the average yield or spread on the managed assets above a certain level. Another rule might require

manager to maintain the average maturity of the assets within a certain range.


16/17


8. Pros&ConsAdvantages:

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 TrueUnderlying Risk

Expenses Origination & Management Fees reduce the economies to Investors9. CDOMarketGrowth

The first CDO was issued in 1987 by bankers at Drexel Burnham Lambert Inc. and a decade later, CD

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]

68 7883 87

158

251

456430

62

4 8 3

0

50

100

150

200

250300

350

400

450

500

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

GlobalCDOIssuance($billions)


17/17

C

T

c

2

p

q

b

g

tr

a

r

ollateralize

In 20

here has n

ntrast to t

5,600 crore

CDO

resent econ

uestions ran

en blamed

The c

reater trans

ansfer risk

d public-tr

packaged a

Debt Oblig

2, ICICI h

t been muc

e phenome

between 20

have been

omic turmo

ge from reg

for whateve

lass of asse

arency in t

should be i

ded compa

nd redistrib

tions

d structured

h growth in

nal growth

2 and 2005

in the limeli

il. Many q

ulatory issu

r ills are tra

ts that CD

e pricing a

vestigated i

nies. The fir

ted. CDOs

India's mai

India's C

in the retail

(ICRA).

ght after th

estions ha

s to attacki

elling arou

s falls into

d trading o

n detail an

st law of ris

eed to be t

den CDO f

O market t

loan secur

subprime

e been rai

ng the very

d the mark

needs to b

these prod

brought o

k managem

sted agains

r its corpor

hereafter (

itization m

risis - the c

ed about t

basis of iss

t today.

e looked in

cts. Also, t

to balance

ent says: Ri

this golden

ate loans, b

s 1,900 cr

rket from a

ollapse of fi

he future o

ance of CD

to from a r

he extent to

sheets and

sk is neither

rule.

t failed to a

re and Rs

bout Rs 1,

nancial inst

these inst

Os. Credit

gulatory a

which instr

ublic discl

created no

ttract invest

,600 crore)

00 crore to

itutions and

ruments. T

erivatives h

gle - to en

uments actu

sures of b

destroyed;j

collateralized debt obligation - report

Documents