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Structured Finance and Collateralized Debt Obligations P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come Structured Finance and Collateralized Debt Obligations New Developments in Cash and Synthetic Securitization Second Edition JANET M. TAVAKOLI John Wiley & Sons, Inc. iii P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come iii P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come Structured Finance and Collateralized Debt Obligations i P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come Founded in 1807, John Wiley & Sons is the oldest independent publish- ing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and market- ing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and fi- nancial instrument analysis, as well as much more. For a list of available titles, visit our Web site at www.WileyFinance.com. ii P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come Structured Finance and Collateralized Debt Obligations New Developments in Cash and Synthetic Securitization Second Edition JANET M. TAVAKOLI John Wiley & Sons, Inc. iii P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come Copyright C 2008 by Janet M. Tavakoli. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. Originally published as Collateralized Debt Obligations and Structured Finance. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 646-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Tavakoli, Janet M. [Collateralized debt obligations and structured finance] Structured finance and collateralized debt obligations : new developments in cash and synthetic securitization / Janet M. Tavakoli. — 2nd ed. p. cm. — (Wiley finance series) Originally published in 2003 under title: Collateralized debt obligations and structured finance Includes bibliographical references and index. ISBN 978-0-470-28894-8 (cloth) 1. Asset-backed financing—United States. 2. Mortgage-backed securities—United States. I. Title. HG4028.A84T38 2008 332.632044—dc22 2008008483 Printed in the United States of America. 10987654321 iv P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come Contents Preface xiii Acronym Key xix CHAPTER 1 Securitization Terminology 1 Simplified Cash CDO 4 The CDO Arbitrage 5 CHAPTER 2 Structured Finance and Special Purpose Entities 7 SPCs and Historical Abuse 10 SPEs and SPVs 16 Documentation 18 Setup Costs 19 Example of a Multiple Issuance Entity 19 Cayman-Domiciled SPEs 22 Repackagings to Satisfy Investor Demand 24 Credit-Linked Notes and Funding Costs 25 Structured Floaters 27 Principal-Protected Notes 27 Loan Repackagings 28 Liquidity 29 Mismatched Maturities 29 Unwind Triggers Linked to Derivatives Transactions 30 DAX-Linked Note with Triggers 32 Ratings 34 Master Trusts 34 Owner Trusts 35 Grantor Trusts 36 Real Estate Mortgage Investment Conduits 36 Multiseller and Single-Seller Conduits 37 v P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come vi CONTENTS Domestically Domiciled Corporations 39 Bankruptcy-Remote? 40 Enron, JPMorgan Chase, and Sureties 43 CHAPTER 3 Credit Derivatives and Total Rate of Return Swaps 45 Risk to Portfolio Value 45 Credit Derivatives and Credit Default Swaps 47 Negotiated Language 49 Basis Risk: Persistent CDS Language Issues 49 Physical Settlement and Cash Settlement Negotiations 50 Digital, Binary, Zero-One, All-or-Nothing, or Fixed Recovery Cash Settlement 52 Initial Value × (Par − Market Value) 53 Normalized Price Method—Alternate Termination Payment 54 Hedge Costs in Cash and Synthetic CDOs 55 Deliverables: CDOs and the Cheapest-to-Deliver Option 55 Convertible Bonds and Asset Swaps 56 Negative Basis Trades 62 Default and Recovery Rate 62 The Default Protection Seller: Counterparty Credit and Correlation 65 Default Language for Sovereign Debt 65 Default Language for Nonsovereign Debt: Controversy and CDOs 66 CDS Pricing Issues 69 Synthetic CDOs 70 Total Rate of Return Swaps (Total Return Swaps) 72 Pricing TRORS on Levered CDO Tranches 74 TRORS versus Repos 75 Equity TRORS: Corporate Loans Disguised as Capital Injections 76 Information Asymmetry and Moral Hazard 78 CDS versus TRORS 78 Pay-as-You-Go 79 Indexes 81 CHAPTER 4 CDOs and the Global Capital Markets 83 Evolution of the CDO Market 84 P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come Contents vii CHAPTER 5 Risk and Valuation Issues 91 The Portfolio Diversification Myth 91 Modern Portfolio Theory: Bane of CDOs 92 Abnormal Is Normal 96 Mark-to-Market Hazard 98 Cash Flow Hazard 99 Global Derivatives Risk 100 Loans and Leveraged Loans 101 The Leverage Paradox 103 New Structured Finance Deals 104 Fraud 104 Hedge Funds: A New Investor Class 107 Tavakoli’s Law, Hedge Funds, and the Great Unwind 110 Brain Damage Theory 112 Dead Man’s Curve and Leveraged Funds 113 Margin of Safety versus One-Sided Illiquid Leveraged Bets 114 CHAPTER 6 Early CDO Technology 117 True Sale Hybrid and Synthetic Structures 117 Credit Enhancement 119 Monoline and Multiline Insurance 119 CDO Classification 121 Market Value CDOs 124 Cash Flow CDOs 124 The Origins of U.S. Securitization 126 Collateralized Mortgage Obligations 135 CHAPTER 7 Early Warning Commercial Financial Services 143 Rating Agencies’ Failed Models 143 Anatomy of a Flawed Process 144 Terminology 145 Early Red Flags 147 CFS Gets Creative 149 Selling Out the Future 149 Ignoring an Audit Report 150 Lessons to Be Learned 151 Fallout from CFS’s Bankruptcy 153 P1: a/b P2: c/d QC: e/f T1: g FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come viii CONTENTS CHAPTER 8 Subprime and Alt-A Mortgages: Collateral Damage 155 Truthiness in Lending and Borrowing 158 The Predators Fall 160 Classic Ponzi Scheme 162 Portfolio Risk 164 The Risk Managers’ Dilemma 164 How to Create a Securitization Disaster 165 Models versus Common Sense 167 Lack of Appropriate Due Diligence and/or Disclosure 172 Investors and Ratings 173 Hedge Funds and ABX Indexes: Alpha Bets 174 A Good Year (for Some) 177 BSAM’s Hedge Funds Undone by Leverage 181 Bear Stearns’ Hedge Fund Lenders Bailout 184 Disclosure: Investor Fallout from the Mortgage Debacle 186 “The First Thing We Do, Let’s Kill All the Lawyers” 188 Market Fallout from the Mortgage Debacle 190 Redlining and Red Ink 191 CHAPTER 9 Cash versus Synthetic Arbitrage CDOs 193 Comparison of Managed Arbitrage CDO Features: Cash versus Synthetic Deals 193 The Arranger and the Manager 195 Mandate Agreement 196 Deal Assembly 197 CDS Language for the Synthetic CDO 197 Selecting the Portfolio and Impact on Rating 198 Rating Criteria and Restrictions 199 Substitution and Reinvestment Criteria 207 Warehousing Assets 207 Pricing and Closing 208 Ramping Up the Portfolio 208 Reinvestment Period 209 Noncall Period 209 Pay-Down Period 210 Weighted Average Life and Expected Final Maturity 210 Early Termination 210 Legal Final Maturity 211 Tranching and the Synthetic Arbitrage Advantage 211 Waterfalls for Cash versus Synthetic Arbitrage CDOs
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