Collateralized Debt Obligations

IBBM Financing with Asset-Backed Securities

Prof. Ian Giddy Stern School of Business New York University W orldwide Securitization Volum e

Source: abalert.com , March 2004

FORD (SPONSOR)

LOANS.

Servicing Agreem ent

SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE

ISSUES LOANS. ASSET-BACKED CERTIFICATES

DB (Originator)

REFERENCE POOL OF LOANS (Stay on balance sheet)

CREDIT SW AP AGREEMENT SPECIAL PURPOSE VEHICLE

ISSUES TOP QUALITY ASSET-BACKED INVESTMENTS CERTIFICATES

ß Collateralized loan obligations (CLOs) ß Collateralized bond obligations (CBOs)

ß Cash flow backed CLOs and CBOs ß Market value backed CBOs ß Synthetic CLOs

Copyright ©2004 Ian H. Giddy CDOs 6 Cash Flow Backed CLOs MMootitvivaatitoionnss:: ¢ ¢ FFrereee u upp c caappitiatall ¢ ¢ LLoowweer rc coosst to of f BANK (SELLER) fufunnddiningg ¢ ¢ Distressed loan Distressedr dloan aarbrbitirtaraggee ( 3(3rd ppaartryty s sppoonnssoorsrs)) LOANS

SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE

ISSUES LOANS ASSET-BACKED CERTIFICATES

ß Initial Review © Originator‘s credit evaluation system © Pool composition & stress testing ß On-Site Due Diligence ß Legal Integrity © Bankruptcy-remoteness of SPV © Validity of asset transfer to SPV © Perfection of security interests in underlying collateral ß Determining Credit Enhancement

CREDIT ¢ Senior-Sub with ENHANCEMENT priorities of cash flows ¢ Cash reserve accounts ¢ Letters of credit ¢ Guarantees

Cash ABS LOANS flows SPV flows Investors

Copyright ©2004 Ian H. Giddy CDOs 12 Cash Flow Backed CBOs MMootitvivaatitoionn:: ¢ ¢ CCaasshh f lfoloww aarbrbitirtaraggee ( b(boonnddss hhaavvee g goooodd reretuturnrnss r erelalatitvivee toto r irsiskk, ,b buut tm maayy bbee i lillilqiquuidid))

BONDS MANAGER

SALE SPECIAL PURPOSE VEHICLE

ISSUES BOND ASSET-BACKED PORTFOLIO CERTIFICATES

MANAGER

Selects portfolio Collateral cash flows m eet ABS interest & principal needs

Cash ABS BONDS flows SPV flows Investors

BONDS MANAGER

SALE SPECIAL PURPOSE VEHICLE

ISSUES BOND ASSET-BACKED PORTFOLIO CERTIFICATES

MANAGER

Trades bonds to m eet interest & principal needs

ABS BONDS Investors Cash SPV flows flows

Assets Liabilities

DB (Originator)

REFERENCE POOL OF LOANS (Stay on balance sheet)

CREDIT SW AP AGREEMENT SPECIAL PURPOSE VEHICLE

ISSUES TOP QUALITY ASSET-BACKED INVESTMENTS CERTIFICATES

ß CLNsare SPV debt backed by the credit of the selling bank (or better) ß No loans are sold to the SPV ß But performance is based on the performance of a reference pool of loans ©If the reference credits perform, full debt service is made on the CLN ©If the reference credits default, the CLN is deemed —defaulted“and payment is halted.

GERMAN BANK (Originator)

REFERENCE POOL OF LOANS (Stay on Balance Sheet)

CREDIT SW AP AGREEMENT SPECIAL PURPOSE VEHICLE

TOP QUALITY ISSUES INVESTMENTS ASSET-BACKED CERTIFICATES

GERMAN BANK (Originator)

REFERENCE POOL OF LOANS (Stay on Balance Sheet)

PROTECTION against EURIBOR POOL DEFAULTS plus —PREMIUM“ SPECIAL PURPOSE VEHICLE

TOP QUALITY ISSUES INVESTMENTS ASSET-BACKED CERTIFICATES

ß Problems with the collateral ©Debates about —events of default“ ©W orkouts and other pre-default losses ß Problems with the sponsor bank ©Obtaining title to the collateral ©Those —high quality investments“ ß And all those swaps

BANK SPV

REFERENCE Deposit and ABS POOL OF LOANS credit guarantee

The guarantee: ¢ Pledge of a deposit in the sponsor bank ¢ Part or all of that deposit will be forfeited if there are pool losses ¢ —Losses in the transaction are defined as am ounts written off in com pliance with the bank‘s usual procedures“

Credit Enhancement Calculation

Assets Liabilities Loan Portfolio Securities Classes From A From BB+From B A 50 AAA 47.5 52.5 32.8 132.8 BB+ 100 AA 0 B 100 NR 117.2 250 250

Capital: 20 Capital: 9.376

Cost Cost Debt 7% ABS 5% Equity 15% Debt 8% Equity 16% Total 7.64% Total 6.71%

Copyright ©2004 Ian H. Giddy CDOs 33 Case Study: Global High Yield Bond Trust ß W hat is the legal structure of this deal? ß W hat are the assets? ß W hat are the different classes of securities, and their terms? ß How do the synthetic CLOs work? (Draw a diagram) ß Should investors buy the subordinated tranche?

ß Total Return Swaps ß Credit Default Swaps ß Credit Spread Options ß Credit Linked Notes

One view

And another

The key distinction between a Credit Swap and a TR Swap is that the form er results in a contingent or floating paym ent only following a Credit Event, while the latter results in paym ents reflecting changes in the m arket valuation of a specified asset in the norm al course of business.

Payoff

Put W riter

150BP

Bond Spread Bond Price

BANK Credit Default Swap SPV

Credit Guarantee Deposits Credit- REFERENCE Linked POOL OF LOANS Fee Notes (like spread on bond) T-bonds (ABS)

ß Diversification of risk away from institution‘s own portfolio ß More credit to one borrower than bank can hold directly ß Bank capital relief ß Leveraged investments in credit- sensitive assets (eg hedge funds)

ß Chase Secured Loan Trust (CSLT) notes offer investors access to the high-yield bank loan market. One of the attractive aspects of this market to investors is that, while offering double-digit returns in many cases, the senior-secured status of bank loans has given them a very stable, and favorable, default percentage over the years. This is a market that has been widely untapped by institutional investors with only 20 - 25 percent of the $250 billion in syndicated leveraged loans outstanding held by this sector. The Chase structure uses credit derivatives to offer these investors access to this asset class. ß Take, for example, an investor who is prohibited from investing in anything lower than investment grade securities. In the Chase structure, the underlying credit derivative is a Total Return Swap between Chase and a trust. Chase pays the trust the total return on a loan portfolio of $100 million for example, which yields LIBOR plus 250 basis points. In exchange, Chase receives LIBOR plus 100 basis points from the trust. An investor who purchases a trancheof the CSLT in the form of a note receives the same return on the loan portfolio that is received by the trust from Chase on the TRS. For this return, the investor does not put up the total $100 million as would be required to participate in actual loan syndication. Rather, the investor pays $20 million for the tranche, which is used by the trust to purchase treasuries to post as collateral against the trust's payment on the TRS. W hen all the cash flows are broken down on the transaction, including the five times leverage of the $20 million for access to the $100 million loan portfolio plus the yield on the treasuries of 6 percent, the investor generates a total yield in this example of 13.5 percent. ß Draw a diagram to show how this is achieved

ß Evaluation of credit factors ß Discriminantanalysis and credit-scoring models like Altman‘s z-score ß Option pricing models

Ian H. Giddy Stern School of Business New York University 44 W est 4th Street, New York, NY 10012, USA

ian.giddy@ nyu.edu http://giddy.org