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Collateralized Debt Obligations IBBM Financing with Asset-Backed Securities Collateralized Debt Obligations Prof. Ian Giddy Stern School of Business New York University W orldwide Securitization Volum e Source: abalert.com , March 2004 Copyright ©2004 Ian H. Giddy CDOs 2 Asset-Backed Securities: The Typical Structure FORD (SPONSOR) LOANS. Servicing Agreem ent SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE ISSUES LOANS. ASSET-BACKED CERTIFICATES Copyright ©2004 Ian H. Giddy CDOs 3 The Alternative: Synthetic ABS DB (Originator) REFERENCE POOL OF LOANS (Stay on balance sheet) CREDIT SW AP AGREEMENT SPECIAL PURPOSE VEHICLE ISSUES TOP QUALITY ASSET-BACKED INVESTMENTS CERTIFICATES Copyright ©2004 Ian H. Giddy CDOs 4 Collateralized Debt Obligations Collateralized loan obligations (CLOs) Collateralized bond obligations (CBOs) Copyright ©2004 Ian H. Giddy CDOs 5 Collateralized Debt Obligations Cash flow backed CLOs and CBOs Market value backed CBOs 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 Copyright ©2004 Ian H. Giddy CDOs 7 CLO Transaction Structure Copyright ©2004 Ian H. Giddy CDOs 8 CLO Rating Criteria 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 Copyright ©2004 Ian H. Giddy CDOs 9 Source: Fitch, “Bank CLOs: an Overview“ Copyright ©2004 Ian H. Giddy CDOs 10 Cash flow Backed CLOs 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 11 Senior-Sub CLO Structure 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 Copyright ©2004 Ian H. Giddy CDOs 13 Cash Flow Backed CBOs MANAGER Selects portfolio Collateral cash flows m eet ABS interest & principal needs Cash ABS BONDS flows SPV flows Investors Copyright ©2004 Ian H. Giddy CDOs 15 Market Value Backed CBOs MMootitvivaatitoionn:: PPrircicee a arbrbitirtaraggee (b(boonnddss a arere uunnddeerprprirciceedd, , aanndd t rtaraddeeaabblele)) BONDS MANAGER SALE SPECIAL PURPOSE VEHICLE ISSUES BOND ASSET-BACKED PORTFOLIO CERTIFICATES Copyright ©2004 Ian H. Giddy CDOs 16 Market Value Backed CBOs MANAGER Trades bonds to m eet interest & principal needs ABS BONDS Investors Cash SPV flows flows Copyright ©2004 Ian H. Giddy CDOs 18 Rating Agencies Analyze Price Volatility to Determ ine CE Requirem ents Copyright ©2004 Ian H. Giddy CDOs 20 Advance rates determ ine how m uch rated debt can be issued against the m arket value of an asset. Copyright ©2004 Ian H. Giddy CDOs 21 Creating a CBO Assets Liabilities Copyright ©2004 Ian H. Giddy CDOs 22 Exam ple of Market Value CBO Asset Mix and Financing Copyright ©2004 Ian H. Giddy CDOs 23 Synthetic ABS DB (Originator) REFERENCE POOL OF LOANS (Stay on balance sheet) CREDIT SW AP AGREEMENT SPECIAL PURPOSE VEHICLE ISSUES TOP QUALITY ASSET-BACKED INVESTMENTS CERTIFICATES Copyright ©2004 Ian H. Giddy CDOs 24 Synthetic ABS or Collateralized Loan Notes CLNsare SPV debt backed by the credit of the selling bank (or better) No loans are sold to the SPV 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. Copyright ©2004 Ian H. Giddy CDOs 25 Synthetic ABS 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 Copyright ©2004 Ian H. Giddy CDOs 26 Synthetic ABS 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 Copyright ©2004 Ian H. Giddy CDOs 27 Credit Swaps in Synthetics: Doubts 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 Copyright ©2004 Ian H. Giddy CDOs 28 Typical Credit Default Swap Arrangem ent 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“ Copyright ©2004 Ian H. Giddy CDOs 29 Leveraged CDO (Super Senior Tranche) Copyright ©2004 Ian H. Giddy CDOs 30 Prom ises, Prom ises Copyright ©2004 Ian H. Giddy CDOs 31 Super-Senior Copyright ©2004 Ian H. Giddy CDOs 32 Bank Capital Savings 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 W hat is the legal structure of this deal? W hat are the assets? W hat are the different classes of securities, and their terms? How do the synthetic CLOs work? (Draw a diagram) Should investors buy the subordinated tranche? Copyright ©2004 Ian H. Giddy CDOs 34 Global High Yield Bond Trust Copyright ©2004 Ian H. Giddy CDOs 35 Appendix: Types of Credit Derivatives Total Return Swaps Credit Default Swaps Credit Spread Options Credit Linked Notes Copyright ©2004 Ian H. Giddy CDOs 36 Total Return Swap One view And another Copyright ©2004 Ian H. Giddy CDOs 37 Credit Default Swaps 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. Copyright ©2004 Ian H. Giddy CDOs 38 Credit Spread Options ayoff Put W riter 0 150BP Bond Spread Bond Price Copyright ©2004 Ian H. Giddy CDOs 39 Credit-Linked Notes BANK Credit Default Swap SPV Credit Guarantee Deposits Credit- REFERENCE Linked POOL OF LOANS Fee Notes (like spread on bond) T-bonds (ABS) Copyright ©2004 Ian H. Giddy CDOs 40 Purposes of Credit Derivatives Diversification of risk away from institution‘s own portfolio More credit to one borrower than bank can hold directly Bank capital relief Leveraged investments in credit- sensitive assets (eg hedge funds) Copyright ©2004 Ian H. Giddy CDOs 41 Chase Secured Loan Trust Notes 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. 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. Draw a diagram to show how this is achieved Copyright ©2004 Ian H. Giddy CDOs 42 Valuation Evaluation of credit factors Discriminantanalysis and credit-scoring models like Altman‘s z-score Option pricing models Copyright ©2004 Ian H. Giddy CDOs 43 ABSresearch.com 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 Copyright ©2004 Ian H. Giddy CDOs 45.
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