Structured finance can bring unstructured losses… The chairman of American Express, Kenneth Chenault, was man enough to admit last week that his outfit “did not fully comprehend” the risk underlying a portfolio of whizz-bang investments known as CDOs. The Economist, July 2001
The global financial markets are up to their elbows in one of the strangest and most complicated credit crises in history. Events have triggered in rapid succession with mind-numbing effect. No sooner does the dust settle in one part of the market then it is kicked up in another.
It has affected investors across the globe, particularly in North America, Europe, Australia and Asia. It is feared that write-offs of losses on securities linked to US sub-prime mortgages, with their ripple effect on other segments of the credit markets, could reach a trillion US dollars. The severity of this crisis on bank capital has been such that US banks need to resort to cutting dividends and calling global investors for capital infusions of more than US$230bn, as of May 2008, followed by the US$700bn recovery plan in October. It has also forced some global financial giants to either fail or to be taken over/bailed out by the regulators.The list includes the Bear Sterns take over by JP Morgan Chase, Lehman Brothers’ bankruptcy, Merrill Lynch’s acquisition by Bank of America and federal government takeovers of Fannie Mae, Freddie Mac and AIG to name a few.
The magnitude of recently announced write-downs by major financial institutions suggests that some institutions were not properly addressing the risk associated with highly structured complex products in their portfolio. A major share of the write-downs relates to instruments that are connected to sub-prime mortgage loans. As a matter of fact, only a modest share of the write-downs relates to asset-backed securities (ABS) backed directly by sub-prime mortgage loans. A much greater share relates to collateralised debt obligations (CDOs) that used sub-ordinated ABS as their underlying assets (i.e. structured finance collateralised debt obligations or SF CDOs).
This article provides a conceptual understanding of CDOs and explains important concepts, such as different types of transactions based on the motivation of the sponsor, capital structure and the CDO lifecycle. It also touches upon highly structured variants, such as synthetic CDOs, CDO squared (derivatives of derivatives of derivatives) and the risk associated with them.
Collateralised Debt Obligations – Important Attributes
A CDO is an asset backed security backed by a diversified pool of one or more debt obligations, such as bank loans, high yield investment grade corporate bonds, special situation loan, distressed debt, and ABS, residential and commercial mortgage-backed securities. The funds to purchase the underlying assets are obtained from the issuance of debt obligations.
‘Credit tranching’ is a standard feature of all CDOs and refers to creating multiple classes (tranches) of securities for issuance to investors, each of which has a different seniority relative to the others. Most CDOs have actively managed portfolios. A typical deal has a manager (management company) that collects fees for managing the portfolio. The ability of the asset manager to make the interest payments to the tranches and pay off the tranches as they mature depends on the performance of the underlying assets. The proceeds to meet the obligations to the CDO securities (interest and principal repayment) and equity can come from coupon interest payment from the underlying assets, maturing assets in the underlying pool or sales of assets in the underlying pool.
Evolution of CDOs
CDOs are structured, leveraged transactions, which were initially backed by high-yield corporate bonds and loans but now include many different asset types. They offer debt investors that hold rated tranches an opportunity to invest in different levels of risk and return. They also offer the potential of high returns to the equity investors willing to take on the first loss position should some of the assets default.
Over the past five years, as the market became more familiar with CDO structures and risks, the transactions evolved to include different types of collateral including emerging market debt, project finance loans, and investment-grade corporate debt. The transaction structures have expanded from the basic cash flow structures that passed through principal and interest payments generated by the assets, to market value structures that look at the market value of the collateral to payback investors, to the synthetic structures that pass on to investors only the credit risk of the underlying assets.
Arbitrage versus Balance Sheet Transactions
CDOs are categorised based on the motivation of the sponsor of the transaction. For example, if the motivation is to earn the spread between the yield offered on the assets in the underlying pool and payment made to various tranches, then the transaction is referred to as arbitrage transaction. Usually transactions where an investment management firm acts as a sponsor come under this category and the firm earns the fee proportional to the amount of assets it manages. The positive spread generated mostly goes to the holders of equity class also called as ‘first loss tranche’, with a portion going to the manager as performance based fees.
Arbitrage transactions are further classified into two types – cash flow CDO and market value CDO. In most CDOs, the source of funds for repaying the CDO’s securities is scheduled payments from the assets that compose the underlying portfolio. Such a CDO is called a cash flow CDO. Other CDOs are structured so that sales of assets from the portfolio can supply a source of funds to repay the CDO’s securities. Because repayment depends on the market value of the assets in the portfolio, those deals are called market value CDOs. Since the market value credit structure is less often used, we will focus mainly on cash flow structure.
When banks act as sponsor for the transaction, the underlying motivation is to remove assets from their balance sheet by creating a CDO and transferring the assets to the CDO’s portfolio for reducing the risk- based capital requirements. Such transactions are referred as balance sheet transactions.
Parties to a CDO
- CDO – special purpose legal entity which issues CDOs.
- Asset managers – select initial portfolio of an arbitrage CDO and manage it according to prescribed guidelines.
- Asset sellers – supply the portfolio for balance sheet CDO and typically retain its equity tranche.
- Monoline bond insurers – guarantors for the senior-most tranche in CDO.
- Rating agencies – approve the legal and credit structure for CDO, perform due diligence on asset manager and trustees and rate the various seniorities of debt issued by CDO.
Cash Flow CDO
Cash flow CDO issue different tranches of liabilities and use the net proceeds to purchase the pool of assets. The cash flows generated by the assets are then used to pay back investors generally in sequential order, from the senior investors that hold the highest-rated (typically AAA) securities to the ‘equity investors’ that bear the first-loss risk and generally hold unrated securities. To compensate for the risk associated with bearing the first-loss position, the equity investors are generally paid most of the residual interest and may achieve a high annual rate of return. The money invested by the note holders is used to purchase the assets and cover the costs associated with executing the transaction. The par value of the securities at maturity is used to pay the notional amounts of the liabilities.
The example below gives an insight into the capital structure of a typical cash flow CDO.
Capital Structure – Cash Flow CDO
CDO usually issues different classes of securities designated as senior debt, mezzanine debt, subordinate debt and equity with different credit risk characteristics. As the name suggests, the size of senior class is set in such a way that it attends highest credit rating (AAA) and the other classes are designed to achieve the rating in ascending order except the equity tranche at the bottom of the structure. The equity tranches receives the residual cash flows, hence no rating is sought.
The ratings reflect both the expected credit quality of the underlying pool of collateral as well as how much protection a given tranche is afforded by tranches that are subordinate to it (i.e. acting as credit enhancement).
Within the stipulation of strict seniority, there is a great variety in the features of CDO debt tranches. The driving force for CDO structure is to raise funds at the lowest possible cost to generate the maximum rate of return for CDO’s equity holder who is at the bottom of the chain of seniority. For example, consider a CDO having an underlying portfolio of high yield corporate bonds with an average rating – (Moody’s B1/S&P B+). The total size of the portfolio is US$100m and the CDO issues six classes of securities.
In the example above, senior notes command the lowest yield because of the highest rating and highest subordination (30% for Class A, 20% for Class B), whereas the equity tranche will command the highest yield since it is at the bottom of the deal’s capital structure with no subordination.
If there are defaults or the CDO’s collateral otherwise underperforms/migrates/early amortise, scheduled payments to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. This is referred to as the ‘cash flow waterfall’.
Market Value CDO
Market value CDO is similar to cash flow CDO, but they do not issue liabilities based on the par value of the assets. Rather, the liabilities are issued based on an advance rate associated with each type of asset purchased. The advance rate is specific to each asset and to each tranche of liability, and is based on historical price or return volatility for each asset type. The collateral pool is then marked to market on a periodic basis, and if the aggregate pool marks breach the pool advance rates, the collateral manager must sell collateral and pay down notes to bring the advance rates back in compliance. Market value transactions can be based on traditional corporate bonds and loans, or on instruments such as private equity or shares of hedge funds.
Static versus Managed Transaction
In a static CDO, the collateral or referenced entity is known and fixed through the life of the CDO. Investors can assess the various tranches of the CDO with full knowledge of what the collateral will be (or variation thereof). The primary risk they face is credit risk. On the other hand, with a managed CDO, a portfolio manager is appointed to ‘actively’ manage the underlying collateral of the CDO. The life of a managed deal can therefore be divided into three phases:
- Ramp-up phase that lasts about a year, during which the portfolio manager initially invests the proceeds from sales of the CDO’s securities. Sometime there is a warehousing period during which it is the sponsor who finances the build-up before securitising.
- Re-investment phase that may last five or more years. During this phase, the manager actively manages the CDO’s collateral, reinvesting cash flows as well as buying and selling assets within the guidelines prescribed.
- Finally, at the end of amortisation phase, the collateral matures, prepay or is sold, and the different tranches’ investors may receive some or all of their investment back according to the pre-establish waterfall.
Managed CDO – Risk Faced by Investors
At the time they purchase the CDO’s securities, investors in a managed deal do not know what specific assets the CDO will invest in and understand that those assets will change over time. The only known fact is the current identity of the portfolio manager and the investment guidelines that he will work under.
Accordingly, investors in managed CDOs face both credit risk as well as the risk of poor management. Today, most CDOs are managed deals whereby investors have the added burden of paying portfolio management fees, and the portfolio manager is the sponsor or related.
The CDO’s governing documents generally specify parameters for the initial portfolio but not the exact composition. For example, the terms of the CDO might require that the initial portfolio have a minimum average rating, a minimum average yield, a maximum average maturity, and a minimum degree of diversification. During the ramp-up phase, the manger must select assets so that the portfolio satisfies all the parameters.
Rating agencies have imposed tests – quality tests and coverage tests on the underlying collaterals. The tests are designed to protect investors by triggering amortisation if a deal’s performance deteriorates. However, a CDO manager sometimes can adhere to manipulation in the tests to avoid early amortisation. Such sustained manipulation when noticed results in the sudden and substantial downgrade by rating agencies.
Different Types of CDOs
CDOs can be classified into different types based on the underlying portfolio constituents as mentioned below:
- CBO (collateralised bond obligations) – underlying portfolio constituents bonds.
- CLO (collateralised loan obligations) – underlying portfolio constituents loans.
- SF CDO – underlying portfolio constituents ABS or mortgage-backed securities (MBS)
- Multi-sector CDO – underlying portfolio constituents a combination of bonds, loans, MBS or ABS.
Structured CDOs
A major share of write down as a result of current credit crisis is attributed to structured CDOs such as SF CDOs, Synthetic CDOs and CDO Squared having sub prime mortgages as underlying constituents.
Synthetic CDOs
According to the data published by BIS just before the crisis began, sales of collateralised debt obligations reached a record US$251bn globally in the first quarter 2007. Sales of synthetic CDOs (bonds backed by credit derivatives rather than actual bonds and loans) amounted to a record high of more than US$121bn.
Synthetic CDO is where the underlying portfolio is composed of credit default swaps (CDS) rather than pool of assets comprising bonds or loans. In such cases, CDO does not actually own the pool of assets on which it has the risk. Instead, it gains credit exposure by selling protection via CDSs to the originators of its asset portfolio. Since CDS permit ‘synthetic’ exposure to credit risk, a CDO backed by CDS is called a synthetic CDO.
Synthetic CDO buys protection from investors via the tranches it issues. A protection buyer (generally the CDO’s asset manager) purchases protection against default risk on a reference pool of assets. Those assets can consist of any combination of loans, bonds, derivatives, or receivables. The protection buyer pays a periodic fee (like an insurance premium) and receives in return payment from the protection seller (the CDO investors) in the event of a ‘credit event’ affecting any item in the reference pool. Each tranche’s liability for credit losses in the reference portfolio ends at a particular ‘detachment or exhaust point’.
Synthetic CDO absorbs the economic risk, but not the legal ownership, of its reference credit exposures. The risk is transferred to investors from the entity holding the physical assets. For investors in the synthetic CDO, the occurrence of a credit event under any CDS in the underlying portfolio has essentially the same effect as if the CDO had purchased a bond that subsequently defaulted.
Synthetic CDO tranches can also be either ‘funded’ or ‘unfunded’. If a tranche is funded, the CDO investor pays the notional amount of the tranche at the beginning of the deal and any defaults cause a write-down of principal. Throughout the deal, the investor receives Libor plus a spread that reflects the risk associated with the tranche. The investor’s funds are put into a collateral account and invested in low-risk securities (government or AAA-rated debt). Unfunded tranches are similar to swaps. No money changes hands at the beginning of the deal. The investor receives a spread and pays when defaults in the reference portfolio affect the investor’s tranche (after any subordinate tranches have been eaten away by previous defaults). Because unfunded tranches rely on the investor’s future ability and willingness to pay into CDO, they create counterparty credit risk that must be managed.
Let us take an example of a hypothetical ‘partially funded’ synthetic CDO. The US$1bn reference portfolio for the this hypothetical CDO consists of unfunded portion of US$900m, with the underlying collateral as CDS on 100 reference credits with an average rating of BBB and all the underlying exposures are investment grade.
Apart from the super senior tranche, the other tranches (equity and mezzanine) of the synthetic CDO are funded. That is, the holders of those tranches invest the principal amount of their tranches. They receive interest payments to compensate them both for the risk that they take and for the time value of their invested principal. The structure would look as follows:
The holder of that tranche makes no principal investment but receives premium payments as protection seller for providing the protection against the losses on the underlying portfolio if they exceed 10% (US$100m). If they exceed, then the holder of the super senior tranche would be required to pay the CDO issuer the amount of losses over and above US$100m.
CDO squared
A CDO-squared, sometimes denoted as CDO^2 or CDO2, is a type of collateralised debt obligation where the underlying portfolio includes tranches of other CDOs. During the last couple of years, CDOs-squared, particularly of the synthetic type, have become an important segment of the global CDO market.
Synthetic CDOs-squared offer investors higher spreads than single-layer CDOs but may also present additional risks. Their two-layer structures somewhat increase their exposure to certain risks by creating performance ‘cliffs’ due to non-linearity. That is, seemingly small changes in the performance of underlying reference credits can cause larger changes in the performance of a CDO-squared. If the actual performance of the reference credits deviates substantially from the original modeling assumptions, the CDO-squared can suffer large unexpected losses.
Conclusion
A decline in credit standards by mortgage originators in underwriting over the last three years was a major factor behind the sharp increase in delinquency rates for mortgages originated during 2005 and 2006. The pressure to increase the supply of sub-prime mortgages arose because of the demand by investors for higher yielding assets.
A major contributor to the crisis was the huge demand by CDOs for BBB mortgage-backed bonds that stimulated a substantial growth in home equity loans. This CDO demand for BBB ABS bonds was due to the fact that the bonds had high yields, and the CDO trust could finance their purchase by issuing AAA-rated CDO bonds paying lower yields. This was because the rating agencies assigned AAA ratings to the CDO’s senior bond tranches that did not reflect the CDO bond’s true credit risk.
Because these tranches were mis-priced, the CDO equity holders generated a positive net present value investment from just re-packaging cash flows. This process boosted the demand by CDOs for residential mortgage-backed securities (RMBS). Furthermore, this re-packaging was so lucrative, that it was repeated a second time for CDO squared trusts. This, in turn, created demand for CDOs containing MBS and CDO tranches.
When the crisis started after a sudden increase in delinquency rates on sub-prime mortgages, a massive amount of senior tranches of these securitisation products were downgraded from triple-A rating to non-investment grade in a very short span of time leading to major write-downs by the investors.
The data compiled by ‘credit flux’ on crises related write-downs (disclosed as of end of August 2008) shows that almost 50% of the write-downs are due to collateralised debt obligations that used sub-ordinated ABS as their underlying assets.
Write-downs due to CDOs
Hopefully, this article will have helped readers from different segments of financial markets to gain a better understanding of CDOs and their structured variants in order to learn the basic fundamentals behind this financial innovation, which is at the heart of current credit crisis.