Ch6 Cash Collateralized Debt Obligations

1. Cash CDOs
1-1 Definition: An ABS(asset-backed security) structure in which the secriritized products issued have P&I backed by the cash flows on a pool of debt instrument collateral.

Credit-sensitive assets securitized -> SPE -> Securities backed by credit-sensitive assets

ABCs of CDO: http://www.youtube.com/watch?v=Sac-qiZoU_0&NR=1

1-2. Video lecture: http://www.youtube.com/watch?v=WMwAyDnKjyk
**The senior tranche investors prefer low correlation among assets
Primary Motivation of Balance Sheet CDO
- remove from balance sheet
- transfer credit risk
- finance (raise cash)

2. Types of CDOs
CDOs are distinguished based on the type of collateral or their economic purpose
Video lecture: http://www.youtube.com/watch?v=Sac-qiZoU_0

2-1. Type of Collateral
2-1-1. Collateralized loan obligation (CLOs)
Leveraged commercial & industrial loans, often associated with highly leveraged transaction like LBOs (http://www.youtube.com/watch?v=lqQBPCDgP9A)

2-1-2. Collateralized bond obligation (CBOs)

2-1-3. Structured finance CDOs (resecuritizations)
structured securites include ABSs (asset-backed securities), notes (& equity), CMBSs & RMBSs (commercial & residential mortgage backed securities), TruPS(trust preferred stock, http://www.investopedia.com/terms/t/trustpreferredsecurity.asp), etc

2-2. Economic Motivation
2-2-1. Balance sheet CDOs
divesting some or all of credit sensitive assets because of the following reason
- credit risk management
- fund rising
- balance sheet management
- preservation of debt capacity

2-2-2. Arbitrage CDOs
the originator is merely a repackager: buying loans or bonds or ABS from the market, pooling them together and securitising them for making arbitraging profits.


3. Balance Sheet CDOs
3-1. Structure
- Assets: borrowers
- Originator/Transferor: banks, true sale to an SPE & residual interest retained
- SPE/Transferee: subordination, C/E (incudes CCA, cash collateral A/C), diversion of XS(excess spread, usually 50 bp)
- Swap Dealer
- Custodian/Trustee
- Underwriter
- Investors

3-1-1. C/E (Credit Enhancement)
3-1-1-1. Internal C/E
- Excess Spread: the difference between the interest rate received on the underlying collateral and the coupon on the issued security
- Overcollateralization: the face value of the underlying asset portfolio is larger than the security it backs
- Holdback
- Direct Equity Issue
- CCA(Cash Collateral A/C) : the issuer borrows the required credit support amount from the bank and deposits the cash in short-term commercial paper that has the highest available credit quality
3-1-1-2. External C/E
- Wrapped Securities, Insurance & Guaranties
- Letter of Credit
- Credit Default Swap
- Put Option on Assets

3-2. Motivations & Benerfits
3-2-1. Customized Credit Risk Transfer
- credit reinsurance <- senior-sub securitization - XOL(excess of loss) reinsurance <- residual tranche: more senior securities sold to thirt-party investors provide the different XOL layer of credit reinsurance for the underlying assets e.g.)300/100 XOL layer=> $300M: attachment point, $400M: limit, cover the next $100M in losses, which is the amount of reinsurance

3-2-2. Monetization of Assets
reducing the size of the balance sheet, preserving or maintaining debt capacity

3-2-3. Reducing Adverse Selection Costs
- CDOs are relatively transparent & in the securitization process, the assets are placed a self-contained structure, credit & liquidity enhanced, and put on display for investors => reducing adverse selection costs => a lower WACC
- reducing the capacity for the firm to mismanage the assets & deploy them in negative NPV => reducing agency costs => a lower WACC

3-2-4. Funded Credit Protection

3-2-5. Regulatory Capital Argitrage
- Basel Accord
- regulatory capital relief:

3-2-5. Rating
- Collateral Requirements & Asset Quality Tests
- Coverage Tests: O/C(overcollateralzation) test - O/C ratio for a specific tranche above some minimum, I/C(interest coverage) test - I/C ratio for a given trache to exceed a defined threshold at all time


4. Arbitrage CODs
Assets, frequently bonds rather than loans, are acquired on the open market and securitized to generate trading profits from perceived arbitrage opportunitie (rating arbitrage)
* yield-enhancement investment structures

4-1. Structure
similar to the structure of a balance sheet CDO with a few exceptions
- collateral manger select & possibly manage the underlying pool of assets to back the CDO
- the residual tranche is not necessarily retained by any participant internal to the structure. The residual is sold as a separate security or is retained by the collateral manager in its trading portfolio

4-2. Cash Flow vs. Market Value CDOs
- In a cash flow CDO, the P&I waterfalls are funded by normal scheduled P&I on the collateral portfolio
- In a market value CDO, the waterfalls may be funded by liquidation of the asset collateral

4-3. Static vs. Managed Portfolios
Arbitrage CDOs: some degree of ongoing management of the collateral portfolio.
- lightly managed portfolio
- active management: ramp-up & reinvestment period

4-4 Motivations & Benefits
- main concern: CDO funding gap (the difference between the yield on the asset portfolio & the yield on the CDO liabilities plus CDO structure senior fee & costs); higher funding gap => CDO's highly subordinated debt & higher the expected return on equity