Collateralized debt obligations
Structure, pricing and applications
©2002
Diplomarbeit
128 Seiten
Zusammenfassung
Inhaltsangabe:Abstract:
This work aims to give the reader a holistic introduction to Collateralized Debt Obligations (CDOs), an asset category which has recently experienced both popularity and criticism. Collateralized Debt Obligations represent a subset of asset-backed securities. As opposed to classical types of asset-backed-securities like mortgage-backed securities or credit card debt-backed securities, a Collateralized Debt Obligation is a vehicle transforming bank loans or commercial paper into tranches of traded securities.
While Collateralized Debt Obligations have been an established part of the U.S. fixed income market, it was only recently that academics showed interest in this asset category. From an asset pricing standpoint, CDOs represent a challenge as credit risk from a heterogeneous pool is passed through to tranches. Hence, asset pricing models have to account for expected defaults and default correlation on the one hand while incorporating the structural support the CDO is offering to the debt tranches on the other.
Also, regulatory agencies such as the Basel Committee on Banking Supervision have increasingly covered CDOs and their use in credit risk management, thus further stimulating interest in this asset category.
The report is mainly organized in three parts. The first part presents the basic ideas of Collateralized Debt Obligation as well as their structure and principal economics. Part II is the core of the report focusing on the aforementioned asset pricing problem and presenting various models to cope with it. Finally, the third part presents some of the multifaceted applications of Collateral Debt Obligations and concludes with an outlook for the product category. Here, special focus is laid on the European and German market as this is seen as a major area for growth. Inhaltsverzeichnis:Table of Contents:
Index of figuresv
Index of tablesvi
Prefacevii
1.INTRODUCTION1
1.1Definitions1
1.2Mathematical Classification2
1.3Purpose and Relevance of CDOs4
1.4Motivation and Aim of the Study6
2.STRUCTURE AND DESIGN OF CDOS8
2.1Underlying Assets9
2.2Tranches10
2.3Purpose11
2.3.1Risk Transfer11
2.3.2Credit Risk Pricing Arbitrage11
2.4Credit Structure13
2.4.1Market Value Structure13
2.4.2Cash Flow Structure13
2.5Summary and Typical CDO Structures15
3.RATIONALE AND ECONOMIC FEATURES18
3.1Incentives to enter CDO Contracts19
3.1.1Comparative Advantages in Holding Specific Risks19
3.1.2Incentives for Equity […]
This work aims to give the reader a holistic introduction to Collateralized Debt Obligations (CDOs), an asset category which has recently experienced both popularity and criticism. Collateralized Debt Obligations represent a subset of asset-backed securities. As opposed to classical types of asset-backed-securities like mortgage-backed securities or credit card debt-backed securities, a Collateralized Debt Obligation is a vehicle transforming bank loans or commercial paper into tranches of traded securities.
While Collateralized Debt Obligations have been an established part of the U.S. fixed income market, it was only recently that academics showed interest in this asset category. From an asset pricing standpoint, CDOs represent a challenge as credit risk from a heterogeneous pool is passed through to tranches. Hence, asset pricing models have to account for expected defaults and default correlation on the one hand while incorporating the structural support the CDO is offering to the debt tranches on the other.
Also, regulatory agencies such as the Basel Committee on Banking Supervision have increasingly covered CDOs and their use in credit risk management, thus further stimulating interest in this asset category.
The report is mainly organized in three parts. The first part presents the basic ideas of Collateralized Debt Obligation as well as their structure and principal economics. Part II is the core of the report focusing on the aforementioned asset pricing problem and presenting various models to cope with it. Finally, the third part presents some of the multifaceted applications of Collateral Debt Obligations and concludes with an outlook for the product category. Here, special focus is laid on the European and German market as this is seen as a major area for growth. Inhaltsverzeichnis:Table of Contents:
Index of figuresv
Index of tablesvi
Prefacevii
1.INTRODUCTION1
1.1Definitions1
1.2Mathematical Classification2
1.3Purpose and Relevance of CDOs4
1.4Motivation and Aim of the Study6
2.STRUCTURE AND DESIGN OF CDOS8
2.1Underlying Assets9
2.2Tranches10
2.3Purpose11
2.3.1Risk Transfer11
2.3.2Credit Risk Pricing Arbitrage11
2.4Credit Structure13
2.4.1Market Value Structure13
2.4.2Cash Flow Structure13
2.5Summary and Typical CDO Structures15
3.RATIONALE AND ECONOMIC FEATURES18
3.1Incentives to enter CDO Contracts19
3.1.1Comparative Advantages in Holding Specific Risks19
3.1.2Incentives for Equity […]
Leseprobe
Inhaltsverzeichnis
Markus Lorenz
Collateralized debt obligations
Structure, pricing and applications
ISBN: 978-3-8366-2106-9
Druck Diplomica® Verlag GmbH, Hamburg, 2008
Zugl. Universität Fridericiana Karlsruhe (TH), Karlsruhe, Deutschland, Diplomarbeit,
2002
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CDOs: Structure, Pricing, and Applications
ii
Contents
Index of figures ...v
Index of tables...vi
Preface... vii
Part I
CDO Structures
1. INTRODUCTION ...1
1.1
Definitions...1
1.2
Mathematical Classification ...2
1.3
Purpose and Relevance of CDOs ...4
1.4
Motivation and Aim of the Study ...6
2. STRUCTURE AND DESIGN OF CDOS ...8
2.1
Underlying Assets...9
2.2
Tranches ...10
2.3
Purpose ...11
2.3.1
Risk Transfer ...11
2.3.2
Credit Risk Pricing Arbitrage...11
2.4
Credit Structure ...13
2.4.1
Market Value Structure ...13
2.4.2
Cash Flow Structure...13
2.5
Summary and Typical CDO Structures ...15
3. RATIONALE AND ECONOMIC FEATURES ... 18
3.1
Incentives to enter CDO Contracts ...19
3.1.1
Comparative Advantages in Holding Specific Risks ...19
3.1.2
Incentives for Equity Holders...19
3.1.3
Incentives for Debt Holders ...20
3.2
Results of Imperfections inherent to CDO Contracts...22
3.2.1
Adverse Selection ...22
3.2.2
Moral Hazard ...26
CDOs: Structure, Pricing, and Applications
iii
Part II
Evaluation of CDOs
4. PRICING OF COLLATERALIZED DEBT OBLIGATIONS ... 28
4.1
Multi-obligor Default Models ...30
4.1.1
Importance of Correlation in Pricing Models ...30
4.1.2
Diversity Scores ...32
4.1.3
Infectious Defaults ...33
4.1.4
Default Intensity Models...37
4.1.5
Modeling Dependent Defaults with Copulas ...41
4.2
Recovery Risk ...44
4.3
Risk-neutral Transformation...46
4.4
Pricing in default intensity models ...47
4.5
Pricing Example in Default Intensity Models ...49
4.5.1
Collateral Pool ...49
4.5.2
Sinking-fund Tranches ...50
4.5.3
Prioritization Schemes ...50
4.5.4
Simulation and Discussion ...53
4.6
Alternative Pricing Model: Loss Cascades...58
4.6.1
Loss Distribution in the Collateral Portfolio...58
4.6.2
Loss Distribution in the CDO Tranches...60
4.6.3
Simulation and Pricing Results ...60
4.7
Approximate CDO Pricing ...64
4.7.1
Monte-Carlo Simulation...64
4.7.2
Reduced Form CDO Valuation...66
5. RATING OF COLLATERALIZED DEBT OBLIGATIONS ... 68
5.1
Assessment of the Collateral Credit Quality...70
5.1.1
Default Rates and Severity ...70
5.1.2
Pool Diversity ...71
5.1.3
Credit Enhancement levels ...71
5.2
Assessment of the Legal Structures and the Parties Involved...73
5.3
Assessment of Pool Administration ...74
5.4
Rating Agency-Specific Differences...76
5.4.1
Moody's Investors Service ...76
5.4.2
Standard and Poor's ...77
5.4.3
Fitch IBCA ...77
CDOs: Structure, Pricing, and Applications
iv
Part III
CDOs in Practice
6. APPLICATIONS OF CDOS... 79
6.1
Credit Risk Management ...80
6.1.1
Credit Risk Management Strategies ...80
6.1.2
CDOs in Active Credit Portfolio Management ...81
6.1.3
CDOs as Reinsurance Instruments ...82
6.1.4
Comparative Advantages of CDOs...83
6.2
Balance Sheet Management and Regulatory Capital Relief...84
6.3
CDOs as a Funding Source ...88
6.4
High Yield Fixed-Income Investment...89
6.5
Arbitrage and Equity Tranche Speculation ...92
7. OUTLOOK FOR CDOS IN EUROPE AND GERMANY ... 94
7.1
The European Asset-Backed Security Market...95
7.2
The German CDO market 2000-2002...97
7.3
Regulatory Issues ...99
7.4
Economic Drivers for the German CDO Market...101
8. CONCLUDING REMARKS ... 103
9. REFERENCES... 106
10. APPENDIX... 112
10.1 Legal and Economic CDO Transaction Structure ...113
10.2 Glossary of Terms...114
INDEX ... 116
CDOs: Structure, Pricing, and Applications
v
Index of figures
Figure 1: CDO issuance in US$ billions ...5
Figure 2: Typical tranche structure of a CDO... 10
Figure 3: CDO building blocks ... 15
Figure 4: Subordination structure of a European bank CDO (names hidden) ... 17
Figure 5: Call-option characteristics of the equity tranche... 20
Figure 6: CDO spreads over US Libor in basis points, maturity 8-12 years ... 21
Figure 7: Decreasing and convex profit function ... 24
Figure 8: Optimal Securitization level ... 25
Figure 9: Default distribution under infectious defaults... 35
Figure 10: Default distribution in a multi-sector portfolio under infectious defaults ... 36
Figure 11: Recovery rate distributions... 45
Figure 12: Effects of correlation on default distribution ... 55
Figure 13: Impact on market values of correlation in different collateralization scenarios ... 56
Figure 14: Expected losses in the CDO tranches ... 62
Figure 15: Losses in mezzanine and senior tranches compared to corporate zero bonds... 62
Figure 16: Joint default probability and correlation on multivariate normal portfolios ... 65
Figure 17: Comparative spreads for different debt classes 1996-2000 ... 90
Figure 18: Equity tranche return vs. collateral pool default rate ... 92
Figure 19: Risk/return characteristics for various assets ... 93
Figure 20: History of European asset-backed securities issuance... 95
Figure 21: Break-down of European asset-backed securities by type and origin ... 96
Figure 22: Origin of European CDOs in the first quarters 2000-2002... 97
CDOs: Structure, Pricing, and Applications
vi
Index of tables
Table 1: Typical CDO structures 16
Table 2: Data sources for the calibration of correlation models 31
Table 3: Moody's Diversity Scores 33
Table 4: Default clusters in the U.S. 34
Table 5: Default parameter sets for simulation purposes 54
Table 6: Conditional default probabilities and default correlation 54
Table 7: Par spreads under different collateralization and correlation scenarios 56
Table 8: Loss cascade structure of sample CDO 61
Table 9: Expected losses and required returns in the CDO tranches 61
Table 10: Evolution of risk management strategies 81
Table 11: Proposed risk weightings according to rating and claim origin 85
Table 12: Typical spreads for various ABS types and rating categories 90
CDOs: Structure, Pricing, and Applications
vii
Preface
This work aims to give the reader a holistic introduction to Collateralized Debt Obligations
(CDOs), an asset category which has recently experienced both popularity and criticism.
Collateralized Debt Obligations represent a subset of asset-backed securities. As opposed to
classical types of asset-backed-securities like mortgage-backed securities or credit card debt-
backed securities, a Collateralized Debt Obligation is a vehicle transforming bank loans or
commercial paper into tranches of traded securities.
While Collateralized Debt Obligations have been an established part of the U.S. fixed income
market, it was only recently that academics showed interest in this asset category. From an
asset pricing standpoint, CDOs represent a challenge as credit risk from a heterogeneous pool
is passed through to tranches. Hence, asset pricing models have to account for expected
defaults and default correlation on the one hand while incorporating the structural support the
CDO is offering to the debt tranches on the other.
Also, regulatory agencies such as the Basel Committee on Banking Supervision have
increasingly covered CDOs and their use in credit risk management, thus further stimulating
interest in this asset category.
The report is mainly organized in three parts. The first part presents the basic ideas of
Collateralized Debt Obligation as well as their structure and principal economics. Part II is the
core of the report focusing on the aforementioned asset pricing problem and presenting
various models to cope with it. Finally, the third part presents some of the multifaceted
applications of Collateral Debt Obligations and concludes with an outlook for the product
category. Here, special focus is laid on the European and German market as this is seen as a
major area for growth.
This work has benefited from the comments of various individuals in academia and practice
whom I whish to thank.
First and foremost, I would like to thank my advisor, Professor Zari Rachev for offering a
great environment in terms of research and advice. Not only is the head of the institute of
Mathematical Economics and Statistics which hosted this project but he is also the one who
stimulated my curiosity for the subject of finance in general and credit risk pricing in
particular through numerous classes, seminars, and discussions throughout the past couple of
years.
CDOs: Structure, Pricing, and Applications
viii
Also, I wish to thank Stefan Trueck who has been my direct supervisor for his helpful
comments, as well as for his ongoing support and motivation.
I am indebted to Professor Hans Stoll for comments and discussions regarding the economics
and dynamics of asset-backed securities markets in both the U.S. and Europe.
Finally, I would like to express my gratitude to Dr. Andreas Gruber and Dr. Jürgen Voß from
Allianz Lebensversicherungs AG for their support and the trustful cooperation we entered.
Their numerous comments regarding the structure of the thesis, the asset pricing mechanics as
well as the a market participant's view on Collateralized Debt Obligations were a precious
enrichment and have significantly benefited this project.
CDOs: Structure, Pricing, and Applications
1.Introduction
1
PART I: CDO Structures
1. INTRODUCTION
1.1 Definitions
Collateralized Debt Obligations (CDOs) are a special form of asset-backed securities, an asset
category that has dramatically gained significance over the past 20 years. CDOs belong to the
same basic class of assets like mortgage-backed securities which have become an established
part of the fixed income market. CDOs are structured fixed income securities with cash flows
linked to the performance of various underlying debt instruments. The underlying collateral
backing a CDO consists of one or more types of debt, including high yield bonds, emerging
market corporate and sovereign debt, and subordinated securities from structured transactions.
CDOs exist in several different forms, among which the most relevant are balance sheet and
arbitrage CDOs. The terms Collateralized Bond Obligations (CBOs) and Collateralized Loan
Obligations (CLOs) are often used to help categorizing the vehicle by the assets it is
constructed from. CBOs are generally backed by below investment grade debt, possibly
including emerging markets and in certain issues, distressed securities, whereas CLOs are
generally backed by bank loans with a preponderance of deals backed by investment grade
loans. In this report, unless otherwise specified, the term CDO will refer to the umbrella term,
including the Collateralized Bond Obligations and Collateralized Loan Obligations.
CDOs: Structure, Pricing, and Applications
1.Introduction
2
1.2 Mathematical Classification
This sections attempts to categorize Collateralized Debt Obligations in more formal
economical and mathematical terms. CDOs fall in the class of basket credit derivatives. Basket
credit derivatives are financial contracts whose payout depends on the credit performance of a
portfolio of bonds or loans over a pre-determined time horizon. There exist two basic
categories of basket credit derivatives, characterized by the way payouts are linked to credit
events in the underlying pool and how the distribution of payments to various groups of
investors is administrated.
One category consists of i-th to default contingent claims or as they are also called, ranked
basket derivatives. Here, the payout depends on the temporal ranking of the credit events. In
its simplest form the contract consists of two parties, the protection seller and the protection
buyer. The seller will pay the buyer a certain amount of money when one of the names in the
specified pool of names defaults before a pre-determined maturity time T.
Default times are generally represented as stopping times of a stochastic default process.
Given a pool of n securities, the array of stopping times
(
)
n
,...,
,
2
1
,
i
T
i
,
represents the
collection of default times in the underlying pool. Then, the first-to-default time is
)
1
(
, which
is easily determined by:
}
,...,
,
min{
2
1
)
1
(
n
=
(1.1)
Respectively,
)
(i
is the i-th default time. i-th-to-default contracts are usually in the form of a
credit default swap maturing at time T
with an underlying basket of n reference entities. At
)
(i
the buyer of protection can deliver to the seller a nominal amount of obligations equal to
the nominal of the contract issued by the defaulting obligor k (i.e.
)
(i
k
=
) in
exchange for
par.
Following the basic approach of Esposito (2002)
1
, the payoff structure of the protection leg of
an i-th-to-default contract with a unit nominal can be stated from the protection buyer's point
of view:
(
)
}
{
1
1
1
i
k
n
i
k
=
=
-
(1.2)
where
k
denotes the recovery rate or loss given default of obligor k.
1
Esposito, M. (2002): "Basic Insights in Pricing Basket Credit Derivatives", Proceedings of the 2nd
International Conference "Managing Credit and Market Risk", Verona, February 2002
CDOs: Structure, Pricing, and Applications
1.Introduction
3
In exchange for this claim, the protection buyer compensates the seller with a certain premium
periodically until
)
(
i
.
Collateralized Debt Obligations belong to a second category of basket credit derivatives which
consists of percentile basket derivatives. This class is categorized by payouts being dependent
on percentiles of the underlying portfolio's losses. CDOs are usually much more complex
transactions than i-th-to-default swaps. They involve the use of tranches to create different
classes of security from cash flows generated by a collateral pool. Furthermore, with CDOs,
the underlying collateral pool is usually considerably larger than the number of names
underlying ranked credit derivatives.
As the name suggests, a percentile credit basket derivative in its simplest form involving only
two parties states that the protection seller will compensate the protection buyer for the losses
registered on a certain portfolio of bonds, up to the first %. For losses in the collateral pool
up to %, the issuer or protection buyer is completely insured, for losses exceeding % he
has to bear the difference between actual loss and %. Let L:
]
1
,
0
[
be the random variable
representing the total percentage loss at maturity T
due to credit events experienced by the
collateral pool during the life of the CDO, and let L
x
denote the x-percentile of the distribution
of L. Thus, in the simple two party example the loss to be born by the protection buyer is:
}
,
min{
L
L
(1.3)
This principal insurance scheme applies to a more realistic setting of multi-tranche
Collateralized Debt Obligations. Assuming the collateral portfolio flows are divided into three
zero coupon tranches maturing at time T: The junior tranche, covering the first loss in the
collateral up to L
; the mezzanine tranche, covering all losses between L
and L
, (
]
1
,
0
[
,
,
<); and the senior tranche, taking the residual loss for L>L
. The respective payoffs at time
T of the three tranches can then be stated as:
}
0
,
max{
1
}
0
,
max{
}
0
,
max{
}
0
,
max{
L
L
L
C
L
L
L
L
L
L
C
L
L
C
senior
mezzanine
junior
-
-
-
=
-
+
-
-
-
=
-
=
(1.4)
The payoff to the junior tranche may alternatively be stated as:
}
,
min{
L
L
L
C
junior
-
=
(1.5)
This allows for an option-like interpretation of CDO contracts. The junior tranche's payoff
equals the payoff of a put option written on the collateral portfolio's losses with strike price
L
. The holder of the junior tranche has written this put option, i.e. this party has established a
short position and the protection seller has bought the put option on the basket's losses with
strike price equal to L
.
CDOs: Structure, Pricing, and Applications
1.Introduction
4
Akin to the interpretation of equity holders in a public company
2
, the junior tranche may
alternatively be interpreted as a long position in a call option on the net value of the collateral
pool which has positive payoffs in case that actual losses L are smaller than the pre-defined
border L
. This interpretation corresponds to the representation in equation (1.4)
Section 3.1.2 will seize on this option-like nature of the junior tranche when discussing
incentives to enter CDO contracts and in section 4.5 several well-known characteristics of
option prices will reappear.
1.3 Purpose and Relevance of CDOs
The purpose of CDOs is generally multifaceted. From an issuer's standpoint the following
motives are dominant:
Risk transfer
: Holders of securitizable assets, such as commercial banks aim to sell
assets or transfer the credit risk. The underlying motives are generally corrections to
the balance sheet or reduction of regulatory capital.
High-yield investment vehicles
: Asset managers and equity tranche investors hope to
achieve leveraged returns from the differential of after-default yield on assets and the
financing cost due debt tranches. In addition, the asset manager is able to charge a fee
to the investor for the service of monitoring and trading the CDO's assets
Collateralized Debt Obligations have experienced increased popularity in the U.S. fixed
income market and today CDO issuances represent about half the market of asset-backed
securities. JP Morgan estimates the outstanding CDO volume at $500 billion.
3
The following chart illustrates the rapid development those products have experienced over
the last decade:
2
for a discussion of the classical option-like interpretation of equity and debt, see: Mason,P. and
Merton, R. (1985): "The Role of Contingent Claim Analysis" in Altman/Subrahmanyam: Recent
Advances in Corporate Finance, Irwin Homewood
3
Lucas, D. and Sam, T. (2001) "CDO Handbook" , Global Structured Finance Research Report, JP
Morgan Securities Inc., p.2
CDOs: Structure, Pricing, and Applications
1.Introduction
5
Figure
1: CDO issuance in US$ billions
Source: JPMorgan: CDO Handbook
The success of CDOs in the U.S. asset-backed-securities can be traced to the acceptance of the
product by credit risk hedgers and institutional investors.
In this context, it is important to note that in perfect (i.e. frictionless and unregulated) markets
CDOs would not serve a purpose. Their existence is due to market imperfections and
regulations. Indeed, CDOs are specifically designed to address issues like regulatory capital
requirements and liquidity restrictions.
CDOs: Structure, Pricing, and Applications
1.Introduction
6
1.4 Motivation and Aim of the Study
While the U.S. CDO market is highly developed and sophisticated, the European CDO market
currently seems to lack a comparable position. However, the European market is quickly
picking up compared to its American counterpart, which is due to the following factors:
Regulatory restrictions:
The Basel II referendum in its proposed version imposes
significant capital requirement for bank loans to non-investment grade rated clients,
thus creating a demand for creditors to sell those loans and clear their balance sheets in
order to effectively manage debt portfolios and to facilitate growth.
Risk transfer:
CDOs enable the holder to buy or sell a specific risk profile. CDOs are
usually diversified and can hence be used as portfolio instruments to either
complement or enhance a fixed-income portfolio.
Market demand:
The market for corporate liabilities in countries like Germany is not
yet highly developed. This is due to the banking system, where the Hausbank is taking
over the position of the creditor for significant portions of a company's liability. With
CDOs, fixed-income investors are enabled to participate in a liquid and organized
market for corporate debt and they may purposely buy credit risk. In 1999, only 36%
of corporate debit financing in Europe took place through bond issues, whereas bank
loans represent 64% of this market. Contrary, in the U.S. 71% of debt financing was
facilitated through bond issues, only 29% took place via bank loans.
4
The degree of
disintermediation is therefore expected to grow in Europe and will thereby create
demand for more sophisticated fixed income products.
Given the projected development of CDO products in the European market a number of highly
interesting questions arise, such as:
Pricing of CDOs
: Whilst it has always been a quest to price credit risk, it is even more
challenging to price a vehicle that is backed by a basked of various loans and issued in
various tranches which are subject to credit risk. Apart from credit risk, interest rate
4
Data Source: Organization for Economic Cooperation and Development (OECD)
CDOs: Structure, Pricing, and Applications
1.Introduction
7
risk, liquidity risk, economic risk, and company and industry event risk have to be
factored in.
Structuring of CDOs
: Obviously, the dependence on the credit risk of the underlying
assets is a main factor for the risk of a CDO. This raises the question how to
sufficiently diversify the collateral pool and how to structure the prioritization scheme
that dictates the distribution of losses.
Monitoring / Rating of CDOs:
While CDOs offer the benefit of a whole portfolio of
risky assets they may have the shortcoming of reduced transparency. Hence rating
agencies aim to rate CDO as a product themselves and this rating process has been
subject to criticism from market participants. This raises the question how to quantify
the risk immanent to a CDO and how to monitor and price this risk.
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
8
2. STRUCTURE AND DESIGN OF CDOs
The fact that CDOs are special purpose vehicles which are designed and marketed by a third
party creates a vast diversity of CDOs. In an attempt to categorize CDOs, this section adopts a
framework presented in Lucas and Sam (2001)
5
. CDOs are distinguished and characterized by
the choices along which an issuer has to decide when designing CDOs, namely:
(i)
underlying assets
(ii)
tranche structures
(iii)
purpose
(iv)
credit structure
5
Lucas, D. and Sam, T. (2001), p. 6ff
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
9
2.1 Underlying Assets
The collateral pool formed of the securitized assets represents the foundation of any CDO. The
choice of assets to incorporate in a vehicle is large and includes, but is not limited to the
following:
securitized commercial loans,
corporate bonds,
sovereign debt
asset backed securities,
emerging market debt.
Even tranches of CDOs may be re-securitized into other CDOs.
In the past, the first two groups represented the main asset category, accounting for
approximately 80% of all asset choices.
6
6
based on average 1987 through 2000, data source: JPMorgan, MCM Corporate Watch, Moody's
Investor Service
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
10
2.2 Tranches
A Collateralized Debt Obligation is segmented into tranches which differ from each other in
terms of seniority towards bankruptcy and timing of repayment. The standard prioritization
scheme used is subordination: Senior CDO notes are paid before mezzanine and lower-
subordinated notes are paid, with any residual cash flow being paid to an equity piece. The
lowest tranche in the capital structure is the equity tranche, which is also called junior
subordinated debt. Hence, it is the first to absorb any potential losses and may shield the other
tranches from credit losses. Furthermore it posses the character of a residual claim as it
receives whatever is left over after the satisfaction of debt tranche losses. Figure 2 shows the
tranche structure of a typical CDO.
Tranches
Typical Rating
A-1
Floating Rate
Revolving Facility
A-2
Fixed Rate Tranche
AA- AAA
B-1
Floating Rate
Tranche
B-2
Fixed Floating Rate
Tranche
A
C
Fixed or Floating Rate Tranche
B
D
Fixed or Floating Rate Tranche
BB
Equity Tranche
Not Rated
Figure 2: Typical tranche structure of a CDO
Source: JPMorgan, CDO Handbook
Since subordinated CDO debt tranches protect more senior debt tranches against credit losses
they receive a higher coupon for taking on greater credit risk. Coupon payments on
subordinated tranches might be deferrable if the CDO does not have sufficient cash flow. A
revolving tranche might serve to allow the CDO to adjust its leverage. As illustrated in Figure
2, a double structure of tranches is often used where the same seniority tranche is comprised
of separate fixed and floating rate sub-tranches. Finally, debt tranches are sometimes
guaranteed by third parties, such as bond insurers.
RI
S
K
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
11
2.3 Purpose
CDOs are classified as either balance sheet or arbitrage CDOs, depending on the motivation
behind the securitization and the source of the CDO's assets. Special CDO types Balance
sheet
and Arbitrage CDOs have evolved in order to satisfy the different purposes. The market
is approximately equally divided between those two types of CDOs.
7
2.3.1 Risk
Transfer
In order to sell assets or transfer risk to a third party, the holder of securitizable assets, such as
a commercial bank, repackages those claims into a CDO.
CDOs which serve this purpose are called Balance sheet CDOs. The motivation may be to
shrink the balance sheet, reduce required regulatory capital, or reduce required economic
capital. The most straightforward way to achieve all three goals is the cash sale of assets to the
CDO. But for a variety of reasons, the risk of the assets might be better transferred to the CDO
synthetically. Here, the ceredit risk immanent to the loans is transferred using credit
derivatives like credit default swaps. This method of synthetically selling the risk can reduce
required capital, but cannot shrink the balance sheet as the issuer will still hold the assets.
Nevertheless, synthetic CDOs are categorized under balance sheet CDOs since the underlying
objective is to transfer risk and reduce economic capital.
2.3.2 Credit Risk Pricing Arbitrage
CDOs that are designed in order to exploit the spread between after-default yield on assets and
financing costs are called Arbitrage CDOs.
These instruments mainly serve the purpose of asset managers and equity tranche investors.
Equity tranche investors hope to achieve a leveraged return between the after-default yield on
assets and the financing cost due debt tranches. This potential spread, or funding gap, is the
arbitrage profit contained in the equity tranche that these investors hope for. Asset managers
on the other hand gain a management fee from monitoring and trading the CDO's assets.
These assets are purchased from a variety of sources in the open market, over a period that
may stretch for months from a warehousing period before the CDO closes to a ramp-up period
after the CDO closes. The asset manager often invests in a portion of the equity tranche or
subordinates a significant portion of its fee to debt and equity tranches. A rationale for this
behavior based on asymmetric information theories will be discussed in section 3.2. There is
7
also see Lucas, D. and Sam, T. (2001), p. 6
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
12
generally more trading in an arbitrage CDO than in a balance sheet CDO, where trading of the
portfolio is not allowed or limited to replacement of amortized assets.
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
13
2.4 Credit Structure
A further distinctive feature of CDOs is the way debt tranches are protected from credit losses.
In the active approach, the CDO is constantly marked-to-market and rebalanced by a CDO
manager, whereas in the passive approach the performance of the CDO purely depends on the
performance of the underlying assets. In the current market environment the latter one, i.e. the
passively managed vehicle prevails.
8
2.4.1 Market
Value
Structure
In a market value structure, the CDO's assets are marked-to-market periodically and compared
to a so called "advance rate mechanism". The procedure is as follows:
The market value of CDO assets is periodically calculated. Asset market values are then
multiplied by the advance rate, a discount factor reflecting the risk of the asset to arrive at so-
called haircut asset values. The advance rate is the asset-specific amount of tranche par and
interest the CDO asset can support, expressed as a percentage of the asset`s market value.
These advance rates decline the higher the rating on the CDO debt tranche and the less diverse
the CDO portfolio is.
The sum of haircut asset values is then compared to debt tranche par and accrued interest in
the over-collateralization test. In other words, the sum of each asset's market value, times each
asset's advance rate, must be greater or equal than debt tranche par and accrued:
accrued
he par and
Debt tranc
te
Advance Ra
ue
Market Val
i
lue
haircut va
i
i
i
4
4
4
4
4
3
4
4
4
4
4
2
1
(2.1)
If market value losses have caused the portfolio to fall below this minimum requirement, the
CDO has failed its over- collateralization test and must sell assets until the structure regains
the prescribed ratio.
Since the collateral pool is actively traded by a manager, the CDO tranches receive payments
based essentially on the marked-to-market returns of the collateral pool which are determined
in large part by the trading performance of the CDO manager.
2.4.2 Cash Flow Structure
In contrast to market value structures presented in the previous section, there is no market
value test in a cash flow CDO. Subordination is sized so that after-default interest and
principal cash flow from the CDO's asset portfolio is expected to cover debt tranche
requirements. This expectation has to factor in the credit risk arising from default probability,
8
also see Lucas, D. and Sam, T. (2001), p. 7
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
14
default correlations, and loss given default. A common cash flow structuring technique is to
divert cash flow from subordinated tranches to senior tranches if the quality of CDO assets
diminishes by some measure.
As the collateral portfolio is not subject to active trading by a manager, the risk regarding
interest and principal payments to the CDO tranches is determined mainly by the number and
timing of defaults of the collateral securities. For this reason, the literature on asset pricing of
CDOs mainly focuses on cash-flow CDO as the incorporation of the CDO manager's behavior
is not relevant here.
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
15
2.5 Summary and Typical CDO Structures
As previously discussed, four characteristics may be utilized to categorize CDOs: Underlying
assets, tranche structure, propose and credit structure. The following chart illustrates this and
demonstrates that using the various options given in each category, the variety of CDOs that
may be constructed is vast.
Figure 3: CDO building blocks
Source: own illustration, also see: JPMorgan: CDO Handbook
However, in reality, several specific combinations of asset types (direct vs. synthetic
exposure), purposes (Balance Sheet vs. Arbitrage), and credit structures (Market Value vs.
Direct purchase or synthetically
gained exposure:
Corporate bonds
Commercial loans
Emerging market corporate
Debt
Sovereign debt
Distressed securities
ASSETS
Different number of tranches
possible
Pay down of principal:
Sequential, contemporaneous
Fixed rate or floating coupon
Revolving tranche possible
LIABILITIES: TRANCHES
PURPOSE
Balance Sheet CDOs
: Risk
transfer, shrink balance sheet
and economic capital
Arbitrage CDOs:
credit risk
pricing arbitrage: aiming for
spread between after-default
yield on assets and financing
cost
CREDIT STRUCTURE
Market Value:
mark-to-market:
if haircut values are less than
CDO tranche par, assets are
rebalanced
Cash Flow:
no active trading,
subordinate tranches shield
senior tranches from credit risk
CDO
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
16
Cash Flow
) have evolved. Among those customary structures the most important are
summarized in the following table:
Table 1: Typical CDO structures
I
II
III
Exposure type
direct
direct
direct
Purpose
Balance sheet
Arbitrage
Arbitrage
Credit Structure
Cash flow
Cash flow
Market Value
Market Share
1987- 2000
9
41 %
36 %
10%
Source: Lucas, D. and Sam, T. (2001), p. 8
Type No. I is obviously designed in order to shrink the issuer's balance sheet and the
subordination is constructed in a way that after-default interests and principals repay debt
tranches as the CDO is not subject to market value tests and active trading. The exposure is
mainly achieved through a true sales transaction as opposed to gaining exposure synthetically.
This is due to the fact that shrinking the balance sheet synthetically may not yield the same
regulatory relief.
10
This structure seems to be appealing to a commercial bank that wants to
unload the balance sheet by selling collateral loans to a third party via the CDO.
Type No. II and III are designed in order to benefit from potential mispricing in credit risk
sensitive instruments. The CDO is constructed in order to yield leveraged returns to equity
holders. Furthermore, it is also actively traded, thus usually provides fees to the asset
manager. Typical investors are asset management institutions and insurance companies
seeking an attractive alternative to classical high yield investments.
A typical CDO as issued by a European bank is illustrated in the following figure
11
. A senior
tranche of 155 million is followed by successively lower-subordination tranches. Section 3.2
will focus on the economical rational for such a securitization structure as a result of the
information asymmetries inherent to CDO contracts.
9
also see Lucas, D. and Sam, T. (2001), p. 8
10
also see: Punjabi,S. and Thierney, J (1999): "Synthetic CLOs and their role in bank balance sheet
management", Working Paper, Deutsche Bank, Fixed Income Research
11
For a more detailed illustration of the legal and economic transaction structure, see the figure in
appendix 10.1
CDOs: Structure, Pricing, and Applications
2. Structure and Design of CDOs
17
Tranche
A1
A2
B
C
Equity
Face
Value
155 MM
56 MM
45.5 MM
14.5 MM
42.5 MM
Share
47 %
18 %
15 %
5 %
13 %
Target
Yield
EuroSwap +
0.400%
EuroSwap +
0.400%
EuroSwap
+ 0.600%
EuroSwap
+ 0.100%
NA
Figure 4: Subordination structure of a European bank CDO (names hidden)
Source : own illustration, Ratings as assessed by Fitch IBCA
Corporate Loans of
Commercial Bank
Special Purpose Vehicle
Portfolio Servicer
Trustee
Cash
Transfer of
Loans
Cash
Issuance of
Notes
A1:
Senior Notes
AAA
A2:
Mezzanine
Notes
AA
B: Mez. Notes
B
C: Subordi-
nated Notes
BBB
Equity
CDOs: Structure, Pricing, and Applications
3. Rationale and Economic Features
18
3. RATIONALE AND ECONOMIC FEATURES
It is important to note that in perfect (i.e. frictionless, liquid, complete, and unregulated)
markets CDOs would not exist as the costs of constructing CDOs and marketing them would
restrain their market presence. The fact that CDOs have been successfully created and
marketed is due to their ability to address specific market imperfections and regulatory
constraints. Furthermore, the liquidity for several bonds and corporate loans may not be
sufficient, leading to a reduction in market value. In this situation, securitization offers a
powerful tool to raise value by adding liquidity to an otherwise illiquid asset under the
umbrella of a CDO.
The specific advantages CDOs provide to different types of investors and the inherent
problems arising from asymmetric information are addressed below.
First, incentives to enter CDO contracts for debt and equity tranche investors as well as for
issuers are illustrates. Thereupon, section 3.2 focuses on the effects of asynchronous
information in context of CDO structuring.
CDOs: Structure, Pricing, and Applications
3. Rationale and Economic Features
19
3.1 Incentives to enter CDO Contracts
3.1.1 Comparative Advantages in Holding Specific Risks
A CDO is a vehicle that allows for the specific segmentation of credit risk. A credit portfolio
is separated by risk categories into tranches. Since market participants often develop
efficiencies in holding certain risk categories, a CDO offers a specific value to those
participants. It provides distilled exposures that might not be available elsewhere and which fit
into investors' specific risk preferences and portfolio constraints. Hence, CDOs provide a
vehicle which allows market participants to exploit their comparative advantages in holding
specific credit risky assets through custom exposures that cannot be achieved in another way.
3.1.2 Incentives for Equity Holders
Arbitrage CDOs are specifically designed in order to allow equity investors to exploit
potential mispricing in credit risk. The equity tranche is entitled to the differential between the
after-default yield on assets and the financing cost due debt tranches. Hence, equity holders
bet on the differential between expected and actual credit loss. The levers for pricing credit
risky assets are the following
12
:
Expected credit followings
Risk premium
Liquidity premium
Equity holders bet that actual credit losses will be smaller than the expected credit losses. The
difference between a posteriori, i.e. observed defaults and the a priori estimated credit losses
belong to the equity holders. Their position is comparable to that of a long position in a call
option which can be explained as follows:
12
Hull, J. (2000): "Options, Futures, and other Derivatives", Prentice Hall, p. 623
Details
- Seiten
- Erscheinungsform
- Originalausgabe
- Jahr
- 2002
- ISBN (eBook)
- 9783836621069
- DOI
- 10.3239/9783836621069
- Dateigröße
- 1 MB
- Sprache
- Englisch
- Institution / Hochschule
- Karlsruher Institut für Technologie (KIT) – Fakultät für Wirtschaftswissenschaften
- Erscheinungsdatum
- 2008 (Oktober)
- Note
- 1,0
- Schlagworte
- collateralized credti risk asset-backed securitization
