History of collateralized debt obligation

Michael Comes

Your signature with timestamp The History of Collateralized Debt Obligations Anyone familiar with the terms CDO and CBO will probably link them with the 2007 mortgage crisis. But collateralized debt and bond obligations (which the terms CDO and CBO stand for) have had a tenuous history since their introduction in the late 1980’s. Since their initial small-scale usage by commercial banks to remove assets from balance sheets into their widespread usage in the 21st century by investors, commercial banks, and mortgage companies, CDOs have transformed the financial landscape. If history is any indication of past performance, then the history of CDOs have proved that their performance has had a pronounced cyclical pattern. In the past the search for high-yielding collateral would provide alpha returns for those CDO managers who found it first. Others would notice the higher returns and bid the price of the collateral, lowering yields for CDO investors. In order to achieve the same returns, CDO investors would have to lower their standards. A wave of defaults would hit and the search for a new collateral asset class would begin, leaving institutional investors, insurance companies and banks with nothing to show for their CDO investments. This paper will start with an introduction to the CDO structure as it started out in the early 1990s and then progress to 2007, introducing the changes that have occurred within the CDO structure and the implications these have had on the economy. Given the widespread usage of CDOs, it is important to understand the long-term and far-reaching impacts they have on the worldwide economy. It is hard to think of anyone who is not directly linked with CDOs or the asset securitization process. Home loans extended to borrowers of all types are packaged into CDOs, insurance policies are hedged with CDO assets, credit card receivables, municipal parking ticket receivables are often packaged and sold to CDO investors as well. Individual CDOs that invest in seemingly unrelated sectors of the economy link them together and pass on the good and the bad to CDO investors. As has been shown in the past, and in the present with the 2007 mortgage crisis, this can have both positive and negative implications.

Collateralized Debt Obligations: An Explanation and Early Structures

i. == Introduction ==

---

A collateralized debt obligation is similar to a mutual fund that buys bonds. A collateralized debt obligation differs from a mutual fund in that it issues bonds instead of shares in the fund, and uses the money to purchase high-yield bonds, leveraged loans and alternative types of assets such as residential mortgages and receivables. Payments from the CDO collateral assets are used to pay back the investors who buy the CDO securities. <CITATION> The CDO presence has grown in the financial landscape since its introduction in the early 1990s. Since 1998, the annualized growth rate of global CDO issuance has averaged 150% per year, transforming the CDO market from what was a $50 billion industry in 1990 into a $2 trillion industry in 2007. from what was a $50 billion industry in 1990 (see table 1).This rapid growth can largely be attributed to conditions within the economy and financial markets that have made CDOs an attractive investment option. There are many specific details that differ between CDOs, however the common characteristic that binds them is a process known as “credit tranching.” This refers to creating multiple classes, or “tranches” of securities, each of which has a different seniority relative to others. This crucial aspect of CDOs defines them and has provided the versatility that has promoted their growth in the 1990s and early 2000’s. ii. == Capital Structure == A CDO may issue four tranches of securities known as 1) senior debt, 2) mezzanine debt, 3) subordinate debt and 4) equity. Each tranche will protect the tranches issued above it (or, “senior” to it) from losses on the underlying portfolio. The CDO sponsor, usually a bank or an investment management firm will size each tranche so that it can attain a desired rating from a credit rating agency such as Standard & Poor’s or Moody’s. Sizing each tranche is an important step in designing a CDO because it create the CDO “arbitrage,” the spread between yield earned on collateral and the amount paid to CDO note holders. This spread represents that value-added by creating the CDO and is used to pay the CDO sponsor and maintenance fees. The following example will illustrate the structure of a CDO transaction. Class Amount (millions) Pct. Of Deal Subordination (%) S&P Rating Class A 243.0 81.0 19.0 AAA Class B 13.5 4.5 14.5 AA Class C 10.5 3.5 11.0 A Class D 9.0 3.0 8.0 BBB Class E 9.0 3.0 5.0 BB Equity 15.0 5.0 0.0 not rated

Shown above is a typical cash flow CDO, with each class or “tranche” listed in descending order with respect to seniority. The “Amount” of each tranche is the principal value that each investor must pay to invest in that CDO tranche. The “Amount,” in turn, accounts for the amount of collateral that each tranche is backed by. As can be seen the Class A tranche is the largest tranche in the deal, it accounts for 81% of the collateral bought buy the CDO. Should defaults exceed $57 million, the principal value of this tranche would be eaten away at. The Class A tranche is the senior-most tranche in the capital structure. This means that if collateral defaults occur, it receives protection from the lower tranches in the capital structure. This protection afforded to this tranche is given the term “subordination.” Subordination is expressed as a percentage and indicates the amount of collateral that will have to default in order for it to experience principal losses. In this example, 19% of the collateral would have to default in order for the Class A tranche to start taking principal losses. Thus, the Class A tranche has 19% subordination in the capital structure. The principal losses would occurs as follows. Assuming a 19% loss on the collateral, the first 5% of defaults would be absorbed by the equity tranche: it is the subordinate-most tranche in the transaction. It’s value is $15 million; the first $15 million, or (5%) of defaults would wipe-out the principal value of this tranche. This would occur if the collateral that backs this tranche, be it bonds or loans, have defaulted, and the borrower cannot repay the principal amount of his loan. The equity tranche references this collateral, so a default on the collateral has the same affect of a default on the equity tranche itself. As can be seen from the diagram, the equity tranche’s tenuous position as the first loss absorber means that it receives the lowest possible rating in the CDO capital structure, “not rated.” After the first $15 million of defaults, losses on the collateral assets work their way up the capital structure. When losses exceed 5% of the collateral, next in line to take losses would be the subsequently most junior tranche, in this case Class E. As can be seen, because the Class E tranche is the second most tenuous in the structure, it receives the second lowest rating within the structure, BB. Continuing on, ff losses were to exceed 8%, the class D tranche would then proceed to take losses. It is not as risky as the two lower tranches and it is therefore given a higher rating than the two below it. There is an inverse relationship between each tranche’s rating and it’s subordination. The greater the subordination, the lower the rating. The incremental process of each subordinate-most tranche absorbing losses on the collateral will continue indefinitely until each tranche is wiped out. When this occurs, the CDO notes are said to have “defaulted,” and note holders leave the transaction having lost principal plus foregone interest. While this is occurring however, note holders have the option of selling their tranches in the secondary market at a discount. However when defaults start to hit, credit rating agencies will downgrade the value of the notes, making them less liquid and harder to sell. Naturally, CDO investors demand compensation for the amount of risk they are taking on by investing in a low tranche in the capital structure. Conversely, investors require less yield for investing in higher tranches. Each tranche’s coupon reflects the amount of risk it carries. Riskier tranches in the low end of the structure will carry higher coupons with greater default risk, while senior tranches, considered to be safer investments will carry lower coupons. ii. ==Motivation== There are many different reasons why a company might sponsor a CDO transaction. The majority of firms who sponsor CDOs are investment management firms who earn fees based on the amount of assets they manage. When these firms create CDOs they increase their income by increasing the amount of assets under management. These are called “arbitrage transactions,” because they are created with the intention of earning a positive spread between the yield from the collateral and payments made to note holders. Within arbitrage transactions, the majority of the profit is received by the equity tranche with some amount going to the CDO manager as a performance-based incentive. Other CDOs are ones utilized by banks to remove assets from their balance sheets. A bank can remove assets from its balance sheet by creating a CDO and transferring the assets to the CDO’s portfolio. This is useful for banks under pressure to meet regulatory capital requirements. It also increases the amount of cash on hand and lets them extend loans. These transactions are called balance sheet CDOs. iii. == Diversification == In principal, a sponsor who creates an arbitrage CDO tries to buy a well-diversified portfolio of assets to back the CDO structure. The intention behind this is that hopefully the diversification will make the CDO structure more valuable than just the sum of it’s parts. The idea of diversification is the premise behind assessing the risk of each CDO transaction. Rating agencies and CDO managers run computer simulations to test correlation between the different types of portfolio collateral. Bonds in the CDO portfolio that are issued by companies in different industries are assumed to have no correlation. Bonds issued by companies in the same industry are assumed to have greater correlation. The same concept holds when assessing risks between asset-backed-securities sectors, which are even more complex due to the uncertainty surrounding their collateral assets. The correlation between assets in a CDO portfolio is an important assumption for assessing the risk of each CDO and predicting the it’s performance. Increased diversification will allow the CDO manager to get a higher credit rating on the senior tranches. A higher rating means that investors will perceive the tranche as a safer investment and will therefore demand a lower coupon than if the tranche received a lower rating. The lower coupon increases the CDO manager’s profit by increasing the difference between yield on the collateral and the coupon paid on the CDO’s notes. Improper assumptions about a CDO’s diversification can misstate performance and lead to incorrect assumptions by managers and credit rating agencies about the strength of the structure. In the past, the complexity of these assessments led to downgrades on CDO tranches by credit rating agencies and forced agencies to rethink their assumptions about correlation between assets in different industries. From 1995-1999 CDOs invested primarily in low-rated, high-yielding bonds with the hope that adequate diversification would enhance the credit quality of the underlying portfolio. The ratings of individual bonds didn’t matter as much as the diversification that was needed to improve ratings on senior tranches. Improved ratings would allow for lower coupons and would therefore provide positive spread between collateral and CDO notes. Heavy high-yield bond investment from CDOs was a byproduct of high-yield bonds issued in the late 1980s that were maturing toward the end of the 1990s and were becoming suitable for CDO investment. In 2001, the massive investment in high-yield assets officially ended due to defaults that occurred as a result of decreasing spreads and downgrades on CDOs that held those assets. TALK MORE ABOUT At that time, many thought that CDO managers focused too broadly on achieving diversity in the CDO portfolio without paying enough attention to the credit quality of the individual assets. From 2001-2003, the opposite occurred, and CDO managers focused on investing in high-rated investment grade debt, sacrificing short term yield for longer term safety of principal. While it may seem like greater diversity, ceteris paribus, can be beneficial to the CDO, in actuality, it benefits only senior note holders. Low correlation reduces portfolio volatility, which protects senior note holders from defaults on bonds in the portfolio from any one sector of the economy. Should defaults occur in a portfolio with high correlation, junior tranches might not be enough to cushion the blow of defaults on the entire portfolio. A senior note holder in a $200 million CDO structure invested solely in bonds of retail companies faces a greater risk than a senior note holder in a CDO with 10% collateral invested in retail company bonds. If retail bonds were to default, the value of the senior note holder’s tranche in the 100% retail bond structure would be downgraded and the senior tranche would lose 100% of it’s value. The note holder in the diversified portfolio may experience a downgrade due to less subordination as well, but the value of his note stays intact because subordinate tranches would absorb the losses. The opposite holds for equity investors. Due to the nature of correlation and equity investment, these investors may seek volatility due to the possibility of greater returns. Using the same example, if the owner of an equity tranche calculated a 65% probability of a $50 million upside on the collateral, and a 35% probability of default, he sees the tranche as a good investment as his profit is directly linked to the $32.5 million expected capital gain on the portfolio. When the cash is received the equity investor will receive the residual cash after the senior tranches receive payments they would have received had the collateral not appreciated in value. The equity tranche holders participate in this upside due to their participation as equity investors, while senior note holders do not because they are debtors. The volatility of the portfolio therefore presents the opportunity for capital gains, and therefore greater returns, for the subordinate tranche This explains why equity tranches tend to be popular investment channels for hedge-funds and high-yield debt funds with greater appetites for risk and conversely why senior tranches are often held by conservative investors such as insurance companies and pension funds. iv. == The Life of a CDO and Performance Tests == ==

Headline text

==

When a CDO is first issued, the CDO manager will use the proceeds from the issued notes to purchase collateral assets. The assets purchased by the CDO manager must meet predefined parameters specified in the contract terms of the CDO. These parameters ensure that the CDO manager purchases assets that provide adequate diversification to protect senior tranches while at the same time yielding enough spread over note coupons to make the transaction profitable. For example, a CDO manager may be required to maintain a minimum average rating, a minimum average yield, and a maximum average maturity that falls within these guidelines. All these parameters must be satisfied or else the safety and the performance of the CDO may be compromised. This period of investing in the initial portfolio assets, which lasts from two to three months is called the ramp-up phase. When the CDO is fully invested, the manager actively manages the underlying portfolio by placing trades and reinvesting cash flows from the amortization of bonds and the maturity of assets within the portfolio. This is called the reinvestment phase because all cash received from the underlying assets is reinvested in collateral instead of being used to repay note holders. The manager is only allowed to invest in assets that meet the specified minimum requirements laid out in the CDO contract and is therefore subject to constraints that may limit his ability to find assets appropriate for investment as CDO collateral. For example, a CDO manager unable to invest in bonds within a particular industry due to diversity requirements, will be forced to invest cash in low-yielding short-term assets while he’s searching for assets suitable as CDO collateral. During this time, note holders may suffer from “negative arbitrage,” whereby the yields on the collateral assets will not be enough to pay tranche coupons. After the reinvestment phase, which lasts from three to five years, the CDO must repay it’s own securities with cash generated from the collateral. This is known as the “amortization phase,” and it is the last phase in the life of a CDO. Instead of reinvesting proceeds on eligible collateral assets the manager must apply the cash toward its own notes, ending the CDO transaction. The two preceding paragraphs describe the ideal situation whereby CDO collateral assets make timely interest payments and defaults are kept above the required minimum as set forth in the initial contract. Often times, however, defaults and missed interest payments may reduce the value of the collateral below certain predefined limits. For example, most transactions require “overcollateralization ratios,” set forth in the contract, that require the par value of collateral to exceed the par value of notes by a certain amount. Transactions also have “interest coverage tests” which specify that interest cash flow generated by the collateral exceed that paid to notes by predetermined amounts. When either of these two ratios slip below the required limit, signaling that the CDO’s performance has deteriorated, the CDO enters the amortization phase in a process known as early amortization. At this point, the CDO manager is no longer able to invest cash proceeds in collateral, but must use the proceeds to repay CDO’s notes and end the transaction. This is generally a huge disappointment for investors and sponsors alike as early amortization results in million dollars losses associated with legal fees, taxes, salaries and transactions costs assumed in order to acquire collateral assets. This explanation covers the basic attributes of the CDO arbitrage-motivated transaction. This type of transaction accounts for 85% of CDOs outstanding (SIFMA). Since the beginning of their widespread use as financial instruments, CDOs have taken on different forms characterized by structural characteristics and types of collateral assets. Beginning with the first CDO issuance in 1987 the CDO structure has grown in complexity to include a wide range of assets from asset back securities to high-yielding leveraged loans. The remainder of this paper will discuss the deviations of CDOs from their basic form and the implications that these deviations have had on the economy. The CDO structure has taken two forms that have characterized its presence since its inception. From 1990-1995 the basic “cash flow structure” was utilized, whereby cash raised by issuing CDO notes was used to purchase collateral. During these years, the CDO market averaged $1.4 billion outstanding; comparatively small when considering that in 1999, the total value of CDOs outstanding was estimated to be around $120 billion. The drastic increase can be attributed to the rising popularity in “synthetic” CDOs; CDOs that make use of the credit derivative instrument known as the “credit default swap.” Whereas before 1995 the CDO market was driven solely by cash flow structures backed by high-yield debt, popularity started to decline due to decreasing yield spreads that made CDOs unprofitable. The resurgence in the popularity of CDOs between 1995 and 2000 can be attributed to growth in synthetic CDOs, which in 2003 accounted for 75% of all CDOs outstanding. A synthetic CDO transaction allows the sponsor to transfer the credit risk of collateral assets to subordinate tranche investors while allowing sponsors to reap the rewards of payments from a credit default swap agreement between the senior note holder and a third party seeking credit protection. In a synthetic CDO the senior-most tranche will be unfunded and will indirectly reference collateral assets through a credit default swap, whereby the senior tranche holder will enter into an agreement with a bondholder to pay the bondholder the principal amount of a particular bond should his bonds default. In return for taking on this risk, the senior-most tranche receives periodic interest payments from the bond holder. These interest payments will in some way be related to the payments on the bond referenced by the credit default swap transaction and will be used to pay coupons on the tranches in the CDO transaction. The senior note in a synthetic transaction is “unfunded,” meaning that the note holder does not pay cash to buy into the CDO. There isn’t any collateral to buy. Instead, the note holder will receive periodic interest payments from the swap agreement and will have to repay the owner of the referenced bonds should defaults occur. Conversely, the subordinate tranches in a synthetic transaction will be funded and will purchase low-risk, investment-grade assets which will serve to protect the senior tranche from losses. Should the assets referenced by the credit default swap, default, the losses would work up the capital structure the same way they would in a cash flow CDO, wiping out the value of the subordinate tranches. In return for payments on referenced assets, the subordinate note holders and unfunded senior note holders must pay the credit default swap protection buyer the full amount of defaulted principal, which will come from sales of collateral purchased by subordinate tranches. However, selling this collateral wipes out the value of subordinate tranches. For investors in a synthetic CDO, the occurrence of a default under the credit default swap agreement has the same effect as a collateral default in a cash flow transaction. In order to understand the rising popularity of synthetic CDOs it is important to understand the motivation behind the transaction that distinguishes them from arbitrage cash flow transactions. <GIVE NUMBERS> Cash flow arbitrage transactions, such as the one described above are designed with the CDO investor in mind as a way of designing an asset that will provide above-market returns. Synthetics have been used as a way for commercial banks to remove assets from their balance sheets; except that instead of removing them from their balance sheets, they are mitigating their exposure to those assets by setting up a credit default swap and taking ownership in the un-funded senior tranche. When assets referenced by the credit default swap default, the losses are passed down to subordinate tranche holders. From the standpoint of the CDO investor, the potential for moral hazard is greatly increased. In selling off assets that in some way compromise the financial health of the sponsoring institution the risk is transferred to investors at a lower price due to the senior tranche’s credit enhancement friom subordinate tranches. Whereas an arbitrage cash flow transaction will buy a diversified pool of assets in the interest of returning high-yields to investors, the subordinate tranches in a synthetic CDO act as merely buffers to protect the senior tranches from losses on the credit default swap. Janet Tavakoli, in a review of synthetic CDOs in the International Financing Review attributes the expansive growth to two primary economic drivers in a synthetic CDO transaction. The first is the unfunded senior tranche which, due to its nature and its low price relative to AAA tranches that are priced below it, allow it be of greater size and allows for greater flexibility than tranches in cash deals. The second economic drive in CDO transactions has been the equity tranche’s leveraged exposure to high-quality collateral assets. Because tranches in synthetic deals tend to be much larger than equity tranches relative to cash flow deals, the equity tranche benefits by gaining access to capital via the senior tranches