Cdo Training Session (2)

Collateralized Debt ObligationsAn Overview

Welcome and Introduction

CDOs – Introduction and OverviewStructuring of CDOs – WarehousingCDO Portfolio Management, Compliance,

Risk Management, Accounting and Operations of CDOs (Intro and Prelude for the next presentation)

Questions

CDOs – Introduction and Overview

What are CDOs?Types of CDOsParties to a CDO TransactionMotivations for managing and/or

investing in CDOsAdvantages of CDOsDisadvantages of CDOsTypical Cash Flows of CDOsLife Cycle of CDOs


What are CDOs?◦ CDOs are a form of Asset-Backed Security (ABS) that

derives its returns and/or performance from the cash flow activity of it underlying assets, which include, but are not limited to, the following:

High Yield (HY) and/or Investment Grade (IG) Bonds Leveraged (Bank and/or Middle Market) Loans Prime/Mid-prime/Sub-prime Residential Mortgage-Backed

Securities (RMBS) Commercial Mortgage-Backed Securities (CMBS) IG and HY Senior and Mezzanine CDO Tranches Credit Default Swaps (referencing the aforementioned

assets); can either sell protection (typical) or buy protection (rare)

Emerging Market (EM) Debt


SPV / IssuerCDO Entity

Assets(Categories)

HY Corp. BondsIG Corp. Bonds

Leveraged LoansPrime RMBS

Midprime RMBSSubprime RMBS

CMBSCDOs

CDS (referencingall of the above)

Unfunded CDS CPTRS Counterparty

Super Senior Swap CP(optional)

Senior Notes (AAA)

Senior Notes (AA)

Junior Mezz Notes (BBB)

Equity/Sub Notes (NR)

Collateral Manager

PPN Notes

Combo Notes

Mezzanine Notes (A)

• Portfolio Management

• Administration

• Risk Management

Fees

Trustee

Fe

es

• Collateral Administration

• Portfolio Analytics

• Investor Reporting

• Trade Settlement

Principal, Interest, Premiums & Fees

Principal & Interest (or Premiums)

Buys ABSBuys Assets

IRS/IRC/IRF Counterparty

Net Swap/Cap/Floor

Payments

The Typical CDO Structure – A Graphical Representation


What are CDOs? - Continued◦ Unique Aspects to CDOs vs. Other Traditional ABS

Active Portfolio Management (Static Funds are rare) Revolving Asset Turnover Periods (5-7 years) Call Provisions and Lock-Out Periods Tranched Liabilities – various payment priorities and

cash flow mechanisms Trading restrictions established via complex,

interrelated Compliance Rules Coverage Tests (Overcollateralization, Interest

Coverage, Interest Diversion, etc.) Trustee presence and involvement, in addition to third-

party verification and review (i.e., Big 4 Auditors) Enhanced Reporting Requirements (Monthly)


Types of CDOs◦ Collateralized Bond Obligations (HY/EM Debt) – “CBOs”◦ Collateralized Loan Obligations (“CLOs”)◦ Collateralized Synthetic Obligations (“CSOs”)◦ Structured Finance CDOs◦ Residential (Single, Multi-Family) Mortgage CDOs◦ Commercial Real Estate CDOs◦ Constant Proportion Debt Obligations (“CPDOs”)

Funding for CDOs◦ LT Cash – Debt/Equity Capital funds purchased assets◦ ST Cash – CP issuance (and roll-over) funds LT assets◦ Synthetic – CDS/TRS/Liquidity Facility◦ Hybrid – Combination of Cash and Synthetic


Parties to a CDO◦ Issuer/SPV – Legal entity that issues the CDO◦ Underwriter – Structures and places CDO Debt and

Equity with investors; also provides financing during the warehousing period (if necessary)

◦ Collateral Manager –Performs Portfolio Management function (asset selection, portfolio administration, risk management, etc.)

◦ Trustee – Provides Custodian and Portfolio Administration Services and serves as the official record regarding holdings and cash transactions

◦ Rating Agencies – Evaluates and rates debt◦ Independent Auditors – Performs CDO issuance,

waterfall verifications, and tax (PFIC) reporting services, as applicable


Motivations for doing a CDO Transaction◦ Expand Assets Under Management (“AUM”) – CDOs are a

great way for investment management firms to increase AUM via access to Investment Bank clientele vs. utilizing its own sales force (generally non-existent for small shops). More AUM means for more management fees.

◦ Expand Asset Management Expertise –CDOs allow traditional fixed income managers to expand their normal asset base by adding investment buckets that allow for investments in different assets. This strategy can also be executed by adding the requisite PM expertise to the asset management team (and launching new funds) as well.

◦ Secured Financing/Leveraged Returns – Unlike TRS, Repurchase Agreements or Margin Trading, CDOs can be utilized to generate leveraged returns to equity investors by utilizing LT debt to invest assets that generate alpha.


Motivations for Investing in a CDO◦ Higher Risk-Adjusted Return Prospects – CDO debt investors

typically receive a higher spread vs. similarly rated instruments. CDO Equity seeks leveraged returns.

◦ Diversification – By pooling assets of various products, industries, tenor and credit profiles (limited by trading rules), investors find CDOs attractive for their risk-mitigating return (i.e., low correlation to S&P 500) prospects vs. taking single-name risk.

◦ Expand Asset Exposures – Although the investor profile for CDOs include both Institutional and Sophisticated/HNW investors, CDOs provide investors the ability to gain exposure to instruments that they otherwise would not be able to (e.g., CDS contracts on CDO tranches)


Advantages of CDOs◦ Diversification (low correlation with other instruments)◦ Favorable Taxation – Typically created offshore in tax-

advantaged jurisdictions (i.e., Cayman Islands, Ireland, etc.) and co-issued onshore in Delaware, the earnings and profits gained by CDOs is shielded from federal and state taxation.

◦ Adaptive Structures – Properly structured deals can adapt to market volatility (flexibility to vary asset mix or trade rules)

Disadvantages of CDOs◦ These are Very Complex Instruments – Many players in the

market are not experts in the industry or the product◦ Relatively low oversight and transparency –Issued under Rule

144(a) and Reg S, CDOs are issued privately and there are typically no requirements for financial statements or audits.

◦ Capital can be tied up for years once a deal goes bad - Cash checks in, but sometimes doesn’t check out.....


Cash Flow Structure of CDOsInterest Proceeds Principal Proceeds

Taxes and Filing Fees

Admin Expenses

Senior Debt Interest

Senior Mgmt Fees

Coverage Tests

Mezz/Junior Debt Interest(incl. PIK Interest)

Senior Debt

Mezz Debt

Junior Debt

Redemption OrderFail

Pass

Coverage Tests

Net Hedge Payments

Pass

Subordinate Mgmt Fees

Equity Dividend

Taxes and Filing Fees

Admin ExpensesSnr Mgmt Fees

Hedge PaymentsSenior Debt Interest

(subject to Pro-FormaCoverage Tests)Coverage Tests

(Pro-Forma)Fail

Fail

Pass

Mezz/Junior Debt Interest(incl. PIK Interest)

Coverage Tests(Pro-Forma)

ReinvestmentPeriod?

Reinvest Cash

Yes

NoSenior Debt Principal

Mezz/Junior Prin

Sub/Incentive Mgmt Fees

Equity


Lifecycle of a CDO◦ Warehousing Period – SPV is created and assets are acquired

while the debt and equity are sold to investors; typically lasts 3-12 months. The Warehouse “closes” at the end of this period and the CDO goes live (The “Closing Date”).

◦ Reinvestment Period – Typically 5 to 7 years from Closing Date; Investment allowed (within compliance rules)

◦ Non-Call Period – No Calls 3 to 5 years from Closing Date.◦ Amortization/Callable Period – Begins 5 to 7 years after

Closing. During this period, (1) the CDO’s debt can be repaid (partially or completely) with principal cash from sales, amortizations, calls or redemptions or (2) the debt is completely retired with sales proceeds from the sale of assets

◦ Maturity/Termination – All assets are liquidated, all debt is retired, equity is paid residual interest and the SPV is terminated.

Structuring of CDOs - Warehousing

Establishing a WarehouseWarehouse Agreement BasicsWarehouse Asset Management,

Compliance, Administration and Operations

Closing the Warehouse


Establishing The Warehouse◦ When Warehouses are opened, Portfolio Managers contract

with Investment Bankers, who provide financing and Placement Agent services. Why is this done? Managers can ramp-up their portfolios and take advantage of certain market conditions and Underwriters secure new transaction business (which generates fees between 1-5% of the deal size).

◦ The SPV is legally established, along all with the filing of the requisite paperwork (W-8BEN for tax, for example) and the establishment of custodial and trading accounts. Also, a trustee is hired to serve as Warehousing Agent (note that the Underwriter can agree to take the exposure risk on its own balance sheet, thus rendering the need for a Trustee moot).

◦ Trading begins and assets are acquired in compliance with the criteria set forth in the warehousing agreement, or with prior approval of the Underwriter (if such assets are warehoused on the Underwriters’ Balance Sheet).


SPV / IssuerCDO EntityAssets/

Warehouse Acct

Collateral Manager

• Portfolio Management

• Administration

• Risk Management

Mgmt Fees (if any)

WarehousingAgent/Trustee

Fe

es

• Collateral Administration

• Trade Settlement

Principal, Interest, Premiums & Fees

Buys AssetsInvestment Bank/

Underwriter

The Typical CDO Warehouse Structure – A Graphical Representation

Loan Proceeds

• Financing Costs & Loan Proceeds

• Debt & Equity Placement Fess

Sales Proceeds (for FAS 140

sales); only for assets sold

directly to SPV


Warehouse Agreement Basics◦ Portfolio Investments – (1) Identifies qualified assets for

purchase, (2) spells outs the procedures for acquiring such assets, and (3) spells out the conditions and circumstances under which assets can be sold in the warehouse (generally requires consent of warehouse provider)

◦ Financing – Spells out (1) the size of the Commitment, (2) the conditions under which such proceeds can be used (i.e., to purchase assets), (3) the process under which such finances can be accessed (i.e., formally requesting advances), (4) the cost of such financing and the payment terms, and (5) the term of the financing itself

◦ Cash Flow Mechanics – Classification of Cash and treatment◦ Portfolio Management – Duties and Responsibilities◦ Positive and Negative Covenants – Do’s & Don’ts◦ Compliance


Warehouse Asset Management – CLOs◦ One may ask “Why are we doing a CDO deal? Isn’t the

market dead?” Yes and No.... The CDOs that are receiving all of the negative

press/publicity are generally Structured Finance CDOs – not CLOs. Here are some facts concerning Bank Loans and CLOs:

◦ In the 20+ year history of CDOs, no AAA issued CLO tranche has ever been downgraded;

◦ Issuer Weighted Cumulative Defaults of BB/B rated loans between the years of 1995-2004 were approximately 12.4%; the same default rate on BB/B bonds was approximately 40%; and

◦ The Recovery rate on Bank Loan defaults between 1995-2004 (all seniority levels) approximated 78%


Warehouse Asset Management – CLOs, Cont.’◦ Portfolio Management Topics

Diversity mix – identify performing credits among different industries to maximize returns; more diversity contributes to minimize default correlation Credit Migration/Rating Monitoring – in addition to credit analysis, PMs must stay aware of rating agency views of industry sectors and the credits in the managed asset pool. Adverse rating actions can impair future trading prospects.

Performance/Cash Flow adequacy – during the warehouse, it is typically the case that all cash generated by the portfolio go to the Underwriter (because they fund the warehouse), while capital gains (if any) are shared.


Compliance◦ Weighted Average Rating Tests – Maintain Ratings and

Monitor Credit Rating Movements◦ Weighted Average Recovery Rates◦ Weighted Average Spread Tests◦ Overcollaterilization Tests◦ Diversity Tests◦ Weighted Average Life Tests◦ Portfolio Concentration Tests

Industry Concentrations Issuer Concentrations Geographic Concentrations Seniority Concentrations Fixed Rate Concentrations


Administration & Operations◦ Trade Capture and Confirmation◦ Cash Reconciliations (Daily)◦ Position Reconciliations (Weekly)◦ Portfolio Monitoring and Administration (Real Time)◦ Compliance Monitoring (Real Time)◦ Compliance Reporting (Daily)◦ Portfolio Analysis/Reporting (Weekly/Monthly)◦ Accounting/Transaction Recording (Daily)◦ Financial Reporting (Quarterly & Annual)◦ Risk Management

Monitor Asset Quality and Compliance Levels (Monthly) Cash Flow/Credit Analysis (Coincide with Payment Dates) Quantitative and Qualitative Credit Analysis utilizing

Stochastic Monte Carlo Expected Loss Estimation methods


Closing the CDO Warehouse

Interest Proceeds

Senior Debt

Mezzanine Debt

Junior Debt

Equity

Principal Proceeds

CDO/SPV

Capital Proceeds

(Sources)

Warehouse Provider Interest

Warehouse Provider Loan Proceeds

Portfolio ManagementFees

Sales Price ofWarehouse Assets

Closing DateExpense Acct

Expense Reserve

Legal ExpensesRating Agencies

AccountantsPrinters

Other Expenses

Underwriter Fees

Warehouse ClosingCash Flows

Capital Proceeds

(Uses)

What’s Next? – Stay Tuned!

CDO Portfolio Management, Compliance, Risk Management, Accounting and Operations of CDOs (Intro and Prelude for the next presentation)

◦ What needs to be in place when the CDO goes live?◦ Where do the risks lie? Where do they have to be

monitored? How are risks measured?◦ How do Portfolio Managers, Operations, Finance

coordinate efforts to ensure that nothing falls through the cracks?

◦ What internal controls need to be in place to ensure that the appropriate parties (i.e., Compliance) ensure that CDO Management is properly performed in accordance with legal agreements?

Questions?

Resources for Reference◦ Bloomberg (Keywords “NI CDO”, “NI SYNCDOS”)◦ Moody’s (www.moodys.com)◦ S&P (www.sp.cdointerface.com) ◦ Fitch (www.fitchratings.com)◦ UBS CDO/Leveraged Loan Research (www.ubs.com) ◦ Lehman Brothers Research (www.lehman.com)

http://www.moodys.com/

http://www.sp.cdointerface.com/

http://www.fitchratings.com/

http://www.ubs.com/

http://www.lehman.com/

Cdo Training Session (2)

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