CDOs 101 London
Transcript of CDOs 101 London
CDOs : A Beginner’s Guide
Sharif Anbar-Colas & Aaron WongGlobal Cash CDO Trading
INTERNAL USE ONLY – DO NOT SEND OUT
April 21, 2006
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Agenda
♦ Section 1: How Does a CDO Work?
♦ Section 2: Benefits of a CDO
♦ Section 3: Different types of CDOs
♦ Section 4: CDO Investor Base
♦ Section 5: CDO Team in UBS
SECTION 1
How does a CDO work?
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What is a CDO – Interesting Facts
- A CDO is a mechanism whereby a third party (the collateral manager) achieves term, non-recourse funding on their portfolio
- This mechanism can be applied to several asset classes (loans, Bonds, CDS, ABS etc)
- First CDO was issued by Drexel in the mid 80s, today there are many players in the primary and secondary market
- UBS is a global leader in this market- Ranked #3 in Global CDO issuance (as per Thomson Financial)
- Issuance has been growing steadily and in Q1 2006 stands about $54bn
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What is a CDO – The CDO Structure
-Think of a CDO as a Corporate Balance Sheet with three components
Corporate Balance Sheet CDO
Assets Portfolio
Debt Liability Tranches
Shareholder’s Equity Equity Tranche
Cashflows
Assets / Portfolio
Interest Due
To Debt HoldersDebt / Liability Tranches
Equity is last in line to receive payout
Excess Spread
To Equity HoldersShareholder Equity / Equity Tranche
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How does it work?
♦ CDOs rely upon statistical diversity
– Imagine a certain bond has a 5% probability of default
– Put 100 bonds of similar characteristics and you expect that 5% of the portfolio will default but the rest will be OK
– If you can take out the risk of the top 95% of the portfolio and separate it form the bottom 5% of the portfolio then you have repackaged the risk of the portfolio
♦ By creating several tranches from one pool, you can tailor the risk to match the appetite of each investor
– Most CDOs have several Liability tranches rated AAA, AA, A, BBB and BB, the equity tranche is not rated
– The return is proportional to the risk, with the AAA investor getting the least return and the equity holder achieving the most
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How Do Debt Tranches Provide Leverage
Portfolio Collateral:
Average Spread Eur+250
Average Rating BBSize €350mm
AAA RatingSpread Eur+25Size €300mm
A RatingSpread Eur+65
Size €20mm
350mm X 250bp = 8.75mm Portfolio interest proceeds
300mm X 25bp = 0.875mm Interest Due to the AAA
20mm X 65bp = 0.13 mm Interest Due to the A
10mm X 175bp = 0.175mm Interest Due to the BBB
Excess Spread going to Equity Tranche
8.75 - 0.875 - 0.13 - 0.175 = 7.57mm
7.57mm / 30mm = 25% Cash on Cash Return
BBB RatingSpread Eur+175
Size 10mm
No Rating
Size 30mm
SECTION 2
Benefits of a CDO
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Why did the market invent CDOs
♦ Portfolio Managers would buy portfolios and earn their return from the interest proceeds on these portfolios
♦ To Enhance returns, managers started repoing these funds
♦ When spreads widen, the margin calls on repoed positions would erode the returns on the levered positions
♦ CDOs enable the portfolio manager to achieve term non recourse funding on his portfolio through the issuance of debt tranches
♦ The CDO manager is immunized from MTM risk during the life of his portfolio and can just focus on managing the credit risk
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How Do Debt Tranches eliminate MTM Risk
♦ When a CDO is issued the coupon on the liability tranches is fixed for the life of the deal
♦ This will lock in the cost of capital of the structure
♦ Excess Spread of Structure = Weighted Average Coupon on Portfolio –Weighted Average Cost of Liabilities
♦ Hence even in a spread widening or tightening environment, since the liability spreads will not change, unless the Average coupon on the portfolio changes, you can expect your returns to stay the same
SECTION 3
Different Types of CDOs
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Main Types of CDOs – By Motivation
♦ Cashflow Arbitrage CDOs
– Most common type of CDO
– Tend be done across all asset classes (HY bonds, Loans, ABS etc)
– Are done to arbitrage the spread of the portfolio relative to the liabilities
♦ Balance Sheet CDOs
– Tend to be much larger than Cashflow Arbitrage deals
– Are done mainly to achieve balance sheet relief by moving assets off balance sheet
♦ Market Value CDOs
– Are used to take advantage of relative cheapness of market
– Structure benefits from Cheap cost of liabilities (like Cashflow Arbitrage CDOs) as well as appreciation in the MV of the portfolio
– Not many of these structures relative to cashflow arbitrage
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Main Type of CDOs – By Asset Class
ABS47%
Leveraged Loans36%
EM1%
TRUPS2%IG Bonds
3%
HY Bonds11%
Source: Creditflux data from 1996-Present
933EM
514Others
1325TRUPS
5941,202Total
1940IG Bonds
67212HY Bonds
207447Leveraged Loans
274431ABS
Size (bn)# DealsDeal Type
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Static Synthetics vs Managed Cash CDOs
Manager goes through workoutNoneDefault Workout
Only to debt NoneCall Risk
After initial non-call periodNoneEquity Optional Redemption
Difficult due to active tradingFeasibleHedging
Manager able to sell and replace assetNo RemedyDeteriorating Credit
Deleverage through cashflow diversionApplied bottom-upLoss Realization
Passed to allNoneTrading gains or losses
Selected by managerNever changesPortfolio Composition
Managed Cash CDOsStatic Synthetics
SECTION 4
CDO Investor Base
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CDO Investors – By Tranche Rating
Banks, SIVs, Conduits, Negative basis playersAAA
Insurance companies, Structured funds and Real money accounts
Hedge funds, CDO equity funds, Alternative investors, and High net worth individuals
AA
A
BBBBB
Equity
SECTION 5
UBS CDO Team
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Global CDO Group
Ramesh Singh, MD
Securitised Products
Fixed Income & Rates (FIR)
Global Credit Group
Simeon Schwartz, MD
Global Rates Group
Chris Ryan, MD
Global CDO Group
James Stehli, MD
Fred EngelJi-mei Ma
Reggie FernandezCheng LeeMatt Rose
Harold HuangBrett HowellPaul Hanig
Global Credit CDO Global SF CDO Secondary Trading CDO ResearchProduct Manager
Lirenn TsaiAnastasios Argeros
Vaibhav Kumar Chi Lee
Steven Margetis Robert MorelliEric Rothman
James YaoRobert Hoke
Keith GrimaldiMalay Patel
Aaron WongSharif Anbar-Colas
(LDN)
Eur Credit & SF CDO
Paul Heyrman (LDN)Yugo Yamamoto (JPN)
Koichi Watabe (NY)Jack Xu (HK)
Simon Perry Harsh Varma
Mohit AgarwalKunal Sood
Douglas LucasLaurie Goodman
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Market leader in CDO origination
Source: Thomson Financial
UBS has ranked #3 in Global CDO origination for Q1 2006
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Sales Credit on CDO Tranches
0.5 pointsAAA
1.5 points
0.75 point
5 points7 points
2.5 points
SC can vary from deal to deal these are from Magii, the last European CLO
AA
A
BBBBB
Equity
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