Basis in abx_tabx_bespoke_sf_cd_os

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Basis in abx_tabx_bespoke_sf_cd_os

  1. 1. Tranche ABX and Basis Risk in Subprime RMBS Structured Portfolios Kevin Kendra February 20, 2007
  2. 2. Introduction What are structured subprime RMBS portfolios? What is “basis risk”? Why is “basis risk” between these structures important now?
  3. 3. What are structured subprime RMBS portfolios? <ul><li>Portfolio exposure to subprime Residential Mortgage-Backed Securities (RMBS) can be obtained using various structures: </li></ul><ul><ul><li>Structured Finance Collateralized Debt Obligations (SF CDOs) </li></ul></ul><ul><ul><ul><li>Cash SF CDOs </li></ul></ul></ul><ul><ul><ul><li>Bespoke SF CDOs </li></ul></ul></ul><ul><ul><ul><li>Hybrid SF CDOs </li></ul></ul></ul><ul><ul><li>ABX.HE Indices </li></ul></ul><ul><ul><li>Tranche ABX.HE (TABX) Indices </li></ul></ul>www.derivativefitch.com
  4. 4. What is “basis risk”? <ul><li>Basis risk describes the risk that offsetting investments in a hedging strategy will not experience cash flow or price gains in the same manner. </li></ul><ul><li>Basis risk has the potential to create an excess gain or loss and therefore is not directional. The amount of basis risk in a hedging strategy describes the how much risk is left behind due to imperfect correlation between the two investments. </li></ul><ul><li>Basis risk in subprime RMBS portfolios generally arises from: </li></ul><ul><ul><li>Performance differences in the underlying portfolio assets </li></ul></ul><ul><ul><li>Structural differences in portfolio instruments </li></ul></ul><ul><ul><li>Liquidity differences in the different secondary markets </li></ul></ul><ul><ul><li>Timing of expected cash flows from the portfolio instruments </li></ul></ul>www.derivativefitch.com
  5. 5. Why is “basis” between these structures important now? <ul><li>Standard tranches of the ABX.HE Index commenced trading on Feb. 14, 2007 </li></ul><ul><li>Index tranches promise to provide: </li></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Transparency </li></ul></ul><ul><ul><li>Standardization </li></ul></ul><ul><ul><li>Market Consensus </li></ul></ul><ul><li>Motivations for TABX participation: </li></ul><ul><ul><li>Hedging </li></ul></ul><ul><ul><li>Relative Value Trading </li></ul></ul><ul><ul><li>Benchmarking </li></ul></ul><ul><ul><li>Leveraged Market Positions </li></ul></ul>www.derivativefitch.com
  6. 6. Framework for Understanding Basis Risk in Subprime RMBS Portfolios <ul><li>Subprime RMBS 101 </li></ul><ul><li>Credit Default Swaps on Subprime RMBS </li></ul><ul><ul><li>Credit Default Swaps 101 </li></ul></ul><ul><ul><li>ISDA Pay-As-You-Go Template 101 </li></ul></ul><ul><ul><li>Subprime RMBS AFC Risk </li></ul></ul><ul><li>Typical Subprime RMBS Portfolio Structures </li></ul><ul><ul><li>Structured Finance CDOs 101 </li></ul></ul><ul><ul><li>ABX.HE and TABX.HE Indices 101 </li></ul></ul><ul><li>Basis Risk between TABX.HE and Other Structures </li></ul>www.derivativefitch.com
  7. 7. Subprime RMBS Overview Subprime RMBS 101
  8. 8. Subprime RMBS 101 <ul><li>Typical Subprime Borrower and Loan Characteristics </li></ul><ul><ul><li>FICO credit score 650 and below </li></ul></ul><ul><ul><li>Prior mortgage delinquencies are acceptable </li></ul></ul><ul><ul><li>Bankruptcy filing within the last 3 to 5 years are acceptable </li></ul></ul><ul><ul><li>Foreclosure within the last 3 to 5 years are acceptable </li></ul></ul><ul><ul><li>Debt-to-Income (DTI) ratios of 40% or higher </li></ul></ul><ul><ul><li>Loan-to-Value (LTV) ratios greater than 80% </li></ul></ul>www.derivativefitch.com
  9. 9. Subprime RMBS 101 <ul><li>Typical Subprime Loan Types </li></ul><ul><ul><li>Hybrid Adjustable-Rate Mortgages (ARMs) </li></ul></ul><ul><ul><ul><li>2/28 Mortgage is fixed for the first two years and then switches to adjustable rate for the remaining 28 years </li></ul></ul></ul><ul><ul><ul><li>Other common Hybrid ARMs 3/27 and 5/25 terms </li></ul></ul></ul><ul><ul><li>Hybrid Interest Only (IO) ARMs </li></ul></ul><ul><ul><li>40-Year Hybrid ARMs </li></ul></ul><ul><ul><li>Piggyback Second Liens </li></ul></ul><ul><ul><li>Limited Documentation Loan Programs </li></ul></ul>www.derivativefitch.com
  10. 10. Subprime RMBS 101 <ul><li>Sample Subprime RMBS Structure </li></ul>www.derivativefitch.com 2/28 Hybrid ARM Mortgage Pool Fixed Rate Mortgage ‘ AAA’ RMBS Mortgage Pools ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS Bonds Special Purpose Vehicle (RMBS Trust) REMIC Trust Individual Mortgages M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 M31 M32 M33 M34 M35 M36 M37 M38 M39 M40 M41 M42 M43 M44 M45 M46 M47 M48 M49 M50 M51 M52 M53 M54 M55 M56 M57 M58 M59 M60 M61 M62 M63 M64 M65 M66 M67 M68 M69 M70 M71 M72 M73 M74 M75 M76 M77 M78 . . . M 2000 M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 M31 M32 M33 M34 M35 M36 M37 M38 . . . M 1000
  11. 11. Subprime RMBS 101 <ul><li>Sample Subprime RMBS Payments </li></ul>www.derivativefitch.com Interest Scheduled Principal & Prepayments ‘ AAA’ L + % or Net WAC Accounts ‘ AA’ L + % or Net WAC ‘ A’ L + % or Net WAC ‘ BBB’ L + % or Net WAC ‘ BBB-’ L + % or Net WAC Residual Excess Interest Servicer REMIC Trust Monthly Mortgage Payments M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 M31 M32 M33 M34 M35 M36 M37 M38 M39 M40 M41 M42 M43 M44 M45 M46 M47 M48 M49 M50 M51 M52 M53 M54 M55 M56 M57 M58 M59 M60 M61 M62 M63 M64 M65 M66 M67 M68 M69 M70 M71 M72 M73 M74 M75 M76 M77 M78 . . . M 2000 M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 M31 M32 M33 M34 M35 M36 M37 M38 . . . M 1000 $ $ $ P $ I Interest Payments Principal Payments ‘ AAA’ ‘ AA’ ‘ A’ ‘ BBB’ ‘ BBB-’ Residual $ I $ P Scheduled Principal & Prepayments
  12. 12. Subprime RMBS 101 <ul><li>Standard Structural Features of Subprime RMBS </li></ul><ul><ul><li>Subordination serves as credit enhancement to account for credit risk </li></ul></ul><ul><ul><li>Interest rate instruments to hedge interest rate risk </li></ul></ul><ul><ul><li>Performance test at three year mark </li></ul></ul><ul><ul><ul><li>If test fails then the priority of payments remains unchanged with the senior notes receiving all principal proceeds </li></ul></ul></ul><ul><ul><ul><li>If test passes then principal proceeds repays subordinated notes until targeted subordination is met. </li></ul></ul></ul><ul><ul><li>Defaulted loans worked out by servicers </li></ul></ul><ul><li>Each Subprime RMBS will have somewhat unique performance profiles </li></ul>www.derivativefitch.com
  13. 13. Subprime RMBS 101 <ul><li>Principal Waterfalls </li></ul><ul><ul><li>Sequential pay </li></ul></ul><ul><ul><ul><li>All scheduled principal and prepayments go to repay the senior bond holders first until paid-in-full, then to the next senior note holder, etc. </li></ul></ul></ul><ul><ul><ul><li>Subprime RBMS are initially sequential pay for the first three years and will remain sequential pay if the performance tests fail </li></ul></ul></ul><ul><ul><li>Credit Enhancement (CE) “Step Downs”, if performance tests pass </li></ul></ul><ul><ul><ul><li>If overcollateralization (OC) targets have been met, the CE is stepped down by repaying subordinate bond holders. </li></ul></ul></ul><ul><ul><ul><li>OC targets are set to double the original subordination, ie. If the original ‘AAA’ bond subordination is 7.5% then the target is 15% </li></ul></ul></ul><ul><ul><ul><li>Test senior note target for compliance first and if passing then check the next senior bond and so on. </li></ul></ul></ul><ul><ul><ul><li>Over periods of rapid prepayments all bonds may be meeting the OC targets, then principal prepayments become inverse sequential pay. </li></ul></ul></ul>www.derivativefitch.com
  14. 14. Sample Principal Waterfalls www.derivativefitch.com Scheduled Principal & Prepayments Accounts Principal Payments ‘ AAA’ ‘ AA’ ‘ A’ ‘ BBB’ ‘ BBB-’ Residual $ P Payments Before Step Down Scenario 1: Sequential Principal Repayment Scheduled Principal & Prepayments Accounts Principal Payments ‘ AAA’ ‘ AA’ ‘ A’ ‘ BBB’ ‘ BBB-’ Residual $ P Scenario 2: Performance Test Passes the Credit Enhancement “Steps Down” by Paying Principal to Subordinated Notes After Step Down Payments Before Step Down After Step Down
  15. 15. Subprime RMBS 101 <ul><li>Interest Waterfalls </li></ul><ul><ul><li>Regular interest </li></ul></ul><ul><ul><ul><li>Paid sequentially to bonds, capped at weighted average mortgage rate net of expenses (Net WAC) or available funds cap (AFC) </li></ul></ul></ul><ul><ul><li>Excess Interest </li></ul></ul><ul><ul><ul><li>Excess interest is the remaining interest proceeds in the interest collection account after paying bondholders regular interest above </li></ul></ul></ul><ul><ul><ul><li>First, excess interest is used to recover realized collateral losses </li></ul></ul></ul><ul><ul><ul><li>Second, excess interest is used to recover any interest shortfalls created where Net WAC is lower than the stated bond coupon </li></ul></ul></ul><ul><ul><ul><li>Finally, the remaining excess interest goes to the residual bond holder </li></ul></ul></ul>www.derivativefitch.com
  16. 16. Sample RMBS Interest Waterfall www.derivativefitch.com Interest ‘ AAA’ L + % or Net WAC Accounts ‘ AA’ L + % or Net WAC ‘ A’ L + % or Net WAC ‘ BBB’ L + % or Net WAC ‘ BBB-’ L + % or Net WAC Residual Excess Interest Interest Payments Principal Payments ‘ AAA’ ‘ AA’ ‘ A’ ‘ BBB’ ‘ BBB-’ Residual $ I Scheduled Principal & Prepayments Losses Interest Shortfalls L + % - Net WAC Step 1 – Interest Paid Sequentially to Bonds, Capped at AFC L + % - Net WAC Step 2 – Excess Interest to Cover Collateral Losses Step 3 – Remaining Excess Interest to Pay AFC Shortfalls Step 4 – Remaining Excess Interest to Residual Holder
  17. 17. Subprime RMBS 101 <ul><li>AFC Interest Shortfall </li></ul><ul><ul><li>AFC Shortfall is the difference between the stated bond coupon and the Net WAC </li></ul></ul><ul><ul><li>AFC Shortfalls accrue over time and may be recoverable </li></ul></ul><ul><ul><li>AFC Shortfalls manifest themselves in times of rising interest rates </li></ul></ul><ul><ul><ul><li>Typical subprime RMBS deals have 75% hybrid ARM mortgages </li></ul></ul></ul><ul><ul><ul><li>RMBS bonds are generally floating rate bonds based on the London InterBank Offering Rate (LIBOR) </li></ul></ul></ul><ul><ul><ul><li>If short-term LIBOR interest rates rise during the 2- or 3-year fixed rate period then the interest coupon from the mortgages is insufficient to pay the RMBS bond holders LIBOR plus the stated spread </li></ul></ul></ul><ul><ul><li>AFC shortfalls may be unrecoverable if excess interest is eroded. </li></ul></ul>www.derivativefitch.com
  18. 18. Credit Default Swaps on Subprime RMBS Credit Default Swaps (CDS) 101 ISDA Pay-As-You-Go (PAUG) Template 101 Subprime RMBS AFC Risk
  19. 19. Credit Default Swaps 101 <ul><li>Protection Seller </li></ul><ul><ul><li>Receives CDS premium payment and reimbursement payments in exchange for providing protection payments if a credit event occurs. </li></ul></ul><ul><ul><li>CDO note holders are protection sellers in a synthetic CDO. </li></ul></ul><ul><li>Protection Buyer </li></ul><ul><ul><li>Pays CDS premium in exchange for protection payments if a credit event occurs. </li></ul></ul><ul><ul><li>CDS Swap Counterparty is the protection buyer in a synthetic CDO. </li></ul></ul><ul><li>Calculation Agent </li></ul><ul><ul><li>Determines the amount of the protection payment upon a credit event per the terms of the credit default swap </li></ul></ul><ul><ul><li>Usually the Protection Buyer serves this role </li></ul></ul>www.derivativefitch.com
  20. 20. Credit Default Swaps 101 <ul><li>Collateral or Eligible Investment </li></ul><ul><ul><li>Highly rated, highly liquid financial instruments purchased from the sales proceeds of the initial CDO notes. </li></ul></ul><ul><ul><li>Provides the index portion of the note coupon </li></ul></ul><ul><ul><li>Provides protection payments or the return of principal to note holders </li></ul></ul><ul><li>Reference Entity and Reference Obligation </li></ul><ul><ul><li>Reference entities are security issuers like a corporation or sovereign </li></ul></ul><ul><ul><li>Reference obligations are securities with specific debt seniority levels </li></ul></ul><ul><ul><ul><li>Reference obligations in a corporate CDS is usually informational to establish the seniority of debt to be valued if a credit event occurs </li></ul></ul></ul><ul><ul><ul><li>Reference obligations in CDS of structured finance assets or leveraged loans or in total return swap structures </li></ul></ul></ul>www.derivativefitch.com
  21. 21. Credit Default Swaps 101 <ul><li>Sample Credit-Linked Note (CLN) using a CDS </li></ul>www.derivativefitch.com Credit-Linked Note Trust CDS Premium (bps) Credit Default Swap Protection Seller CDS Swap Counterparty Protection Payments ($) Note Coupon (L + bps) Protection Buyer Protection Seller CLN Proceeds ($) Collateral or Eligible Investments Reference Entity or Obligation CLN Proceeds ($) LIBOR (L)
  22. 22. Credit Default Swaps 101 <ul><li>Credit Events </li></ul><ul><ul><li>Applicable credit events will vary by CDS </li></ul></ul><ul><ul><li>Typical credit events may include: </li></ul></ul><ul><ul><ul><li>Bankruptcy </li></ul></ul></ul><ul><ul><ul><li>Failure to Pay (FTP) </li></ul></ul></ul><ul><ul><ul><li>Restructuring </li></ul></ul></ul><ul><ul><ul><li>Repudiation/Moratorium, usually emerging markets and sovereigns only </li></ul></ul></ul><ul><ul><ul><li>Obligation Acceleration, usually emerging markets sovereigns only </li></ul></ul></ul><ul><ul><li>Once a credit event has been called and settled then the credit default swap is terminated </li></ul></ul>www.derivativefitch.com
  23. 23. Credit Default Swaps 101 <ul><li>Settlement and Valuation Procedures </li></ul><ul><ul><li>Protection Buyer calls a credit event by sending notice to the Protection Seller what credit event has occurred </li></ul></ul><ul><ul><li>Settlement method is determined by the CDS contract </li></ul></ul><ul><ul><ul><li>Physical settlement means the Protection Buyer gives the Seller the reference obligation, or equivalent, in return for cash par amount </li></ul></ul></ul><ul><ul><ul><li>Cash settlement means the parties look to the market value of the reference obligation to determine the net protection payment </li></ul></ul></ul><ul><ul><li>Fitch’s preferred valuation process includes: </li></ul></ul><ul><ul><ul><li>Dealer poll of at least 5 dealers, not including the Protection Buyer </li></ul></ul></ul><ul><ul><ul><li>Polls typically held 30 to 60 days after credit event notification </li></ul></ul></ul>www.derivativefitch.com
  24. 24. ISDA Pay-As-You-Go (PAUG) Template 101 <ul><li>ISDA PAUG template is designed to replicate the cash flow profile of the cash bond with a credit default swap (CDS) contract </li></ul><ul><li>CDS contracts for corporate and sovereign issuers are insufficient to replicate the payment profile of a structured finance bond </li></ul><ul><li>ISDA PAUG template was introduced in the U.S. in XXXX 2005 for RMBS and CMBS securities for CDO securities in June 2006 </li></ul><ul><li>Introduces the concept of “floating payments” </li></ul><ul><ul><li>Floating payments are paid by the Protection Seller in the event of an AFC Interest Shortfall </li></ul></ul><ul><ul><li>Floating payments may be reimbursed by the Protection Buyer if the AFC Interest Shortfall is ultimately recovered </li></ul></ul>www.derivativefitch.com
  25. 25. ISDA Pay-As-You-Go (PAUG) Template 101 <ul><li>Sample CLN using a PAUG CDS </li></ul>www.derivativefitch.com Credit-Linked Note Trust CDS Premium (bps) Credit Default Swap Protection Seller CDS Swap Counterparty Protection Payments ($) Note Coupon (L + bps) Protection Buyer Protection Seller CLN Proceeds ($) Collateral or Eligible Investments Reference Obligation CLN Proceeds ($) LIBOR (L) Floating Payments
  26. 26. ISDA Pay-As-You-Go (PAUG) Template 101 <ul><li>PAUG Credit Events </li></ul><ul><ul><li>Failure to Pay (FTP) Principal </li></ul></ul><ul><ul><li>Writedown </li></ul></ul><ul><ul><li>Distressed Rating Downgrade (‘CCC’ or below) </li></ul></ul><ul><ul><li>FTP Interest for CDO reference obligations only </li></ul></ul><ul><li>PAUG Floating Amount Events </li></ul><ul><ul><li>Interest Shortfalls </li></ul></ul><ul><ul><li>Principal Shortfalls </li></ul></ul><ul><ul><li>Writedown Amounts </li></ul></ul><ul><li>Protection Buyers typically have an option whether to call a credit event or a floating amount event </li></ul>www.derivativefitch.com
  27. 27. ISDA Pay-As-You-Go (PAUG) Template 101 <ul><li>PAUG Settlement </li></ul><ul><ul><li>The secondary market for structured finance securities is not liquid and therefore valuation procedures are not applicable </li></ul></ul><ul><ul><li>Floating payments are designed to replicate the actual loss amounts </li></ul></ul><ul><ul><li>If a credit event occurs then the Protection Buyer has the option to physically deliver all or part of the notional amount to the Seller </li></ul></ul><ul><ul><ul><li>If the entire notional is physically settled then the CDS is terminated </li></ul></ul></ul><ul><ul><ul><li>If a portion of the notional is settled then the CDS continues on the remaining amount </li></ul></ul></ul>www.derivativefitch.com
  28. 28. ISDA Pay-As-You-Go (PAUG) Template 101 <ul><li>Interest Shortfalls </li></ul><ul><ul><li>RMBS reference obligations are called AFC shortfalls </li></ul></ul><ul><ul><li>CMBS reference obligations are called WAC shortfalls </li></ul></ul><ul><ul><li>CDO reference obligations are called PIK-ing shortfalls </li></ul></ul><ul><li>Interest Shortfall Cap Options </li></ul><ul><ul><li>Fixed Cap: Floating payments are limited to the amount of the CDS premium </li></ul></ul><ul><ul><li>Variable Cap: Floating payment are limited to LIBOR + premium </li></ul></ul><ul><ul><li>No Cap: No limit to the floating rate payments </li></ul></ul><ul><ul><ul><li>Completely replicates the payments of the cash bond or total return swap </li></ul></ul></ul><ul><ul><ul><li>May require principal to be liquidated to pay interest shortfall </li></ul></ul></ul>www.derivativefitch.com
  29. 29. Subprime RMBS AFC Risk <ul><li>Available Funds Cap (AFC) Risk </li></ul><ul><ul><li>REMIC law limits a floating rate RMBS bond pass-through rate to the lesser of: </li></ul></ul><ul><ul><ul><li>Bond spread plus some index (typically 1 month LIBOR), or </li></ul></ul></ul><ul><ul><ul><li>Underlying mortgage collateral pool’s weighted average coupon, net of expenses (Net WAC). </li></ul></ul></ul><ul><ul><li>AFC Risk varies by RMBS transaction based on: </li></ul></ul><ul><ul><ul><li>Actual prepayment speeds of underlying mortgages </li></ul></ul></ul><ul><ul><ul><li>Effectiveness of interest rate hedges in the RMBS structure </li></ul></ul></ul><ul><ul><ul><li>Short-term interest rate increases before Hybrid ARM mortgages switch to floating interest rate payments </li></ul></ul></ul>www.derivativefitch.com
  30. 30. Subprime RMBS AFC Risk www.derivativefitch.com <ul><li>Unrecovered AFC Interest Shortfalls can be prevalent by vintage </li></ul><ul><li>Unrecovered AFC Interest Shortfalls can be present across all rating categories </li></ul>
  31. 31. Key Risks – AFC Risk www.derivativefitch.com <ul><li>Unrecovered AFC Interest Shortfall amounts have been small </li></ul><ul><li>Difference in CDS premium required for No Cap protection may exceed the actual unrecovered AFC interest shortfalls experience in the cash bond market </li></ul>
  32. 32. Subprime RMBS Portfolio Structures Structured Finance CDOs 101 ABX.HE and TABX.HE 101
  33. 33. Structured Finance CDOs 101 <ul><li>Generic Types of SF CDOs </li></ul><ul><ul><li>Cash SF CDOs </li></ul></ul><ul><ul><li>Bespoke SF CDOs </li></ul></ul><ul><ul><li>Hybrid SF CDOs </li></ul></ul>www.derivativefitch.com
  34. 34. Structured Finance CDOs 101 <ul><li>Sample Cash SF CDO Structure </li></ul>www.derivativefitch.com ‘ AAA’ CDO ‘ AA’ CDO ‘ A’ CDO ‘ BBB’ CDO Preferred Shares or Equity CDO Bonds Special Purpose Vehicle (CDO Trust) CDO Trust CDO Portfolio CDO Bond 1 CDO Bond 3 CDO Bond 4 CDO Bond 5 CDO Bond 2 RMBS Bond 1 RMBS Bond 3 RMBS Bond 4 RMBS Bond 5 RMBS Bond 2 RMBS Bond 6 RMBS Bond 8 RMBS Bond 9 RMBS Bond 10 RMBS Bond 7 RMBS Bond 11 RMBS Bond 13 RMBS Bond 14 RMBS Bond 15 RMBS Bond 12 RMBS Bond 16 RMBS Bond 18 RMBS Bond 19 RMBS Bond 20 RMBS Bond 17 RMBS Bond 21 RMBS Bond 23 RMBS Bond 24 RMBS Bond 25 RMBS Bond 22 RMBS Bond 26 RMBS Bond 28 RMBS Bond 29 RMBS Bond 30 RMBS Bond 27 RMBS Bond 31 RMBS Bond 33 RMBS Bond 34 RMBS Bond 35 RMBS Bond 32 RMBS Bond 36 RMBS Bond 38 RMBS Bond 80 RMBS Bond 37 . . . CDO Bond 6 CDO Bond 8 CDO Bond 9 CDO Bond 10 CDO Bond 7 Note Coupon (L + bps) Proceeds ($) Bond Coupons (L + bps) Proceeds ($)
  35. 35. Structured Finance CDOs 101 <ul><li>Cash SF CDO Asset Portfolio Highlights </li></ul><ul><ul><li>Portfolios contain between 60 and 140 bonds </li></ul></ul><ul><ul><li>Assets may be diversified by market sector, however recent vintage SF CDOs have been concentrated in subprime RMBS </li></ul></ul><ul><ul><li>Assets may be diversified by risk profile (intial ratings) </li></ul></ul><ul><ul><li>Assets may be diversified by vintage </li></ul></ul><ul><ul><li>Asset acquisition and selection </li></ul></ul><ul><ul><ul><li>Asset manager warehouses bonds prior to issuing CDO notes </li></ul></ul></ul><ul><ul><ul><li>CDO notes typically issued when asset manager has accumulated approximately 60-80% of the target portfolio </li></ul></ul></ul><ul><ul><ul><li>Initial portfolio is typically fully ramped within 6 months of CDO note issuance </li></ul></ul></ul>www.derivativefitch.com
  36. 36. Structured Finance CDOs 101 <ul><li>Managed vs Static Portfolios </li></ul><ul><ul><li>Static portfolios are typically fully ramped at closing and principal proceeds are used to amortize the senior notes </li></ul></ul><ul><ul><li>Managed portfolios are typically partially ramped at closing and principal proceeds are typically reinvested for a finite period between 3 and 6 years </li></ul></ul><ul><ul><ul><li>If the portfolio experiences negative credit migration then discretionary trading is limited to “maintain or improve” credit quality </li></ul></ul></ul><ul><ul><ul><li>If the portfolio significantly under performs then the transactions may shift to a static portfolio </li></ul></ul></ul>www.derivativefitch.com
  37. 37. Structured Finance CDOs 101 <ul><li>Cash SF CDO Note Highlights </li></ul><ul><ul><li>Credit enhancement comes from subordination and excess spread </li></ul></ul><ul><ul><li>Interest is paid sequentially to note holders </li></ul></ul><ul><ul><li>Overcollateralization (OC) and Interest Coverage (IC) performance tests are checked prior to distributions to subordinate notes </li></ul></ul><ul><ul><li>Excess interest may be used to: </li></ul></ul><ul><ul><ul><li>If tests are passing then distributed to Preferred Shares or Equity </li></ul></ul></ul><ul><ul><ul><li>A portion may be used to repay mezzanine notes </li></ul></ul></ul><ul><ul><ul><li>If tests are failing then distributions may be used to cure the tests </li></ul></ul></ul><ul><ul><ul><ul><li>Purchase new assets </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Pay down senior notes </li></ul></ul></ul></ul>www.derivativefitch.com
  38. 38. Structured Finance CDOs 101 <ul><li>Sample Bespoke SF CDO Structure </li></ul>www.derivativefitch.com Unfunded Super-Senior Revolver First Loss CDO Structure Special Purpose Vehicle (CDO Trust) CDO Trust Reference Portfolio CDS Premium Protection Payments ‘ AAA’ Note Proceeds ($) Unfunded CDS Unfunded CDS Note Coupon (L + bps) Collateral or Eligible Investments Proceeds ($) LIBOR (L) RMBS Bond 1 RMBS Bond 3 RMBS Bond 4 RMBS Bond 5 RMBS Bond 2 RMBS Bond 6 RMBS Bond 8 RMBS Bond 9 RMBS Bond 10 RMBS Bond 7 RMBS Bond 11 RMBS Bond 13 RMBS Bond 14 RMBS Bond 15 RMBS Bond 12 RMBS Bond 16 RMBS Bond 18 RMBS Bond 19 RMBS Bond 20 RMBS Bond 17 RMBS Bond 21 RMBS Bond 23 RMBS Bond 24 RMBS Bond 25 RMBS Bond 22 RMBS Bond 26 RMBS Bond 28 RMBS Bond 29 RMBS Bond 30 RMBS Bond 27 RMBS Bond 31 RMBS Bond 33 RMBS Bond 34 RMBS Bond 35 RMBS Bond 32 RMBS Bond 36 RMBS Bond 38 RMBS Bond 80 RMBS Bond 37 . . . CDS Swap Counterparty
  39. 39. Structured Finance CDOs 101 <ul><li>Bespoke SF CDO Asset Portfolio Highlights </li></ul><ul><ul><li>Portfolios reference between 60 and 100 securities </li></ul></ul><ul><ul><li>Assets may be diversified by market sector but typically have a concentration in subprime RMBS </li></ul></ul><ul><ul><li>Assets may be diversified by risk profile (initial ratings </li></ul></ul><ul><ul><li>Assets may be diversified by vintage </li></ul></ul><ul><ul><li>Asset selection </li></ul></ul><ul><ul><ul><li>Portfolio is negotiated between the Bespoke CDO note holder and the CDS Swap counterparty </li></ul></ul></ul>www.derivativefitch.com
  40. 40. Structured Finance CDOs 101 <ul><li>Bespoke SF CDO Note Highlights </li></ul><ul><ul><li>Attachment points define the amount of portfolio losses the structure needs to sustain before a protection payment would be made </li></ul></ul><ul><ul><li>Detachment point defines the maximum amount of protection payments that the notes could be required to make </li></ul></ul><ul><ul><li>Credit enhancement comes solely from subordination </li></ul></ul>www.derivativefitch.com
  41. 41. Structured Finance CDOs 101 <ul><li>Sample Hybrid SF CDO Structure </li></ul>www.derivativefitch.com Unfunded Super-Senior Revolver ‘ AA’ CDO ‘ A’ CDO ‘ BBB’ CDO Preferred Shares or Equity CDO Structure Special Purpose Vehicle (CDO Trust) CDO Trust CDS Portfolio CDO CDS 1 CDO CDS 3 CDO CDS 4 CDO CDS 5 CDO CDS 2 RMBS CDS 1 RMBS CDS 3 RMBS CDS 4 RMBS CDS 5 RMBS CDS 2 RMBS CDS 6 RMBS CDS 8 RMBS CDS 9 RMBS CDS 10 RMBS CDS 7 RMBS CDS 11 RMBS CDS 13 RMBS CDS 14 RMBS Bond 15 RMBS CDS 12 RMBS CDS 16 RMBS CDS 18 RMBS CDS 20 RMBS CDS 17 . . . Bond Portfolio CDO Bond 1 CDO Bond 3 CDO Bond 4 CDO Bond 5 CDO Bond 2 RMBS Bond 1 RMBS Bond 3 RMBS Bond 4 RMBS Bond 5 RMBS Bond 2 RMBS Bond 6 RMBS Bond 8 RMBS Bond 9 RMBS Bond 10 RMBS Bond 7 RMBS Bond 11 RMBS Bond 13 RMBS Bond 14 RMBS Bond 15 RMBS Bond 12 RMBS Bond 16 RMBS Bond 18 RMBS Bond 20 RMBS Bond 17 . . . Bond Coupons (L + bps) Proceeds ($) CDS Premium Protection Payments ‘ AAA’ CDO Note Coupon (L + bps) Proceeds ($) Funded Notes Unfunded CDS CDS Premium Super-Senior Protection Payments
  42. 42. Structured Finance CDOs 101 <ul><li>Hybrid SF CDO Asset Portfolio Highlights </li></ul><ul><ul><li>Portfolio assets may be in a cash or synthetic form </li></ul></ul><ul><ul><li>Portfolios contain between 60 and 140 bonds or CDS </li></ul></ul><ul><ul><li>Asset attributes similar to the cash SF CDO portfolios </li></ul></ul><ul><ul><li>Portfolios are typically managed </li></ul></ul><ul><ul><ul><li>Asset managers can find relative value on the same asset between cash and synthetic markets </li></ul></ul></ul><ul><ul><ul><li>Asset managers can use the synthetic market to access collateral from vintages that are not available in the secondary market </li></ul></ul></ul><ul><ul><ul><li>Asset managers can use the synthetic market to get full exposure to cash bonds where they received a partial allocation </li></ul></ul></ul>www.derivativefitch.com
  43. 43. ABX.HE and TABX.HE Indices 101 www.derivativefitch.com ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 1 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 2 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 3 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 4 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 5 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 6 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 7 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 8 ABX.HE.AAA ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 9 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 10 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 20 ‘ AAA’ RMBS ‘ AA’ RMBS ‘ A’ RMBS ‘ BBB’ RMBS ‘ BBB-’ RMBS Residual RMBS 11 . . . . . . . . . . . . . . . . . . . . . ABX.HE.AA ABX.HE.A ABX.HE.BBB ABX.HE.BBB-
  44. 44. ABX.HE and TABX.HE Indices 101 <ul><li>ABX.HE Asset Portfolio Highlights </li></ul><ul><ul><li>Portfolios reference 20 bonds </li></ul></ul><ul><ul><li>Assets are all subprime RMBS </li></ul></ul><ul><ul><li>Assets are homogenous by risk profile (intial ratings) </li></ul></ul><ul><ul><li>Assets are originated in a 6 month time frame </li></ul></ul><ul><ul><li>Asset selection </li></ul></ul><ul><ul><ul><li>Aggregate a list of the largest volume subprime RMBS issuers </li></ul></ul></ul><ul><ul><ul><li>Select two representative transactions from each issuer </li></ul></ul></ul><ul><ul><ul><li>Index participants vote on transactions to be included in each index </li></ul></ul></ul>www.derivativefitch.com
  45. 45. ABX.HE and TABX.HE Indices 101 www.derivativefitch.com ‘ BBB’ RMBS 1 ‘ BBB’ RMBS 20 TABX.HE.BBB Reference Obligations ‘ BBB’ RMBS 2 ‘ BBB’ RMBS 3 ‘ BBB’ RMBS 4 ‘ BBB’ RMBS 5 ‘ BBB’ RMBS 6 ‘ BBB’ RMBS 7 ‘ BBB’ RMBS 8 . . . 35 – 100% 20 – 35% 12 – 20% 7 – 12% 3 – 7% 0 – 3% TABX.HE.BBB Tranches ABX.HE.BBB 06-2 Portfolio ‘ BBB’ RMBS 1 ‘ BBB’ RMBS 20 ‘ BBB’ RMBS 2 ‘ BBB’ RMBS 3 ‘ BBB’ RMBS 4 ‘ BBB’ RMBS 5 ‘ BBB’ RMBS 6 ‘ BBB’ RMBS 7 ‘ BBB’ RMBS 8 . . . ABX.HE.BBB 07-1 Portfolio
  46. 46. ABX.HE and TABX.HE Indices 101 <ul><li>TABX.HE Asset Portfolio Highlights </li></ul><ul><ul><li>Portfolios reference 40 bonds from two ABX.HE indices </li></ul></ul><ul><ul><li>Assets are all subprime RMBS </li></ul></ul><ul><ul><li>Assets are homogenous by risk profile (intial ratings) </li></ul></ul><ul><ul><li>Assets are originated in a one year time frame </li></ul></ul>www.derivativefitch.com
  47. 47. Conclusions
  48. 48. ABX.HE and TABX.HE Conclusions <ul><li>The ABX.HE has proven to be effective in providing market transparency in an otherwise opaque market </li></ul><ul><ul><li>Allows market participant to express market views </li></ul></ul><ul><li>The TABX.HE promises to provide similar benchmarking and relative value views for the Bespoke SF CDO market </li></ul><ul><li>TABX.HE will be less effective in benchmarking for cash and hybrid SF CDOs </li></ul><ul><ul><li>Portfolios have significantly different portfolio characteristics </li></ul></ul><ul><ul><li>Portfolios are typically managed in SF CDOs </li></ul></ul><ul><ul><li>TABX.HE is equally weighted by the largest issuers whereby SF CDOs portfolios are typically selected by an asset manager </li></ul></ul>www.derivativefitch.com
  49. 49. www.derivativefitch.com New York One State Street Plaza New York, NY 10004 Tel. +1 212 908 0500 London 101 Finsbury Pavement London EC2A 1RS Tel. +44 (0) 20 7862 4000 Hong Kong Suite 3902, Tower Two, Lippo Centre 89 Queensway, Hong Kong Tel. +852 2263 9963

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