14.2 collateralization debt obligations

Copyright © 2018 CapitaLogic Limited
This presentation file is prepared in accordance with
Chapter 14 of the text book
“Managing Credit Risk Under The Basel III Framework, 3rd ed”
Website : https://sites.google.com/site/crmbasel
E-mail : crmbasel@gmail.com
Chapter 14
Collateralized
Debt Obligations

Copyright © 2018 CapitaLogic Limited 2
Declaration
 Copyright © 2018 CapitaLogic Limited.
 All rights reserved. No part of this presentation file may be
reproduced, in any form or by any means, without written
permission from CapitaLogic Limited.
 Authored by Dr. LAM Yat-fai (林日辉),
Director, CapitaLogic Limited,
Adjunct Professor of Finance, City University of Hong Kong,
Doctor of Business Administration,
CFA, CAIA, CAMS, FRM, PRM.

Outline
 Credit securitization
 Characteristics of CDO
 CDO rating
 CDO assessment
 CDO design
 Appendices

Illiquid secondary market
of credit risky debts
 Mis-match of demand and supply
 High demand on high quality debts
 Limited supply of high quality debts
 Information asymmetry
 Owner with more understanding demands a
higher ask price
 Investor with less understanding offers a lower
bid price

Cash flow CDOs
Debt 1
Debt 2
Debt 3

Debt N
Principal =
USD100 mn
SPE
Ultra senior tranche
Principal = USD 40 mn
Senior tranche
Mezzanine tranche
Equity tranche
Example 14.1

Cash waterfall
 Cash inflows (interests and principal) are collected from a
debt portfolio
 Cash is first paid to the ultra senior tranche as much as
possible according to the specifications of the ultra senior
tranche
 If residual cash is available, then paid to the senior tranche as
much as possible according to the specifications of the senor
tranche
 If residual cash is available, then paid to the mezzanine
tranche as much as possible according to the specifications of
the subordinated tranche
 If residual cash is available, then paid to the equity tranche
according to the specifications of the equity tranche

Cash waterfall
Equity tranche
Mezzanine tranche
Cash inflows from
debt portfolio
Senior tranche
Example 14.2

Cash flow re-distribution

Default of the portfolio principal
 The portfolio principal is reduced
 The interest will only be generated from the
survival portfolio principal
 The amount recovered from the defaulted
portfolio principal will be returned to the ultra
senior tranche and result a deduction of the
principal of the ultra senior tranche.

Credit risk re-distribution

Cash flow CDOs issued under SPE
 An investment bank, e.g. HSBC
 Establishes a SPE independent of HSBC
 Grants a short term loan to the SPE
 The SPE
 Purchases a largely homogeneous debt portfolio with USD 100 mn principal
 Creates a family of several CDO tranches with different risk-return characteristics
 Divides each CDO tranche into 1,000 notes and sells to many investors
 Uses the proceeds from selling the notes to settle the short term loan
 HSBC, as an agent, charges commission on selling the notes of CDO
tranches to many individual investors
 SPE, a liabilities free shell company, has no credit risk
 Individual investors subject to systematic credit risk of the homogeneous
debt portfolio

Outline
 CDO rating
 CDO assessment
 CDO design
 Appendices

Tranching
 Portfolio attachment point (PAP)
 The percentage of defaulted portfolio principal from which the CDO
tranche starts to suffer from loss
 Portfolio detachment point (PDP)
 The percentage of defaulted portfolio principal starting from which
the CDO tranche will suffer from total loss
 Thickness = PDP - PAP
 Equity tranche
 0% PAP
 Ultra senior tranche
 100% PAP and no PDP

Tranching
 Tranche attachment point (TAP)
 The percentage of total tranche principal from which the CDO
tranche starts to suffer from loss
 TAP = PAP × LGD
 Tranche detachment point (TDP)
 The percentage of total tranche principal starting from which the
CDO tranche will suffer from total loss
 TDP = PDP × LGD
 Equity tranche
 0% TAP
 100% TDP

Tranching
 Senior tranche
 Mezzanine tranche
 Equity tranche
 Senior tranche
 Mezzanine tranche 3
 Equity tranche

Synthetic CDO
 Similar to synthetic basket CLN
 Using portfolio CDS and top quality assets to
replicate the cash flows of a CDO tranche
CDO tranche + Portfolio CDS Risk-free security
CDO tranche - Portfolio CDS + Risk-free security



Synthetic CDO
SPE Investors
Top quality
assets
Premiums
Portfolio CDS
Steady cash flows
Financial
institution
CDO tranche

Synthetic CDOs issued under a SPE
 An investment bank, e.g. HSBC
 Establishes a SPE independent of HSBC
 Grants a short term loan to the SPE
 The SPE
 Issues to HSBC a portfolio CDS with USD 1 mn principal of a hypothetical
homogeneous debt portfolio with LGD, maturity, interest rate, interest payment days,
PAP and PDP matching the requirements of investors
 Invests in USD 1 mn principal top quality assets (AAA)
 Divides the CDO tranche into 1,000 notes and sells to many investors
 Uses the proceeds from selling the notes to settle the short term loan
 HSBC, as an agent, charges commission on selling the notes of CDO
tranches to many individual investors
 SPE, a liabilities free shell company, has no credit risk
 Individual investors subject to systematic credit risk of the hypothetical
homogeneous debt portfolio

Market value CDO
 Collaterals
 Cash flow CDO – debt portfolio
 Synthetic CDO – top quality assets
 To push up the value
 Selling high
 Buying low
 Trading profit to offset default loss

Market value CDOs
Debt 1
Debt 2
Debt 3

Debt N
Principal =
USD100 mn
SPE
Senior tranche
Mezzanine tranche
Equity tranche
Active
trading
portfolio

Market value CDO
SPE Investors
Top quality
assets
Premiums
Portfolio CDS
Steady cash flows
Bank
CDO tranche
Active trading portfolio

Cash flows
 Cash outflow
 An initial amount to acquire a CDO tranche
 Cash inflows
 Tranche principal survives
 Scheduled interests and principal
 Tranche principal defaults partially
 Interests and principal in proportion
 Tranche principal defaults completely
 No interests and principal

Valuation
Category Factor Impact to value Variation Impact to
credit risk
Debt portfolio LGD - Moderate +
PD - Material +
RM -
Decreasing
gradually
+
CCC
+ for smaller PAP
- for larger PAP
Moderate
- for smaller PAP
+ for larger PAP
Tranche Principal + Decreasing +
Interest rate + No +
PAP + No -

Credit risk
 Neither EL, 1-year EL nor XCL serves as a
valid credit risk measure
 EL, 1-year EL and XCL fail to incorporate the
effect from the PAP and PDP

Functional purpose
 Broadening of credit market
 Producing higher quality debts from lower quality raw
material
 Credit risk mitigation
 Selling credit risk debts to other investors
 Balance sheet CDO
 Diversification arbitrage
 Pocketing price-cost differential though specific risk
reduction
 Arbitrage CDO
Example 14.3

Outline
 CDO rating
 CDO assessment
 CDO design
 Appendices

CDO rating (1)
Rating Description
AAA A CDO tranche rated AAA has the highest quality. The capacity of the debt
portfolio and tranche structure to meet the interests and principal to the CDO
tranche is extremely strong.
AA A CDO tranche rated AA differs from the highest rated CDO tranches only to
a small degree. The capacity of the debt portfolio and tranche structure to
meet the interests and principal to the CDO tranche is very strong.
A A CDO tranche rated A is somewhat more susceptible to the adverse effects
of changes in circumstances and economic conditions than the CDO tranches
in higher rated categories. However, the capacity of the debt portfolio and
tranche structure to meet the interests and principal to the CDO tranche is still
strong.

CDO rating (2)
Rating Description
BBB A CDO tranche rated BBB is subject to adequate protection from the debt
portfolio. However, adverse economic conditions or changing circumstances
are more likely to lead to a weakened capacity of the debt portfolio and
tranche structure to meet the interests and principal to the CDO tranche.
BB A CDO tranche rated BB is less vulnerable to violation of payment schedule
than other speculative issues. However, it faces major ongoing uncertainties
or exposure to adverse business, financial or economic conditions which
could lead to inadequate capacity of the debt portfolio and tranche structure
to meet the interests and principal to the CDO tranche.
B A CDO tranche rated B is more vulnerable to violation of payment schedule
than the CDO tranches rated BB but the debt portfolio and tranche structure
currently has the capacity to meet the interests and principal to the CDO
tranche. Adverse business, financial, or economic conditions will likely
impair the capacity of the debt portfolio to meet the interests and principal to
the CDO tranche.

CDO rating (3)
Rating Description
CCC A CDO tranche rated CCC is currently vulnerable to violation of payment
schedule, and is dependent upon favorable business, financial and economic
conditions for the debt portfolio and tranche structure to meet the interests
and principal to the CDO tranche. In the event of adverse business, financial
or economic conditions, the debt portfolio is not likely to have the capacity to
meet the interests and principal to the CDO tranche.
CC A CDO tranche rated CC is currently highly vulnerable to violation of
payment schedule.
C A C rating is assigned to a CDO tranche that is currently highly vulnerable to
violation of payment schedule or has payment arrearages allowed by the
terms of the documents.

Outline
 CDO rating
 CDO assessment
 CDO design
 Appendices

Probabilities of loss
 Probability of total loss (PTL)
 Probability of first loss (P1L)
   
   
-1 -1
-1 -1
Φ PDP 1 - CCC - Φ PD
PTL = Φ
CCC
Φ PAP 1 - CCC - Φ PD
P1L = 1- Φ
CCC
 
 
  
 
 
  

Good vs bad quality
CDO tranches
 Good quality CDO tranche
 Lower PTL and P1L
 Bad quality CDO tranche
 Higher PTL and higher P1L
 Hybrid quality CDO tranche
 Higher PTL but lower P1L

CDO quality
(%)
PTL
Below 1
Between
1 and 10
Above 10
Good Moderate Bad
P
1
L
Below 1 Good Good
Between
1 and 10
Moderate
Good
to moderate
Moderate
Above 10 Bad
Good
to bad
Moderate
to bad
Bad

PD range
Credit
rating
PD Probit Probit range PD range (%)
(%) From To From To
AAA 0.0100 -3.7190 -∞ -3.5609 0 0.0185
AA 0.0333 -3.4028 -3.5609 -3.2733 0.0185 0.0532
A 0.0834 -3.1437 -3.2733 -2.9278 0.0532 0.1707
BBB 0.3345 -2.7119 -2.9278 -2.3304 0.1707 0.9892
BB 2.5652 -1.9489 -2.3304 -1.7061 0.9892 4.3990
B 7.1682 -1.4634 -1.7061 -1.2360 4.3990 10.8225
CCC 15.6567 -1.0087 -1.2360 -0.7734 10.8225 21.9655
CC 29.5270 -0.5381 -0.7734 -0.1010 21.9655 45.9782
C 63.1597 0.3361 -0.1010 ∞ 45.9782 100
Example 14.4

Dual rating
(%)
PTL
From 0 0.0185 0.0532 0.1707
To 0.0185 0.0532 0.1707 0.9892
P
1
L
From To Rating AAA AA A BBB
0 0.0185 AAA AAA
0.0185 0.0532 AA
AAA
to AA
AA
0.0532 0.1707 A
AAA
to A
AA
to A
A
0.1707 0.9892 BBB
AAA
to BBB
AA
to BBB
A
to BBB
BBB

Preventive rating
 For an effective period T years
 
 
 
   
   
T
-1 -1
-1 -1
EDR = 1 - 1 - PD
Preventive PDP = EDR + PDP 1 - EDR
Preventive PAP = EDR + PAP 1 - EDR
Φ Preventive PDP 1 - CCC - Φ PD
PTL = 1 - Φ
CCC
Φ Preventive PAP 1 - CCC - Φ PD
P1L = 1 - Φ
CCC


 
 
  
 
 
  
Example 14.5

Preventive rating
(%)
PTL
From 0 0.0060 0.0167 0.0519
To 0.0060 0.0167 0.0519 0.2843
P
1
L
From To Rating AAA AA A BBB
0 0.0060 AAA AAA
0.0060 0.0167 AA
AAA
to AA
AA
0.0167 0.0519 A
AAA
to A
AA
to A
A
0.0519 0.2843 BBB
AAA
to BBB
AA
to BBB
A
to BBB
BBB

Outline
 CDO rating
 CDO assessment
 CDO design
 Appendices

Effective period T years
 
   
   
     
T
-1 -1
-1 -1
T T
EDR = 1 - 1 - PD
Φ PD + Φ 1 - PTL CCC
PDP = Φ
1 - CCC
Φ PD + Φ 1 - P1L CCC
PAP = Φ
1 - CCC
Preventive PDP = EDR + PDP × 1 - EDR = 1 - 1 - PD + PDP × 1 - PD
Preventive PAP = EDR + PAP × 1
 
 
  
 
 
  
     
T T
- EDR = 1 - 1 - PD + PAP × 1 - PD

AAA rated tranche
 
   
 
T
-1 -1
T
Preventive PDP = 100%
Preventive PAP = 1 - 1 - PD
Φ PD + Φ 1 - 0.0185% CCC
+ Φ
1 - CCC
× 1 - PD
 
 
  

AA rated tranche
 
   
 
 
   
 
T
-1 -1
T
T
-1 -1
T
Preventive PDP = 1 - 1 - PD
Φ PD + Φ 1 - 0.0185% CCC
+ Φ
1 - CCC
× 1 - PD
Φ PD + Φ 1 - 0.0531% CCC
+ Φ
1 - CCC
× 1 - PD
 
 
  
 
 
  

A rated tranche
 
   
 
 
   
 
T
-1 -1
T
T
-1 -1
T
Preventive PDP = 1 - 1 - PD
Φ PD + Φ 1 - 0.0531% CCC
+ Φ
1 - CCC
× 1 - PD
Φ PD + Φ 1 - 0.1707% CCC
+ Φ
1 - CCC
× 1 - PD
 
 
  
 
 
  

Re-balancing
 Default of underlying debt portfolio
 Deterioration of CDO quality
 Downgrade
 To maintain the rating
 Reducing senior tranche
 Increasing equity tranche
Example 14.6
Example 14.7
Example 14.8

Outline
 Tranche quality
 Appendices

Universal credit risk measure
 [Expected loss, Loss standard deviation] = [EL, LSD]
 For a single debt
 For a homogenous debt portfolio with 1-year RM
 For other credit instruments
 Monte Carlo simulation
 Applicable to most credit instruments
 Less practical due to two-dimensional presentation
   
RM RM
LSD = EAD × LGD × 1 - PD × 1 - 1 - PD 
 
 
  -1 -1 2 2
PD PD
2
22 - -
LSD = Portfolio EAD
1 x + y - 2xy × CCC
× LGD exp - dxdy - PD
2 1 - CCC2π 1 - CCC
 
 
 
 
  
 
Example 14.9

Credit risk measures
Credit instrument Credit risk measure
Long position Short position
(A) Simple debt
1. Single debt EL, 1-year EL
2. Debt portfolio XCL
(B) Credit default swap
3. Single name CDS
EL, 1-year EL4. Binary CDS
5. Basket CDS
6 Portfolio CDS [EL, LSD]
7. CDS index contract XCL# or [EL, LSD]
(C) Credit structuring
8. Single name CLN
EL, 1-year EL9. Basket CLN
10. Market value CLN
11. Cash flow CDO
[EL, LSD]
12. Market value CDO
# For a CDS index contract with sufficient large number of component CDSs

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