Chapter 14 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),
Principal, Structured Products Analytics, 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
 Appendices

Illiquid secondary market
of credit risky debts
 Mis-match of demand and supply
 High demand on high quality debts
 Limited supply on 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

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

Cash flow re-distribution

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
 Appendices

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

Tranching
 Ultra senior tranche
 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 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 100 mn principal of a hypothetical
homogeneous debt portfolio with LGD, maturity, interest rate, interest payment days,
attachment point and detachment point 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
Reference
portfolio
Portfolio principal + No +
LGD - Moderate +
PD - Material +
RM -
Decreasing
gradually
+
CCC
+ for smaller
attachment point
- for larger
attachment point
Moderate
- for smaller
attachment point
+ for larger
attachment point
Tranche Attachment point +* Mild -
Detachment point + No +
CDO Interest rate + No +
* Subject to a fixed tranche thickness

Credit risk
 Neither EL, one-year EL nor WCL serves as a
valid credit risk measure
 EL, one-year EL and WCL fail to incorporate
the effect from attachment and detachment
points

Functional purpose
 Broadening of credit market
 Producing higher quality debts from lower quality raw
material
 Credit risk mitigation
 Selling debt portfolio to other investors
 Balance sheet CDO
 Diversification arbitrage
 Pocketing price-cost differential though specific risk
reduction
 Arbitrage CDO
Example 14.1

Outline
 CDO rating
 Appendices

Agency 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.

Agency 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.

Agency 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
 Appendices

Universal credit risk measure
 [Expected loss, Loss standard deviation] = [EL, LSD]
 For a single debt
 For a homogenous debt portfolio with one-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 14.2

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

Chapter 14 collateralization debt obligations

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