This report proposes the structure of the Alpha-97 CDO for Western Asset Management. The $386 million CDO contains six tranches ranging from AAA to equity and has an average rating of AA. It will generate an excess spread of 2.315% for equity holders. However, the CDO is exposed to prepayment, credit, and interest rate risks that require hedging and disclosure to potential investors.

1. ALPHA-97
CDO PROPOSAL
Liang Chieh Wang
Fengfeng Xia
Jing Xie
Xingyu Zhang
LEHMAN BROTHERS

2. 2
Executive Summary
This report aims to demonstrate the construction of Alpha-97 collateralized debt obligation
(CDO) for Western Asset Management Company (Western Asset) regarding its recent purchase
of corporate bonds and several commercial banks’ senior loans. The report includes the proposed
structure, return evaluation and risk assessment of CDO. Our team used information available
via our work resources, S&P rating service and other public data sets.
In representative of Lehman Brothers’ Debt Capital Markets Department, our team constructed a
CDO for Western Asset based upon 113 assets it has recently purchased from several
corporations and commercial banks. In general, Alpha-97 CDO generates an excess spread of
2.315% for equity holders and assets managers. It is $386,119,942.00 in size and has six
tranches----AAA(A-1), AAA(A-2), AA, A, B and Equity. Alpha-97 CDO has average rating of
AA (see table 1&2).
Based on records from the Sales Desk at Lehman, there is plentiful demand for the highly rated
bonds. Thus, we put 83.5% in the senior tranche of CDO, 15.06% in the junior tranche and 7% in
the equity tranche approximately. We can place all the senior and junior tranches but there is a
problem to deal with equity tranche. We have potential buyer for the residual tranche but the
prices they offered was not pleasant. Besides, there’re several risks that we need to deal with.
Proposed CDO Structure
We designed a CDO structure with six tranches in table 1.
To solve the issue of equity tranche pricing, we proposed three solutions:
1. Accept the lower price offered by the Structured Credit Investments Group;
2. Search for other buyers to meet the current price;
3. Redesign the current tranches and build a new customized tranche to meet the demand for
securities between AA and BBB. We can place such securities without significant
discount.
Return Evaluation
Since the all-in interest rate earned on the assets, LIBOR + 2.840%, was higher than the all-in
interest and fees paid on the CDO securities, LIBOR + 0.525%, there was an excess spread of
2.315%. Ninety percent of uses of capital provide us a coupon of LIBOR+ 2.35%, and ten
percent of it provides a fixed coupon rate of 8.5%. After paying the interest, we would receive
618,435 dollars as an arbitrage in the first month.

3. 3
Market Analysis
Since 2003, the issues of high yield loans and investment grade bonds have grown respectively
660% and 110%1, showing a strong demand in the market. The introduction of CDO would
satisfy investors’ strong demand for A-rated debt instruments. Potential investors include
insurance companies, banks, pension funds, investment managers, investment banks, and hedge
funds. Due to their flexibility, the tranches closely fitted investors’ various desires for different
degrees of risk and return, which would bring us slightly extra profit. Return of CDOs was
another reason, as it was usually 2 to 3% higher than corporate bonds with the same rating.2 As a
successful investment tool, the A-rated CDO outperformed other low-risk assets. Its interest
return was higher than the coupon rate of 90-day Treasury bills by 0.8%, the secondary market
rate of 3-month certificate of deposit by 0.395%, and the deposit rate of euro-dollars by 0.355%.
Risk Assessment
Prepayment risk
The pool is faced with risk that prepayment speed exceeds the expected one. Different tranches
react differently to the changes of prepayment speed. Overall, faster prepayment will reduce the
value of tranches.
Though the pool is built on floating-rate bonds, prepayment risk will be triggered by factors
other than interest rates. For example, an upgrade of corporate credit level lowers the company’s
financing costs, making it cheaper for company to call its bonds and refinance.
Credit risk
First of all, in terms of default risk, the pool primarily consists of senior secured bank loans and
high-yield corporate bonds with a weighted average rating of B+. According to S&P credit rating
criteria, securities below BBB- are classified as speculative. B means that “the securities are
more vulnerable to adverse business, financial and economic conditions but currently has the
capacity to meet financial commitments” while B+ just shows a higher standing within B rating
category3. Based on Table 1, the average rating of the securities in the pool indicates that there’s
48.74% chance that the issuers fail to meet their liabilities given adverse market conditions. In
Exhibit 1, we present a ratio which is calculated by dividing the spread paid to each tranche by
the default rate over ten tenors. As the bonds and loans approach maturity date, the ratio
increases as the default rate decreases. However, different tranches’ ratios grow at different
speeds. AAA tranche has the fastest ratio while BBB and A have the lowest.
Second, credit ratings of CDOs play significant roles in evaluating the future cash flows. Credit
ratings of underlying bonds might change before maturity, which might affect the ratings of
1 Sifma statistics, last updated Oct. 20, http://www.sifma.org/research/statistics.aspx
2 Morgenson and Rosner, Reckless Endangerment, 2010 pp.279-280
3. Guide to Credit Rating Essentials. Version 1.5. ed. New York: Standard & Poor's, 2014.

4. 4
CDOs. The returns for equity tranche and asset manager can only be achieved when the credit
ratings of senior and junior tranches maintain at the predetermined levels, which based on our
analysis above cannot be guaranteed.
Consequently, we suggest to purchase credit default swaps for some of the low-rating bonds to
hedge credit risks and secure part of cash flows we will generate from the pool.
Interest rate risk
Not like the MBS, the CDOs we are going to issue are floating rate bonds with duration 3
months. In the calculation of tranches’ cash flows, we assume a constant LIBOR. However, after
examining the latest yield curve and comparing it with other months in 2007 (Exhibit 2), we can
infer that large market volatility will occur and interest rates might change significantly. The
equity tranche return is designed to immune to interest rate fluctuation. However, market
volatility might hurt the companies’ business and lead to delinquency in payments, which will
influence the cash flows of equity tranche.
Based on the OAS published by BofA Merrill Lynch (Exhibit 3), the high yield bonds OAS as
well as the differences between high yield bonds and AAA declined during the past five years.
But we cannot simply take it as a signal that high yield bonds bear lower risks than before. The
lower OAS and differences might be the result of lower demand for high yield bonds in market.
Thus, we need to remind the investors about interest rate risks and suggest that investors of this
CDO enter fixed-floating interest rate swap if they are sensitive to the changes of interest rates to
hedge against interest rate risk for the rest of ten years.
Conclusion
Alpha-97 CDO is designed based on market demand and the quality of assets purchased. The
CDO
 Meets the market demand for highly rated bonds;
 Will offer investors LIBOR+0.525% rate of return;
 Will generate an excess spread of 2.315%, given current credit rating;
However, it is our responsibility to remind Western Asset and potential investors that Alpha-97
CDO is exposed to
 Prepayment Risk
 Credit Risk
 Interest Rate Risk

5. 5
Reference
1. Guide to Credit Rating Essentials. Version 1.5. ed. New York: Standard & Poor's, 2014.
2. Ghetti, Herrera, Anderberg, Chang, Mollein, Chaplin, Polizu, and Watson, “Global
Methodologies And Assumptions For Corporate Cash Flow And Synthetic CDOs”,
Standard & Poor’s, August 1, 2014.
3. BofA Merrill Lynch, BofA Merrill Lynch US High Yield B Option-Adjusted Spread©
[BAMLH0A2HYB], retrieved from FRED, Federal Reserve Bank of St. Louis
https://research.stlouisfed.org/fred2/series/BAMLH0A2HYB/, October 25, 2015.
4. BofA Merrill Lynch, BofA Merrill Lynch US Corporate AAA Option-Adjusted Spread©
[BAMLC0A1CAAA], retrieved from FRED, Federal Reserve Bank of St. Louis
https://research.stlouisfed.org/fred2/series/BAMLC0A1CAAA/, October 25, 2015.
5. Board of Governors of the Federal Reserve System (US), 3-Month Eurodollar Deposit
Rate (London) [DED3], retrieved from FRED, Federal Reserve Bank of St. Louis
https://research.stlouisfed.org/fred2/series/DED3/, November 1, 2015.
6. Board of Governors of the Federal Reserve System (US), 3-Month Certificate of Deposit:
Secondary Market Rate (DISCONTINUED) [CD3M], retrieved from FRED, Federal
Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/CD3M/, November
1, 2015.
7. US Department of the Treasury, 13 weeks coupon equivalent,
http://www.treasury.gov/resource-center/data-chart-center/interest-
rates/Pages/TextView.aspx?data=billRatesYear&year=2007, October 25, 2015.

6. 6
Appendix
Table 1: Proposed CDO Structure
Table 2: S&P CDO Default Evaluation
Source: Standard & Poor’s Ratings Service
Size of CDO 386,119,942.00$
LIBOR 5.18%
Average Coupon 5.71%
Weighted Average Default Rate 2.16%
AAA(A-1) % of pool 63.57%
Spread 0.23%
Coupon 5.41%
AAA(A-2) % of pool 15.38%
Spread 0.34%
Coupon 5.52%
AA % of pool 4.55%
Spread 0.45%
Coupon 5.63%
A % of pool 6.18%
Spread 1%
Coupon 6.18%
B % of pool 8.88%
Spread 2.75%
Coupon 7.93%
Equity % of pool 7.00%
CDO Information
Tranche Information

7. 7
Exhibit 1: Spread/Default Ratios
Exhibit 2: 2007.01 – 05 Yield Curves
Source: U.S. Department of the Treasury
0
0.2
0.4
0.6
0.8
1
1.2
10 9 8 7 6 5 4 3 2 1
SPREAD/DEFAULT RATIO
AAA(A-1) AAA(A-2) AA A BBB

8. 8
Exhibit 3: BofA Merrill Lynch US Corporate Option-Adjusted Spread
Source: Federal Reserve Bank of St. Louis