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Cdo Training Session (2)


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2008 CDO Intro discussion

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Cdo Training Session (2)

  1. 1. Collateralized Debt Obligations<br />An Overview<br />
  2. 2. CDOs – Introduction and Overview<br />Structuring of CDOs – Warehousing<br />CDO Portfolio Management, Compliance, Risk Management, Accounting and Operations of CDOs (Intro and Prelude for the next presentation)<br />Questions<br />Welcome and Introduction<br />
  3. 3. What are CDOs?<br />Types of CDOs<br />Parties to a CDO Transaction<br />Motivations for managing and/or investing in CDOs<br />Advantages of CDOs<br />Disadvantages of CDOs<br />Typical Cash Flows of CDOs<br />Life Cycle of CDOs<br />CDOs – Introduction and Overview<br />
  4. 4. What are CDOs?<br />CDOs are a form of Asset-Backed Security (ABS) that derives its returns and/or performance from the cash flow activity of it underlying assets, which include, but are not limited to, the following:<br />High Yield (HY) and/or Investment Grade (IG) Bonds<br />Leveraged (Bank and/or Middle Market) Loans<br />Prime/Mid-prime/Sub-prime Residential Mortgage-Backed Securities (RMBS)<br />Commercial Mortgage-Backed Securities (CMBS)<br />IG and HY Senior and Mezzanine CDO Tranches<br />Credit Default Swaps (referencing the aforementioned assets); can either sell protection (typical) or buy protection (rare)<br />Emerging Market (EM) Debt<br />CDOs – Introduction and Overview<br />
  5. 5. CDOs – Introduction and Overview<br />The Typical CDO Structure – A Graphical Representation<br />Collateral Manager<br />Fees<br />Unfunded CDS CP<br />TRS Counterparty<br />Super Senior Swap CP<br />(optional)<br />IRS/IRC/IRF Counterparty<br /><ul><li>Portfolio Management
  6. 6. Administration
  7. 7. Risk Management</li></ul>Net Swap/Cap/Floor<br />Payments<br />Senior Notes (AAA)<br />SPV / Issuer<br />CDO Entity<br />Assets<br />(Categories)<br />HY Corp. Bonds<br />IG Corp. Bonds<br />Leveraged Loans<br />Prime RMBS<br />Midprime RMBS<br />Subprime RMBS<br />CMBS<br />CDOs<br />CDS (referencing<br />all of the above)<br />Senior Notes (AA)<br />Buys ABS<br />Buys Assets<br />Mezzanine Notes (A)<br />Principal & Interest (or Premiums)<br />Principal, Interest, Premiums & Fees<br />Junior Mezz Notes (BBB)<br /><ul><li>Collateral Administration
  8. 8. Portfolio Analytics
  9. 9. Investor Reporting
  10. 10. Trade Settlement</li></ul>Equity/Sub Notes (NR)<br />Fees<br />PPN Notes<br />Combo Notes<br />Trustee<br />
  11. 11. What are CDOs? - Continued<br />Unique Aspects to CDOs vs. Other Traditional ABS<br />Active Portfolio Management (Static Funds are rare)<br />Revolving Asset Turnover Periods (5-7 years)<br />Call Provisions and Lock-Out Periods<br />Tranched Liabilities – various payment priorities and cash flow mechanisms<br />Trading restrictions established via complex, interrelated Compliance Rules<br />Coverage Tests (Overcollateralization, Interest Coverage, Interest Diversion, etc.)<br />Trustee presence and involvement, in addition to third-party verification and review (i.e., Big 4 Auditors)<br />Enhanced Reporting Requirements (Monthly)<br />CDOs – Introduction and Overview<br />
  12. 12. CDOs – Introduction and Overview<br />Types of CDOs<br />Collateralized Bond Obligations (HY/EM Debt) – “CBOs”<br />Collateralized Loan Obligations (“CLOs”)<br />Collateralized Synthetic Obligations (“CSOs”)<br />Structured Finance CDOs<br />Residential (Single, Multi-Family) Mortgage CDOs<br />Commercial Real Estate CDOs<br />Constant Proportion Debt Obligations (“CPDOs”)<br />Funding for CDOs<br />LT Cash – Debt/Equity Capital funds purchased assets<br />ST Cash – CP issuance (and roll-over) funds LT assets<br />Synthetic – CDS/TRS/Liquidity Facility<br />Hybrid – Combination of Cash and Synthetic<br />
  13. 13. CDOs – Introduction and Overview<br />Parties to a CDO<br />Issuer/SPV – Legal entity that issues the CDO<br />Underwriter – Structures and places CDO Debt and Equity with investors; also provides financing during the warehousing period (if necessary)<br />Collateral Manager –Performs Portfolio Management function (asset selection, portfolio administration, risk management, etc.)<br />Trustee – Provides Custodian and Portfolio Administration Services and serves as the official record regarding holdings and cash transactions <br />Rating Agencies – Evaluates and rates debt<br />Independent Auditors – Performs CDO issuance, waterfall verifications, and tax (PFIC) reporting services, as applicable<br />
  14. 14. CDOs – Introduction and Overview<br />Motivations for doing a CDO Transaction<br />Expand Assets Under Management (“AUM”) – CDOs are a great way for investment management firms to increase AUM via access to Investment Bank clientele vs. utilizing its own sales force (generally non-existent for small shops). More AUM means for more management fees.<br />Expand Asset Management Expertise –CDOs allow traditional fixed income managers to expand their normal asset base by adding investment buckets that allow for investments in different assets. This strategy can also be executed by adding the requisite PM expertise to the asset management team (and launching new funds) as well.<br />Secured Financing/Leveraged Returns – Unlike TRS, Repurchase Agreements or Margin Trading, CDOs can be utilized to generate leveraged returns to equity investors by utilizing LT debt to invest assets that generate alpha.<br />
  15. 15. CDOs – Introduction and Overview<br />Motivations for Investing in a CDO<br />Higher Risk-Adjusted Return Prospects – CDO debt investors typically receive a higher spread vs. similarly rated instruments. CDO Equity seeks leveraged returns.<br />Diversification – By pooling assets of various products, industries, tenor and credit profiles (limited by trading rules), investors find CDOs attractive for their risk-mitigating return (i.e., low correlation to S&P 500) prospects vs. taking single-name risk.<br />Expand Asset Exposures – Although the investor profile for CDOs include both Institutional and Sophisticated/HNW investors, CDOs provide investors the ability to gain exposure to instruments that they otherwise would not be able to (e.g., CDS contracts on CDO tranches)<br />
  16. 16. CDOs – Introduction and Overview<br />Advantages of CDOs<br />Diversification (low correlation with other instruments)<br />Favorable Taxation – Typically created offshore in tax-advantaged jurisdictions (i.e., Cayman Islands, Ireland, etc.) and co-issued onshore in Delaware, the earnings and profits gained by CDOs is shielded from federal and state taxation.<br />Adaptive Structures – Properly structured deals can adapt to market volatility (flexibility to vary asset mix or trade rules)<br />Disadvantages of CDOs<br />These are Very Complex Instruments – Many players in the market are not experts in the industry or the product<br />Relatively low oversight and transparency –Issued under Rule 144(a) and Reg S, CDOs are issued privately and there are typically no requirements for financial statements or audits.<br />Capital can be tied up for years once a deal goes bad - Cash checks in, but sometimes doesn’t check out..... <br />
  17. 17. Cash Flow Structure of CDOs<br />Interest Proceeds<br />Principal Proceeds<br />Taxes and Filing Fees<br />Taxes and Filing Fees<br />Admin Expenses<br />Admin Expenses<br />Snr Mgmt Fees<br />Hedge Payments<br />Senior Debt Interest<br />(subject to Pro-Forma<br />Coverage Tests)<br />Senior Mgmt Fees<br />Fail<br />Net Hedge Payments<br />Senior Debt Interest<br />Coverage Tests<br />(Pro-Forma)<br />Redemption Order<br />Coverage Tests<br />Fail<br />Fail<br />Pass<br />Senior Debt<br />Pass<br />Mezz/Junior Debt Interest<br />(incl. PIK Interest)<br />Mezz/Junior Debt Interest<br />(incl. PIK Interest)<br />Mezz Debt<br />Coverage Tests<br />(Pro-Forma)<br />Coverage Tests<br />Junior Debt<br />Senior Debt Principal<br />Pass<br />Reinvestment<br />Period?<br />No<br />Mezz/Junior Prin<br />Subordinate Mgmt Fees<br />Sub/Incentive <br />Mgmt Fees<br />Equity Dividend<br />Yes<br />Equity<br />Reinvest Cash<br />CDOs – Introduction and Overview<br />
  18. 18. CDOs – Introduction and Overview<br />Lifecycle of a CDO<br />Warehousing Period – SPV is created and assets are acquired while the debt and equity are sold to investors; typically lasts 3-12 months. The Warehouse “closes” at the end of this period and the CDO goes live (The “Closing Date”).<br />Reinvestment Period – Typically 5 to 7 years from Closing Date; Investment allowed (within compliance rules)<br />Non-Call Period – No Calls 3 to 5 years from Closing Date.<br />Amortization/Callable Period – Begins 5 to 7 years after Closing. During this period, (1) the CDO’s debt can be repaid (partially or completely) with principal cash from sales, amortizations, calls or redemptions or (2) the debt is completely retired with sales proceeds from the sale of assets <br />Maturity/Termination – All assets are liquidated, all debt is retired, equity is paid residual interest and the SPV is terminated.<br />
  19. 19. Structuring of CDOs - Warehousing<br />Establishing a Warehouse<br />Warehouse Agreement Basics<br />Warehouse Asset Management, Compliance, Administration and Operations<br />Closing the Warehouse<br />
  20. 20. Establishing The Warehouse<br />When Warehouses are opened, Portfolio Managers contract with Investment Bankers, who provide financing and Placement Agent services. Why is this done? Managers can ramp-up their portfolios and take advantage of certain market conditions and Underwriters secure new transaction business (which generates fees between 1-5% of the deal size).<br />The SPV is legally established, along all with the filing of the requisite paperwork (W-8BEN for tax, for example) and the establishment of custodial and trading accounts. Also, a trustee is hired to serve as Warehousing Agent (note that the Underwriter can agree to take the exposure risk on its own balance sheet, thus rendering the need for a Trustee moot).<br />Trading begins and assets are acquired in compliance with the criteria set forth in the warehousing agreement, or with prior approval of the Underwriter (if such assets are warehoused on the Underwriters’ Balance Sheet).<br />Structuring of CDOs - Warehousing<br />
  21. 21. The Typical CDO Warehouse Structure – A Graphical Representation<br />Collateral Manager<br />Mgmt Fees (if any)<br /><ul><li> Portfolio Management
  22. 22. Administration
  23. 23. Risk Management</li></ul>Sales Proceeds (for FAS 140 sales); only for assets sold directly to SPV<br />Loan Proceeds<br />SPV / Issuer<br />CDO Entity<br />Investment Bank/<br />Underwriter<br />Assets/<br />Warehouse Acct<br />Buys Assets<br /><ul><li> Financing Costs & Loan Proceeds
  24. 24. Debt & Equity Placement Fess</li></ul>Principal, Interest, Premiums & Fees<br /><ul><li> Collateral Administration
  25. 25. Trade Settlement</li></ul>Fees<br />Warehousing<br />Agent/Trustee<br />Structuring of CDOs - Warehousing<br />
  26. 26. Structuring of CDOs - Warehousing<br />Warehouse Agreement Basics<br />Portfolio Investments –(1) Identifies qualified assets for purchase, (2) spells outs the procedures for acquiring such assets, and (3) spells out the conditions and circumstances under which assets can be sold in the warehouse (generally requires consent of warehouse provider)<br />Financing – Spells out (1) the size of the Commitment, (2) the conditions under which such proceeds can be used (i.e., to purchase assets), (3) the process under which such finances can be accessed (i.e., formally requesting advances), (4) the cost of such financing and the payment terms, and (5) the term of the financing itself<br />Cash Flow Mechanics – Classification of Cash and treatment<br />Portfolio Management – Duties and Responsibilities<br />Positive and Negative Covenants – Do’s & Don’ts<br />Compliance<br />
  27. 27. Structuring of CDOs - Warehousing<br />Warehouse Asset Management – CLOs<br />One may ask “Why are we doing a CDO deal? Isn’t the market dead?” Yes and No....<br />The CDOs that are receiving all of the negative press/publicity are generally Structured Finance CDOs – not CLOs. Here are some facts concerning Bank Loans and CLOs:<br />In the 20+ year history of CDOs, no AAA issued CLO tranche has ever been downgraded;<br />Issuer Weighted Cumulative Defaults of BB/B rated loans between the years of 1995-2004 were approximately 12.4%; the same default rate on BB/B bonds was approximately 40%; and<br />The Recovery rate on Bank Loan defaults between 1995-2004 (all seniority levels) approximated 78%<br />
  28. 28. Structuring of CDOs - Warehousing<br />Warehouse Asset Management – CLOs, Cont.’<br />Portfolio Management Topics<br />Diversity mix – identify performing credits among different industries to maximize returns; more diversity contributes to minimize default correlation Credit Migration/Rating Monitoring – in addition to credit analysis, PMs must stay aware of rating agency views of industry sectors and the credits in the managed asset pool. Adverse rating actions can impair future trading prospects.<br />Performance/Cash Flow adequacy – during the warehouse, it is typically the case that all cash generated by the portfolio go to the Underwriter (because they fund the warehouse), while capital gains (if any) are shared.<br />
  29. 29. Structuring of CDOs - Warehousing<br />Compliance<br />Weighted Average Rating Tests – Maintain Ratings and Monitor Credit Rating Movements<br />Weighted Average Recovery Rates<br />Weighted Average Spread Tests<br />Overcollaterilization Tests<br />Diversity Tests<br />Weighted Average Life Tests<br />Portfolio Concentration Tests<br />Industry Concentrations<br />Issuer Concentrations<br />Geographic Concentrations<br />Seniority Concentrations<br />Fixed Rate Concentrations<br />
  30. 30. Structuring of CDOs - Warehousing<br />Administration & Operations<br />Trade Capture and Confirmation<br />Cash Reconciliations (Daily)<br />Position Reconciliations (Weekly)<br />Portfolio Monitoring and Administration (Real Time)<br />Compliance Monitoring (Real Time)<br />Compliance Reporting (Daily)<br />Portfolio Analysis/Reporting (Weekly/Monthly)<br />Accounting/Transaction Recording (Daily)<br />Financial Reporting (Quarterly & Annual)<br />Risk Management<br />Monitor Asset Quality and Compliance Levels (Monthly)<br />Cash Flow/Credit Analysis (Coincide with Payment Dates)<br />Quantitative and Qualitative Credit Analysis utilizing Stochastic Monte Carlo Expected Loss Estimation methods<br />
  31. 31. Closing the CDO Warehouse<br />Warehouse Closing<br />Cash Flows<br />Senior Debt<br />CDO/SPV<br />Capital Proceeds<br />(Sources)<br />Capital Proceeds<br />(Uses)<br />Warehouse Provider<br /> Interest<br />Mezzanine Debt<br />Warehouse Provider<br /> Loan Proceeds<br />Junior Debt<br />Portfolio Management<br />Fees<br />Equity<br />Underwriter Fees<br />Sales Price of<br />Warehouse Assets<br />Legal Expenses<br />Rating Agencies<br />Accountants<br />Printers<br />Other Expenses<br />Interest Proceeds<br />Principal Proceeds<br />Closing Date<br />Expense Acct<br />Expense Reserve<br />Structuring of CDOs - Warehousing<br />
  32. 32. CDO Portfolio Management, Compliance, Risk Management, Accounting and Operations of CDOs (Intro and Prelude for the next presentation)<br />What needs to be in place when the CDO goes live?<br />Where do the risks lie? Where do they have to bemonitored? How are risks measured?<br />How do Portfolio Managers, Operations, Finance coordinate efforts to ensure that nothing falls through the cracks?<br />What internal controls need to be in place to ensure that the appropriate parties (i.e., Compliance) ensure that CDO Management is properly performed in accordance with legal agreements?<br />What’s Next? – Stay Tuned!<br />
  33. 33. Resources for Reference<br />Bloomberg (Keywords “NI CDO”, “NI SYNCDOS”)<br />Moody’s (<br />S&P ( <br />Fitch (<br />UBS CDO/Leveraged Loan Research ( <br />Lehman Brothers Research ( <br />Questions?<br />