Hedging multi-currency risk in CLO structures

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(1)Hedging multi-currency. risk in CLO structures.

(2) Table of Contents TABLE OF CO TE TS. 2. LIST OF TABLES. 5. LIST OF FIGURES. 5. LIST OF BOXES. 6. ABBREVIATIO S. 7. 1.. 8. 1.1. 1.2. 1.3. 1.4. 2.. I TRODUCTIO. I TRODUCTIO. RESEARCH QUESTIO S RESEARCH METHODOLOGY RESEARCH STRATEGY COLLATERALISED DEBT OBLIGATIO S (CDO). 2.1. I T R O D U C T I O. 2.2. W H A T I S A CDO? 2.2.1. T Y P E S O F CDO S 2.2.2. C L AS S I F I C A T I O N B Y S T R U C T U R E 2.2.3. C L AS S I F I C A T I O N B Y I S S U E R ’ S M O TI V A T I O N 2.2.4. C L AS S I F I C A T I O N B Y A S S E T C L A S S 2.2.5. C L AS S I F I C A T I O N B Y C O U N TR Y O R R E G I O N 2.3. H O W D O CDO’ S W O R K ? 2.3.1. T H E S T R U C T U R A L C O M P O N E N TS O F A CDO 2.3.2. T H E CDO M E C H A N I C S 2.3.3. T H E C R E D I T R A T I N G P R O C E S S 2.4. W H Y W O U L D A Y O E B U Y A CDO? 2.5. C O C L U S I O. 3.. THE RISKS RELATED TO CDOS. 3.1. I T R O D U C T I O. 3.2. D I F F E R E T T Y P E S O F R I S K 3.2.1. C R E D I T R I S K 3.2.2. I N T E R E S T R A T E R I S K 3.2.3. L I Q U I D I TY R I S K 3.2.4. P R E P A Y M E N T R I S K 3.2.5. R E I N V E S TM E N T R I S K. 8 8 10 12 13 13 13 14 14 15 15 16 16 16 19 22 26 27 28 28 28 28 29 29 29 30.

(3) 3.2.6. A S S E T M A N A G E R R I S K 3.2.7. C O U N TE R P A R TY / B I V A R I A TE R I S K 3.2.8. S Y S TE M I C O R N O N - I D I O S Y N C R A T I C R I S K 3.2.9. C U R R E N C Y R I S K O R F O R E I G N E X C H A N GE R I S K 3.3. H E D G I G F O R E I G E X C H A G E R I S K 3.3.1. A S S E T S P E C I F I C S W AP S 3.3.2. M A C R O H E D GE 3.3.3. N A T U R A L H E D G E U S I N G A F O R E I G N D E N O M I N A T E D T E R M N O TE 3.3.4. (N A T U R A L ) H E D G I N G U S I N G A R E V O LV I N G M U L TI - C U R R E N C Y F A C I L I T Y 3.4. C O N C LU S I O N. 30 30 30 31 33 33 35 37 40 44. 4.. 45. CURRE CY HEDGES AS PRACTISED I THE MARKET. 4.1. I T R O D U C T I O. 4.2. T H E I T R O D U C T I O O F T H E VF. 4.3. T H E S T R U C T U R E S 4.3.1. T H E M U L TI - C U R R E N C Y CLO S TR U C T U R E 4.3.2. T H E C O N S E Q U E N C E S O F I N C O R P O R A T I N G M U L TI - C U R R E N C Y I N S T R U M E N TS (MCI S ) 55 4.4. T E S T S T R U C T U R E S 4.5. C R I T E R I O F O R C O M P A R I S O. 4.6. C O C L U S I O. 5.. 45 45 47 48. 57 59 60. BASE CASE: THE ORTH WESTERLY CLO III B.V.. 61. 5.1. I T R O D U C T I O. 5.2. T H E B A S E C A S E 5.2.1. S T R U C TU R E S U M M AR Y 5.2.2. K E Y P O R T F O L I O C H A R A C TE R I S TI C S 5.2.3. T H E W A T E R F A L L S 5.2.4. H E D G I N G I N T H E NWIII 5.3. T H E S T A D A R D A D P O O R ’ S R A T I G M E T H O D O L O G Y 5.3.1. S I Z I N G T H E D E F A U L T F R E Q U E N C Y 5.3.2. S I Z I N G T H E L O S S G I V E N D E F A U L T 5.3.3. C O L L A T E R A L A N D S TR U C T U R A L E LE M E N TS 5.3.4. C AS H F LO W M O D E L LI N G 5.3.5. T E S TI N G T H E P R O P O S E D S TR U C T U R E 5.4. C O N C LU S I O N. 61 61 64 64 67 73 75 75 78 80 81 86 87. 6.. 88. RESULTS. 88 88 88 93 96 97. 6.1. I N T R O D U C TI O N 6.2. S T R E S S TE S TI N G T H E T E S T S T R U C T U R E S 6.2.1. C R E A T I N G T H E C A S H F L O W M O D E LS 6.2.2. O P TI M I Z A TI O N O F U P F R O N T C O S TS 6.2.1. O P TI M I S A T I O N O F T H E T R A N C H I N G 6.2.2. D E S C R I P TI O N O F T H E E Q U I T Y S C E N A R I O S 3.

(4) 6.3. R U N N I N G T H E C AS H F L O W M O D E LS 6.3.1. O P TI O N S A S S U M P TI O N 6.3.2. T H E R E S U L TS 6.3.3. A N A L Y S I N G TH E S I M U L A T I O N S 6.3.4. U S I N G P R I N C I P LE T O C U R E T H E A S S E T - L I A B I L I T Y M I S M A T C H 6.4. O P TI M I S I N G TH E H E D G E S 6.5. O P TI M I S I N G TH E TR A N C H I N G 6.6. C A LC U L A T I N G T H E ROE 6.6.1. S T R E S S TE S TI N G T H E R E S U L TS O F TH E E Q U I T Y S C E N A R I O S 6.7. C O N C LU S I O N. 100 100 101 102 104 107 108 109 111 112. 7.. 113. DISCUSSIO. 113 I N T R O D U C TI O N T H E C O N S E Q U E N C E S O F I N C L U D I N G T H E S TR U C TU R A L F E A T U R E S 113 C O N S E Q U E N C E S O F P R I O R I T I S I N G T H E U S E O F P R I N C I P LE T O C U R E TH E AS S E T LI A B I LI T Y M I S M A T C H 115 117 7.4. T H E F I N A L R E S U L TS 7.1. 7.2. 7.3.. 8. 8.1. 8.2.. CO CLUSIO & RECOMME DATIO S C O N C LU S I O N RECOMMENDATIONS FOR FURTHER RESEARCH. 118 118 120. GLOSSARY. 123. REFERE CES. 133. APPE DIX. 136. A.1 P E R F E C T A S S E T S W A P A.2 E U R O P E A CDO O F L E VE R A G E D L O A S R A T E D B Y S T A D A R D & P O O R ' S O F D E C . 31, 2006 A.3 E U R O P E A CDO O F L E VE R A G E D L O A S R A T E D B Y S T A D A R D & P O O R ' S O F J U . 1, 2007 A.4 E U R O P E A CDO O F L E VE R A G E D L O A S R A T E D B Y S T A D A R D & P O O R ' S I C L U D I G MCI S A.5 T H E T E S T S T R U C T U R E S : P R I O R I T Y O F P A Y M E T S A.6 A P P E D I X : M O T E C A R L O S I M U L A T I O A D C O R R E L A T I O. A.7 A P P E D I X : T H E EURIBOR I T E R E S T R A T E S T R E S S C U R V E A.8 A P P E D I X : T H E LIBOR I T E R E S T R A T E S T R E S S C U R V E A.9 A P P E D I X : T H E FX- R A T E S T R E S S C U R V E A.10 A P P E D I X : T H E S&P D E F A U L T R A T E T A B L E A.11 A P P E D I X : R E S U L T S O F T H E C A S H F L O W S I M U L A T I O. A.12 R E T U R O E Q U I T Y. 136 AS 138 AS 142 144 150 152 156 157 158 159 160 177. 4.

(5) List of tables Ta b l e 2 - 1 : C r e d i t R a t i n g s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 4 Ta b l e 4 - 1 : B a s i c e xa m p l e o f t h e t r a n c h i n g i n a m u l t i - c u r r e n c y C L O . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 9 Ta b l e 4 - 2 : E xa m p l e o f a n o ve r c o l l a t e r a l i s a t i o n t e s t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 1 Ta b l e 4 - 3 : E xa m p l e o f a n i n t e r e s t c o ve r a g e t e s t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 1 Ta b l e 4 - 4 : Te s t - s t r u c t u r e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 8 Ta b l e 5 - 1 : C a p i t a l s t r u c t u r e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 2 Ta b l e 5 - 2 : P o r t f o l i o e l i g i b l e c r i t e r i a . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 5 Ta b l e 5 - 3 : I n t e r e s t c o ve r a g e t e s t s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 6 Ta b l e 5 - 4 : O ve r c o l l a t e r a l i s a t i o n t e s t . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 7 Ta b l e 5 - 5 : NW I I I p o r t f o l i o o ve r vi e w . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 6 Ta b l e 5 - 6 : R e c o v e r y R a t e s t i e r e d a p p r o a c h . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 9 Ta b l e 5 - 7 : R e c o v e r y r a t e s a s s e t s s p e c i f i c a p p r o a c h . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 0 Ta b l e 5 - 8 : B D R p e r c e n t i l e s p e r r a t i n g . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 6 Ta b l e 6 - 1 : NW I I I Te s t m a t r i x . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 0 Ta b l e 6 - 2 : S e t t i n g s e q u i t y s c e n a r i o . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 9 Ta b l e 6 - 3 : Te s t r e s u l t s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0 1 Ta b l e 6 - 4 : Te s t r e s u l t s a f t e r i n c l u d i n g t h e p r i o r i t i s a t i o n r u l e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0 6 Ta b l e 6 - 5 : C o m p a r i s o n b e t we e n t h e B D R s a c h i e v e d i n t h e t w o t e s t s . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0 7 Ta b l e 6 - 6 : R e t u r n o n e q u i t y o f t h e d i f f e r e n t s t r u c t u r e s u n d e r d i f f e r e n t d e f a u l t a s s u m p t i o n s ............................................................................................................................ 110. List of figures F i g u r e 1 - 1 : R e s e a r c h F r a m e wo r k. 10. F i g u r e 2 - 1 : T yp e s o f c a s h f l o w C D O t r a n s a c t i o n s F i g u r e 2 - 2 : C r e d i t D e f a u l t S wa p. 14 15. Figure 2-3: Relation between risk and return for the CDO tranches) Figure 2-4: SPV purchases assets. 16 17. Figure 2-5: Cash flow securitisation Figure 2-6: CDO waterfall. 18 19. Figure 3-1: CDO with proceeds denoted in a foreign currency F i g u r e 3 . 2 : A s s e t s p e c i f i c s wa p u s e d b y a C D O. 30 32. F i g u r e 3 - 3 : Ma c r o h e d g e o n a n a s s e t p o r t f o l i o Figure 3-4: Natural Hedged CDO. 34 36. F i g u r e 3 - 5 : N a t u r a l H e d g e , s t r u c t u r e p a ys l i k e - f o r - l i k e F i g u r e 3 - 6 : F o r e i g n e xc h a n g e m i s m a t c h. 37 37. Figure 3-7: Naturally Hedged CDO F i g u r e 4 - 1 : D i vi s i o n o f h e d g i n g s t r a t e g y u s e d i n r e c e n t l y l a u n c h e d C L O. 40. transactions (on a quarterly basis) Figure 4-2: Key elements of the currency hedging structures applied in the market b e t we e n J a n u a r y 2 0 0 6 a n d J u n e 2 0 0 7 Figure 4-3: Summary MCI structures F i g u r e 4 - 4 : I n t e r e s t p r o c e e d s wa t e r f a l l f o r a n a t u r a l h e d g e d t r a n s a c t i o n i n c l u d i n g a MC I. 45 46 51 52. 5.

(6) F i g u r e 4 - 5 : Th e p r i n c i p l e p r o c e e d s wa t e r f a l l o f a m u l t i - c u r r e n c y C L O , i n c l u d i n g a MC I. 53. F i g u r e 4 - 6 : S u m m a r y o f t h e c o n s e q u e n c e s o f i n c o r p o r a t i n g MC I s F i g u r e 5 - 1 : Tr a n s a c t i o n S t r u c t u r e. 55 62. F i g u r e 5 - 2 a : P r i o r i t y o f P a ym e n t s ; I n t e r e s t p r o c e e d s F i g u r e 5 - 2 b : P r i o r i t y o f P a ym e n t s ; I n t e r e s t p r o c e e d s. 68 69. F i g u r e 5 - 3 a : P r i o r i t y o f P a ym e n t s ; P r i n c i p l e p r o c e e d s F i g u r e 5 - 3 b : P r i o r i t y o f P a ym e n t s ; P r i n c i p l e p r o c e e d s. 70 71. Figure 5-4: Portfolio default distribution Figure 6 1: structure of the rating scenarios used by S&P. 76 91. F i g u r e 6 2 : P r i o r i t y o f p a ym e n t s i n c l u d i n g t h e p r i o r i t i s a t i o n r u l e Figure 6 3: ROE of the structures under different default assumptions. 104 108. List of boxes Box 1. 75. Box 2 Box 3. 77 78. Box 4 Box 5. 82 84. Box 6. 117. 6.

(7) Abbreviations ABS CDO 2 CDO 3 CDO CDS CLO CMBS CRA Denom EUR EURIBOR FX FX rate GBP IC LIBOR LMA MCI MCR NIBC Num NV NWIII OC PAS RA RCF RMBS S&P SPE SPV US VFN. Asset Backed Security Collateralised Debt Obligation CDO squared CDO cubed Credit Default Swap Collateralised Loan Obligation Commercial Mortgages backed security Credit Rating Agency Denominator Euro Euro Interbank Offered Rate Foreign Exchange Foreign Exchange Rate Great Britain Pound Interest Coverage London Interbank Offered Rate Loan Market Association Multi-Currency Instrument Multi-Currency Revolver Nederlandse Investerings Bank Capital Numerator Naamloze Vennootschap North Westerly III Overcollateralisation Perfect Asset Swap Rating Agency Revolving Credit Facility Residential Mortgage backed security Standard & Poor's Special Purpose Entity Special Purpose Vehicle United States Variable Funding Note. 7.

(8) 1. Introduction 1.1. Introduction N I B C i s a c t i ve l y l o o k i n g f o r i n n o va t i ve s t r u c t u r e s wh i c h a l l o w i t t o g e n e r a t e l i q u i d i t y b y using the assets on its balance sheet or to arbitrage assets purchased in the market. P r e vi o u s l y a s s e t s w a r e h o u s e d e s p e c i a l l y f o r t h i s p u r p o s e , w h e t h e r p u r c h a s e d i n t h e m a r k e t o r i n t e r n a l l y o r i g i n a t e d . U n f o r t u n a t e l y t h e m a r k e t f o r C D O s h a s ( m o m e n t a r i l y? ) e va p o r a t e d ; t h e u n f a vo u r a b l e m a r k e t c o n d i t i o n s a s a r e s u l t o f t h e c r e d i t c r u n c h ha ve r e s u l t e d i n a s h a r p d e c l i n e i n d e m a nd f o r t h e s e p r o d u c t s . E v e n t h o u g h t h e f u t u r e o f t h e C D O - m a r k e t i s u n c e r t a i n , N I B C wa n t s t o b e p r e p a r e d f o r t h e e ve n t u a l i t y o f t h e m a r k e t r e o p e n i n g . Th e r e f o r e t h e c o m p a n y i s a c t i ve l y r e s e a r c h i n g i n n o v a t i ve s t r u c t u r e s wh i c h c o u l d b e u s e d i n future structured transactions. O n e o f t h e s t r u c t u r e s u n d e r s t u d y i s r e l a t e d t o m u l t i - c u r r e n c y r e vo l v e r s . Mu l t i - c u r r e n c y r e vo l ve r s a r e i n s t r u m e n t s c o n s i s t i n g o f a r e vo l vi n g n o t e d e n o m i n a t e d i n a c u r r e n c y o t h e r t h a n t h e b a s e c u r r e n c y o f t h e m a j o r i t y o f t h e n o t e s i s s u e d b y t h e C D O . Th e s e i n s t r u m e n t s c o m b i n e t h e r i s k s r e l a t e d t o c u r r e n c y m i s m a t c h e s wi t h t h e r i s k s a s s o c i a t e d wi t h r e vo l vi n g instruments. A s o f y e t , f e w t r a n s a c t i o n s h a ve b e e n d o n e w h i c h i n c l u d e m u l t i - c u r r e n c y r e vo l ve r s a n d l i m i t e d i n f o r m a t i o n i s a v a i l a b l e o n t h i s t o p i c . N I B C h a s s o m e e xp e r i e n c e wi t h t h e i n c l u s i o n o f m u l t i - c u r r e n c y i n s t r u m e n t s i n i t s f i n a n c i a l s t r u c t u r e s ; h o w e ve r , t h e y a r e i n t e r e s t e d i n e xp l o r i n g a l t e r n a t i ve s o l u t i o n s t o t h o s e u s e d by t h e m u n t i l n o w. Th e r e f o r e t h e r e s e a r c h o b j e c t i ve o f t h i s t h e s i s i s f o r m u l a t e d a s :. -. To understand what kinds of multi-currency hedging techniques are currently applied in the market; and To assess the impact of the hedges used to manage the risk related to the multi-currency revolvers on the capital structure and costs associated with the structure.. To p r o vi d e s t r u c t u r e t o t h i s r e s e a r c h a n u m b e r o f r e s e a r c h q u e s t i o n s w i l l b e f o r m u l a t e d i n t h e f o l l o wi n g s e c t i o n . Th e s e r e s e a r c h q u e s t i o n s wi l l s e r ve a s g u i d a n c e d u r i n g t h e r e s e a r c h p r o c e s s a n d e n s u r e t h a t a l l n e c e s s a r y s t e p s r e q u i r e d t o a c h i e ve t h e r e s e a r c h o b j e c t i ve wi l l be taken.. 1.2. Research questions Th e f i r s t s t e p t o a c h i e ve t h e r e s e a r c h o b j e c t i ve ( s ) wi l l b e t o d o c u m e n t t h e b a s i c p r o p e r t i e s o f C D O s , a n d e xp l a i n h o w t h e y wo r k . S u b s e q u e n t l y, t h e r o l e a n d i n f l u e n c e o f t h e r a t i n g a g e n c i e s o n t h e s t r u c t u r i n g p r o c e s s wi l l b e h i g h l i g h t e d . Th i s l e a d s t o t h e f o l l o wi n g research questions: 1). What is a CDO? How does a CDO work? And what is the role of the rating agencies in the structuring of CDOs?. Th e i n t e r e s t o f N I B C , h o we v e r , i s n o t d i r e c t e d a t C D O s p e r s e , b u t s p e c i f i c a l l y a t t h e p o s s i b i l i t i e s o f h e d g i n g m u l t i - c u r r e n c y r i s k . Th e o r g a n i s a t i o n h a s b e e n i n vo l ve d i n C D O s t r u c t u r i n g f o r q u i t e s o m e t i m e a n d h a s t h e k n o wl e d g e a n d c a p a b i l i t i e s t o s u c c e s s f u l l y 8.

(9) c o m p l e t e a t r a n s a c t i o n . S o m e o f i t s p r e vi o u s t r a n s a c t i o n s h a ve i n c l u d e d a s s e t s denominated in currencies other than the CDO’s base currency to increase the portfolio d i ve r s i f i c a t i o n . B u t wh i l e t h e s e f o r e i g n d e n o m i n a t e d a s s e t s i n c r e a s e t h e d i ve r s i f i c a t i o n benefits, they do introduce currency and interest rate risk to the structure. F o r e i g n c u r r e n c y r i s k e m a n a t e s f r o m f l u c t u a t i o n s i n t h e f o r e i g n e xc h a n g e r a t e . I n t e r e s t rate risk is a consequence of the different base interest rates specific to the different d o m i c i l e s , f o r e xa m p l e E U R I B O R i n E MU - c o u n t r i e s ve r s u s U K - L i b o r i n t h e U n i t e d K i n g d o m . Th e s e f l u c t u a t i o n s c a n c a u s e a m i s m a t c h b e t w e e n t h e va l u e o f t h e c a s h f l o ws o b t a i n e d f r o m t h e a s s e t s ( f o r e i g n c u r r e n c y) a n d p a ya b l e t o t h e l i a b i l i t i e s ( b a s e c ur r e n c y ) . To h e d g e t h i s m i s m a t c h N I B C h a s e m p l o ye d va r i o u s h e d g i n g t e c h n i q u e s , p r e d o m i n a n t l y p e r f e c t a s s e t s s wa p s . Th e s e h e d g i n g t e c h n i q u e s h o we v e r h a ve p r o ve n t o b e e x p e n s i ve a n d q u i t e r i g i d . To r e d u c e t h e s e n e g a t i ve c o n s e q u e n c e s f r o m h e d g i n g , N I B C i s i n ve s t i g a t i n g t h e i m p a c t o f t h e i n c l u s i o n o f r e vo l vi n g m u l t i - c u r r e n c y n o t e s i n i t s C D O s t r u c t u r e s . I n o r d e r t o p r o c e e d wi t h t h e r e s e a r c h , t h e p r o p e r t i e s o f t h e s e i n s t r u m e n t s wi l l b e d o c u m e n t e d a n d t h e c o n s e q u e n c e s o f t h e i r i n c l u s i o n i n C D O - s t r u c t u r e s wi l l b e i n ve s t i g a t e d . Th e f o l l o w i n g r e s e a r c h q u e s t i o n s wi l l c o ve r t h e s e i s s u e s : 2). W h a t i s a mu l t i - c u r r e n c y r e v o l v e r ? A n d h o w d o e s t h e i n c l u s i o n o f a m u l t i - c u r r e n c y 1. revolver influence the CDO capital structure and waterfall ? NIBC is not the first financial institution looking at multi-currency revolvers as a means to h e d g e c u r r e n c y e xp o s u r e . Mu l t i - c u r r e n c y r e vo l v e r s h a ve b e e n u s e d b y o t h e r i s s u e r s . A t p r e s e n t , a n u m b e r o f s t r u c t u r e s , wh i c h a p p l y s o m e f o r m o f a m u l t i - c u r r e n c y r e vo l ve r a s a h e d g e f o r f o r e i g n e xc h a n g e r i s k , a r e i n t h e m a r k e t . I m i t a t i o n i s t h e s i n c e r e s t f o r m o f f l a t t e r y ; i n s t e a d o f t r yi n g t o r e i n ve n t t h e wh e e l , t h i s t h e s i s wi l l f i r s t r e vi e w t h e c u r r e n t p r a c t i s e s e m p l o y e d i n t h e m a r k e t a n d c o m p a r e t h e i r b a s i c p r o p e r t i e s . Th i s r e s u l t s i n t h e t h i r d r e s e a r c h q u e s t i o n : 3). W h a t k i n d o f h e d g i n g s t r u c t u r e s a r e c u r r e n t l y b e i n g o r h a v e b e e n e mp l o y e d i n C D O s w h i c h i n c l u d e mu l t i - c u r r e n c y r e v o l v e r s ?. Th e h e d g i n g s t r u c t u r e s e m p l o ye d i n s e ve r a l t r a n s a c t i o n s wi l l b e i n ve s t i g a t e d a n d c l a s s i f i e d i n t o s e ve r a l c a t e g o r i e s . Th e e f f e c t i ve n e s s o f t h e va r i o u s h e d g i n g s t r u c t u r e s f o u n d i n e xi s t i n g C D O s wi l l b e t e s t e d o n a b a s e c a s e m o d e l : a n e xi s t i n g C D O s t r u c t u r e d b y N I B C i n vo l vi n g m u l t i - c u r r e n c y a s s e t s . Th i s m o d e l l i n g e xe r c i s e a n d t h e s u b s e q u e n t c o m p a r i s o n o f t he va r i o u s s t r u c t u r e s are captured in the fourth research question: 4). W h a t i s t h e i mp a c t o f i mp l e me n t i n g t h e s e h e d g i n g s t r u c t u r e s i n o u r b a s e c a s e mo d e l ? A n d h o w s h o u l d t h e s e s t r u c t u r e s b e c o m p a r e d ?. Th e m a i n h e d g i n g - s t r u c t u r e s wi l l b e i m p l e m e n t e d i n t h e e xi s t i n g m o d e l , a n d u s e d t o s t r u c t u r e a C D O t h a t wi l l c o m p l y wi t h a p r e d e t e r m i n e d s e t o f r e q u i r e m e n t . Th e s e va r i o u s 1. The waterfall stipulates the rules by which the cash flow available to an issuer is allocated to meet. t h e e x p e n s e s , p a y m e n t s t o t r a n s a c t i o n c o u n t e r p a r t i e s , a n d t h e d e b t s e r v i c e p a y m e n t s o we d t o holders of the various classes of security issued in connection with the transaction.. 9.

(10) s t r u c t u r e s a r e l i k e l y t o r e s u l t i n C D O s t h a t d i f f e r i n b o t h r i s k a n d c o s t a s we l l a s i n r e t u r n o n t h e e q u i t y t r a n c h e a n d e a s e wi t h wh i c h r e i n ve s t m e n t s c o u l d o c c u r . Th e r e s u l t s o f t h i s s t r u c t u r i n g e xe r c i s e wi l l b e t h e n c o m p a r e d b a s e d o n a s e t o f r e l e va n t c r i t e r i a . Th i s b r i n g s us to the most interesting and final research question: 5). W h i c h h e d g i n g s t r u c t u r e w h i c h u s e s a mu l t i - c u r r e n c y r e v o l v e r p r o v i d e s t h e mo s t efficient hedge for our base case CDO?. I n s u m m a r y t h e r e s e a r c h p e r f o r m e d i n t h i s t h e s i s s h o u l d a l l o w f o r a c o m p r e h e n s i ve o ve r vi e w o f t h e w o r k i n g s o f a C D O , t h e i m p l i c a t i o n s o f u s i n g m u l t i - c u r r e n c y r e vo l ve r s i n C D O t r a n s a c t i o n s a n d t h e p e r f o r m a n c e o f m u l t i - c u r r e n c y r e vo l vi n g h e d g i n g s t r u c t u r e s . Th e c o m p a r i s o n b e t we e n t h e va r i o u s s t r u c t u r e s i d e n t i f i e d i n a n s we r i n g q u e s t i o n 3 , b a s e d o n t h e c r i t e r i a e s t a b l i s h e d u n d e r r e s e a r c h q u e s t i o n 4 , wi l l d e t e r m i n e wh i c h h e d g i n g s t r u c t u r e i s m o s t e f f i c i e n t a n d s h o u l d t h e r e b y e n s u r e t h a t t h e r e s e a r c h o b j e c t i ve i s a c h i e ve d .. 1.3. Research Methodology To c o m e t o a g e n e r a l u n d e r s t a n d i n g o f t h e s t e p s t h a t n e e d t o b e t a k e n i n o r d e r t o r e a l i s e t h e r e s e a r c h o b j e c t i ve s a r e s e a r c h f r a m e wo r k i s u s e d . A r e s e a r c h f r a m e wo r k i s a s c h e m a t i c r e p r e s e n t a t i o n o f t h e r e s e a r c h o b j e c t i ve a n d vi s u a l i s e s t h e r e s e a r c h p e r s p e c t i v e (Verschuren and Doorewaard 2005). Th e r e s e a r c h f r a m e wo r k u s e d i n t h i s r e s e a r c h p r o j e c t i s d e p i c t u r e d i n f i g u r e 1 - 1 . Figure 1-1: Research Framework. Step 1:. Study the mechanics of CDOs, rating agencies’ methodology, the CDO market, f o r e i g n e xc h a n g e h e d g i n g t e c h n i q u e s a n d p r e l i m i n a r y s t u d y a c t i v i t i e s ( s u c h a s e xp e r t d i s c u s s i o n s ) .. Step 2:. Document the current application of VFN in CDO structures.. Step 3:. Determine the main multi-currency CDO structures.. Step 4:. Create a number of criteria to objectively assess the performance of the various structures.. Step 5:. Analyse the performance of the structures using the criteria.. Step 6:. F o r m u l a t e r e c o m m e n d a t i o n s wi t h r e g a r d s t o t h e u s a g e o f V F N i n C D O s t r u c t u r e s .. 10.

(11) Th e s t e p s i n t h i s r e s e a r c h f r a m e wo r k a r e f o r m u l a t e d , f r o m l e f t t o r i g h t , a s f o l l o ws : To a c h i e ve t h e r e s e a r c h o b j e c t i ve s a s f o r m u l a t e d i n s e c t i o n 1 . 2 a d i ve r s e s e t o f k n o wl e d g e a n d s k i l l s wi l l h a ve t o b e d e ve l o p e d . F o r e x a m p l e t o b e a b l e t o d i f f e r e n t i a t e b e t w e e n b e n e f i t s o f t h e i n n o va t i o n s i n h e d g i n g f o r e i g n e xc h a n g e r i s k a n d t h o s e o f g e n e r a l h e d g i n g p r a c t i s e s u s e d i n C D O s t r u c t u r e s , e xp e r t k n o wl e d g e o n m a r k e t f o r C D O i s r e q u i r e d . F u r t h e r m o r e , t o e va l u a t e t h e s e i n n o va t i o n s t h e y wi l l h a ve t o b e t e s t e d i n a C D O s t r u c t u r e . To s u c c e s s f u l l y c o m p l e t e t h e m o d e l l i n g o f s u c h a C D O , t h e m e c h a n i c s of a C D O h a ve t o b e u n d e r s t o o d . F o r a t h o r o u g h e va l u a t i o n p r o c e s s o f t h e va r i o u s s t r u c t u r e s s o u n d c r i t e r i a must be used. Th e r e f o r e i n s t e p 1 t h e t h e o r e t i c a l f r a m e wo r k wi l l b e e s t a b l i s h e d , s t i p u la t i n g t h e l i t e r a t u r e a n d k n o wl e d g e s o u r c e s u s e d t o e xe c u t e t h e c o n s e c u t i ve s t e p s i n t h i s r e s e a r c h p r o j e c t . Th e theoretical framework consists of general theory related to CDO structuring, hedging f o r e i g n e xc h a n g e r i s k a n d t h e m e t h o d o l o g i e s u s e d b y t h e r a t i n g a g e n c i e s t o s t r e s s t e s t C D O s t r u c t u r e s . A l l t h e s e s o u r c e s wi l l b e s e l e c t e d o n t h e b a s i s o f a p r e l i m i n a r y s t u d y c o n d u c t e d o n t h i s t o p i c w h i c h i n c l u d e d va r i o u s l e c t u r e s a n d e xp e r t i n t e r vi e ws . S c i e n t i f i c k n o wl e d g e i n t h e a r e a o f h e d g i n g f o r e i g n e xc h a n g e r i s k i n C D O s t r u c t u r e s u s i n g va r i a b l e f u n d i n g n o t e s i s l a c k i n g . Th e r e f o r e t h i s k n o wl e d g e wi l l f i r s t h a ve t o b e g a i n e d b y e m p i r i c a l l y s t u d yi n g o f m u l t i - c u r r e n c y C L O s wh i c h c u r r e n t l y a p p l y t h e s e t e c h n i q u e s a n d a r e t r a d e d i n t h e m a r k e t , s t e p 2 . Th i s i n i t i a l s t u d y wi l l c o n t r i b u t e t o a n s we r i n g t h e f i r s t p a r t o f t h e r e s e a r c h o b j e c t i ve s a s f o r m u l a t e d i n s e c t i o n 1 . 2 . A f t e r h a vi n g e xe c u t e d s t e p t wo o f t h i s r e s e a r c h f r a m e wo r k , t h e m a i n t yp e s o f s t r u c t u r e s u s i n g V F N s s h o u l d b e e s t a b l i s h e d . To a l l o w f o r a r e l e va n t c o m p a r i s o n b e t we e n t h e m , t h e s e s t r u c t u r e s s h o u l d b e e x p o s e d t o s i m i l a r t e s t s . Th e C D O s t r u c t u r e s s h o u l d o n l y d i f f e r w i t h r e g a r d s t o t h e h e d g i n g t e c h n i q u e t h e y a p p l y w h i l e k e e p i n g a l l e l s e e q u a l . Th e s e s t r u c t u r e s wi l l b e d e ve l o p e d i n s t e p 3 o f t h i s r e s e a r c h f r a m e wo r k . Th e c r i t e r i a u s e d i n a s s e s s i n g t h e s e s t r u c t u r e s s h o u l d a l l o w f o r a f a i r a n d o b j e c t i ve c o m p a r i s o n b e t we e n t h e va r i o u s s t r u c t u r e s , wh i l e t e s t i n g f o r t h e r e l e va n t f e a t u r e s o f t h e s t r u c t u r e s . T h e c r i t e r i a s h o u l d f a c i l i t a t e a n e a sy c o m p a r i s o n b e t we e n t h e p e r f o r m a n c e s o f t h e va r i o u s s t r u c t u r e s g i ve n t h e h e d g i n g t e c h n i q u e u s e d . Th e a p p r o p r i a t e c r i t e r i a f o r t h i s p r o c e s s wi l l b e e s t a b l i s h e d i n s t e p 4 . Th e r e s u l t s o b t a i n e d a t s t e p 5 wi l l b e t h e o u t c o m e o f t h e a s s es s m en t o f t h e d i f f e r e n t s t r u c t u r e s a n d wi l l f o r m t h e b a s i s o f t h e r e c o m m e n d a t i o n s . T h e g i s t o f t h e s e r e c o m m e n d a t i o n s wi l l b e d e r i ve d f r o m a m u t u a l c o m p a r i s o n b e t we e n t h e p e r f o r m a n c e o f t h e s t r u c t u r e s a n d f r o m t h e r e s u l t s o f a n a na l ys i s o f t h e b e h a vi o u r o f e a c h i n d i vi d u a l structure. A t t h e u t m o s t r i g h t , i n d i c a t e d wi t h s t e p 6 i n t h e a b o ve f i g u r e , t h e r e c o m m e n d a t i o n s i n d i c a t e t h e f i n a l s t e p o f t h i s r e s e a r c h p r o j e c t . Th e s e r e c o m m e n d a t i o n s s h o u l d c on s t i t u t e a n a n s we r o n t h e r e s e a r c h o b j e c t i v e s . I n o t h e r w o r d s , t h e y s h o u l d e xp l a i n t h e i m p a c t o f t h e va r i o u s h e d g i n g s t r u c t u r e s o n t h e p e r f o r m a n c e o f C L O s a n d t h e r e wi t h c o n c l u d e t h i s r e s e a r c h .. 11.

(12) 1.4. Research strategy I n o r d e r t o a c c o m p l i s h t h e s t e p s s e t o u t i n th e r e s e a r c h f r a m e wo r k a n d t h u s f u l f i l t h e r e s e a r c h o b j e c t i ve , t h r e e t yp e s o f r e s e a r c h s t r a t e g i e s wi l l b e a p p l i e d : d e s k r e s e a r c h , g r o u n d t h e o r y a p p r o a c h a n d e xp e r i m e n t s . Desk research Th e i n i t i a l s t e p s i n t h i s r e s e a r c h wi l l c o n s t i t u t e o f d e s k r e s e a r c h i n w h i c h e xi s t i n g m a t e r i a l s a r e u s e d s u c h a s N I B C ’ s i n t e r n a l d o c u m e n t s , r e l e va n t b o o k s , r e s e a r c h p a p e r s , r a t i n g a g e n c y r e p o r t s a n d m a r k e t d a t a . Th e s e m a t e r i a l s p r o vi d e a n a c c e s s i b l e a n d c o m p r e h e n s i v e s o u r c e o f i n f o r m a t i o n a n d p r o vi d e t h e n e c e s s a r y k n o wl e d g e t o f o r m u l a t e a n s we r s t o research questions 1, 2 and 4. The grounded theory approach U n f o r t u n a t e l y d e s k r e s e a r c h wi l l f a l l s h o r t o f a n s we r i n g t h e t h i r d r e s e a r c h q u e s t i o n , wh i c h r e q u i r e s a d e g r e e o f k n o wl e d g e n o t f o u n d i n a n y r e a d i l y a va i l a b l e s o u r c e s . Th e r e f o r e , i n a n s we r i n g t h e s e q u e s t i o n s a d i f f e r e n t r e s e a r c h s t r a t e g y wi l l b e a p p l i e d : t h e g r o u n d e d theory approach. By using the grounded theory approach different theoretical insights can b e g a i n e d b y s t u d yi n g a n d c o m p a r i n g t h e c h a r a c t e r i s t i c s o f d i f f e r e n t C D O s t r u c t u r e s wh i c h a r e c u r r e n t l y u s e d i n t h e m a r k e t . Th i s p a r t o f t h e r e s e a r c h wi l l d e t e r m i n e wh i c h f a c t o r s a r e common to multi-currency CDO, establishing the essential features of VFN based hedging s t r u c t u r e s . Th e r e w i t h t h i s a p p r o a c h wi l l r e s u l t i n t h e d o c u m e n t a t i o n o f n e w t h e o r e t i c a l c o n c e p t s a n d c o n t r i b u t e t o t h e t h e o r y d e ve l o p i n g a p p r o a c h o f t h i s r e s e a r c h . Experiments Th e f i n a l r e s e a r c h q u e s t i o n s , q u e s t i o n 4 a n d 5, wi l l b e a n s we r e d u s i n g a n e xp e r i m e n t a l r e s e a r c h s t r a t e g y. Th e t h e o r y d e v e l o p e d b y a p p l yi n g d e s k r e s e a r c h a n d t h e g r o u n d t h e o r y a p p r o a c h wi l l b e t e s t e d a n d e va l u a t e d . T h i s t e s t i n g a n d e va l u a t i n g s h o u l d b e c o n s i d e r e d a s a l a b o r a t o r y e xp e r i m e n t b a s e d o n c o m p u t e r s i m u l a t i o n s i n wh i c h a l l o u t s i d e f a c t o r s a r e s t r i c t l y c o n t r o l l e d . I n o t h e r wo r d s , t h e d i f f e r e n t C D O s t r u c t u r e s wh i c h w i l l b e c r e a t e d b a s e d o n t h e d e v e l o p e d t h e o r y wi l l b e e xp o s e d t o e x a c t l y t h e s a m e f a c t o r s a n d o n l y d i f f e r w i t h r e g a r d s t o t h e va r i a b l e s d e s i g n a t e d f o r t e s t i n g . U s i n g t h i s t yp e o f e xp e r i m e n t wi l l r e s u l t i n a n o b j e c t i ve c o n c l u s i o n wi t h a h i g h d e g r e e o f i n t e r n a l a n d e xt e r n a l v a l i d i t y Th e r e s u l t s o f t h i s e xp e r i m e n t a r e c o m p a r e d e x- p o s t b a s e d o n t h e c r i t e r i a d e ve l o p e d i n s t e p 4 o f t h e r e s ea r c h f r a m e wo r k a n d c o n s e q u e n t l y recommendations, presented in the form of a conclusion.. make. the. basis. of. the. 12.

(13) 2. Collateralised Debt Obligations (CDO) 2.1. Introduction C o l l a t e r a l i s e d d e b t o b l i g a t i o n s , c o m m o n l y a b b r e vi a t e d a s C D O s , a r e u s u a l l y vi e we d a s i n o r d i n a t e l y c o m p l e x s t r u c t u r e d f i n a n c i a l p r o d u c t s ; t o u g h t o c r e a t e a n d p r o b a b l y e ve n t o u g h e r t o u n d e r s t a n d . B u t wh i l e t h e s e p r o d u c t s s u r e l y a r e m o r e c o m p l e x t h a n o r d i n a r y bonds, the theory behind collateralised debt obligations is by no means rocket science. To a s s i s t i n t h e c o n c e p t u a l i s a t i o n o f t h i s c o m p le x c o n c e p t t h e b a s i c t h e o r y b e h i n d a C D O wi l l b e e xp l a i n e d i n t h i s i n t r o d u c t o r y c h a p t e r . D o i n g s o , t h e f i r s t r e s e a r c h q u e s t i o n , a s f o r m u l a t e d b e l o w , wi l l b e a n s we r e d . 1). What is a CDO? How does a CDO work? And what is the role of the rating agencies in the structuring of CDOs?. To a c h i e ve t h i s g o a l , t h e c o n c e p t o f a C D O i s i n t r o d u c e d i n s e c t i o n 2 . 2 . Th e r e a f t e r t h e m e c h a n i s m s p u t t o wo r k i n a C D O wi l l b e d e s c r i b e d i n s e c t i o n 2. 3 . F o l l o we d b y a discussion on the role the rating agencies play in the creation of a structured financial p r o d u c t s u c h a s a C D O i n s e c t i o n 2 . 4 . F i n a l l y t h i s c h a p t e r w i l l b e c o n c l u d e d wi t h s e c t i o n 2 . 5 , i n wh i c h a s h o r t o ve r vi e w o f t h e m a i n r e a s o n s wh y i n ve s t o r s p u r c h a s e C D O s i s presented.. 2.2. What is a CDO? C o l l a t e r a l i s e d d e b t o b l i g a t i o n s , o r C D O s , a r e s t r u c t u r e d ve h i c l e s t h a t a r e s i m i l a r t o l e ve r a g e d c l o s e d - e n d f u n d s ( S t a n d a r d & P o o r ’ s , 2 0 0 2 ) . I n o t h e r wo r d s , a C D O i s s i m i l a r t o a r e g u l a r m u t u a l f u n d t h a t b u ys b o n d s . U n l i k e a m u t u a l f u n d , h o we ve r , t h e C D O i s s u e s bonds, rather than shares, to raise the necessary capital to purchase these bonds. In simplest terms, a CDO is an arrangement that raises money primarily by issuing its own ( r a t e d ) b o n d s w i t h d i f f e r e n t l e ve l s o f r i s k a n d r e t u r n . Th e p r o c e e d s a r e t h e n i n ve s t e d i n a p o r t f o l i o o f b o n d s , l o a n s , o r s i m i l a r a s s e t s ( N o m u r a F i xe d I n c o m e R e s e a r c h , 2 0 0 4 ) . B u t n o t a l wa ys d o e s a C D O o w n t h e a s s e t s o u t r i g h t . S o m e t i m e s t h e C D O a c q u i r e s e xp o s u r e t o t h e s e a s s e t s s yn t h e t i c a l l y b y e n t e r i n g i n t o a c r e d i t d e f a u l t s wa p ( C D S F i g u r e 2 - ) ( J . P . Mo r g a n S e c u r i t i e s I n c . , 2 0 0 1 ) . I n a c r e d i t d e f a u l t s wa p , t h e C D O r e c e i ve s a p e r i o d i c p a ym e n t f r o m t h e s wa p - c o u n t e r p a r t y ( t h e p r o t e c t i o n b u ye r ) i n e xc h a n g e f o r p r o t e c t i o n i n c a s e o f a d e f a u l t o n t h e r e f e r e n c e a s s e t . Th e p a ym e n t s r e c e i ve d o n t h e r e a l a n d s yn t h e t i c a s s e t s i n t h e p o r t f o l i o a r e t h e m a i n s o u r c e o f f u n d s f o r r e p a yi n g t h e C D O s o wn s e c u r i t i e s .. 13.

(14) 2.2.1.. Types of CDOs. C D O s c a n b e c l a s s i f i e d b y 1 ) s t r u c t u r a l c h a r a c t e r i s t i c s , 2 ) i s s u e r m o t i va t i o n , 3 ) a s s e t c l a s s composition, and 4) the region or country of the collateral (Figure 2-2-1). F i g u r e 2 - 2 - 1 : T yp e s o f c a s h f l o w C D O t r a n s a c t i o n s. Source: Barclays CDO guide, 2002. 2.2.2.. Classification by structure. C D O s c a n b e b r o a d l y d i vi d e d i n t o t h r e e s t r u c t u r a l c a t e g o r i e s : c a s h s t r u c t u r e s , s yn t h e t i c structures and market value structures (NIBC, 2008-3). C a s h s t r u c t u r e s a r e t h e m o s t c o m m o n l y u s e d s t r u c t u r e s i n t h e c u r r e n t m a r k e t . Th e C D O u s e s t h e c a s h o b t a i n e d b y i s s u i n g t h e n o t e s t o t h e i n ve s t o r s t o b u y a s s e t s ( B a r c l a ys , 2002). S y n t h e t i c s t r u c t u r e s d o n o t b u y t h e a s s e t s o u t r i g h t , b u t a c h i e ve e xp o s u r e t o t h e r e f e r e n c e a s s e t b y i s s u i n g c r e d i t p r o t e c t i o n i n t h e f o r m o f C D S ( F i g u r e 2 - ) ( N I B C , 2 0 0 8 - 1 ) . Th i s s t r u c t u r e i s s o m e t i m e s p r e f e r r e d t o t h e c a s h s t r u c t u r e i n b a l a n c e s h e et C D O s i s s u e d b y b a n k s , a s s yn t h e t i c s e c u r i t i e s d o n o t r e q u i r e t h e t r a n s f e r o f a s s e t s . Th e t r a n s f e r a b i l i t y o f the bank’s assets might be limited by the accompanying loan documentation. Th e r e a r e t w o t yp e s o f s yn t h e t i c C D O s t r u c t u r e s : n o n - f u n d e d a n d p a r t i a l l y f u n d e d ( N I B C , 2 0 0 8 - 1 ) . N o n - f u n d e d s y n t h e t i c C D O s i s s u e n o s e c u r i t i e s a t a l l , wh i l e p a r t i a l l y f u n d e d structures issue securities to partially fund the acquisition of assets. Ma r k e t v a l u e s t r u c t u r e s a r e s i m i l a r t o c a s h f l o w C D O s , b u t t h e S P V d o e s n o t i s s u e l i a b i l i t i e s o n t h e p a r va l u e o f t h e a s s e t s . R a t h e r t h e S P V i s s u e s l i a b i l i t i e s b a s e d o n t h e a d va n c e r a t e a s s o c i a t e d wi t h t h e t yp e o f a s s e t s p u r c h a s e d ( S t a n d a r d & P o o r ’ s , 2 0 0 2 ) .. 14.

(15) Ma r k e t va l u e s t r u c t u r e s a r e d i s r e g a r d e d f o r t h e r e m a i n d e r o f t h i s t h e s i s d u e t o t h e i r d i f f e r e n t n a t u r e , l i m i t e d m a r k e t - s h a r e a n d t h e s i g n i f i c a n t d i f f i c u l t i e s r e v o l vi n g a r o u n d t h e va l u a t i o n o f t h e u n d e r l yi n g a s s e t s u n d e r t h e c u r r e n t m a r k e t c o n d i t i o n s . Figure 2-2: Credit Default Swap. Source: J.P. Morgan Securities Inc., 2001. 2.2.3.. Classification by issuer’s motivation. W he n l o o k i n g a t t h e m o t i va t i o n o f t h e i s s u e r , C D O s c a n b e c l a s s i f i e d i n t o t wo t yp e s : arbitrage CDOs and balance sheet CDOs (NIBC, 2008-1). A r b i t r a g e c a s h f l o w C D O s i s s u a n c e i s d r i ve n b y e i t h e r o p p o r t u n i t i e s i n c a p i t a l m a r k e t d i s l o c a t i o n ( a r b i t r a g e ) o r r e g u l a t o r y c a p i t a l - r e l i e ve m o t i va t i o n s . Th e i s s u e r o f a r b i t r a g e C D O s t r i e s t o p r o f i t f r o m t h e s p r e a d b e t w e e n r e l a t i ve l y h i g h e r - yi e l d a s s e t s a n d l o we r c o s t , m o r e h i g h l y r a t e d l i a b i l i t i e s ( S t a n d a r d & P o o r ’ s , 2 0 0 2 ) . Th e g r e a t e r t h e s p r e a d b e t we e n t h e c o u p o n s r e c e i ve d f r o m t h e a s s e t s a n d p a i d t o t h e r a t e d l i a b i l i t i e s , t h e g r e a t e r t h e p o t e n t i a l l e ve r a g e d yi e l d o n t h e e q u i t y. A s a r e s u l t , t h e r e t u r n o n C D O e q u i t y, i n t h e a b s e n c e o f d e f a u l t s o n a s s e t s , g r e a t l y e xc e e d s t h e we i g h t e d a ve r a g e c o u p o n e a r n e d o n t h e u n d e r l yi n g p o r t f o l i o . I n c o n t r a s t , b a l a n c e s h e e t C D O s i s s u a n c e i s m o t i va t e d b y t h e d e s i r e o f t h e s p o n s o r i n g i n s t i t u t i o n t o r e d u c e r e g u l a t o r y c a p i t a l r e q u i r e m e n t s , i n c r e a s e l e n d i n g c a p a c i t y, l o we r t h e c o s t o f f u n d i n g , m a n a g e r i s k , a n d / o r d i ve r s i f y f u n d i n g s o u r c e s ( S t a n d a r d & P o o r ’ s , 2 0 0 2 ) . Th e s e g o a l s c a n b e r e a c h e d e i t h e r b y t h e s a l e o f t h e s p e c i f i c a s s e t s o r t h e t r a n s f e r r i n g o f t h e r i s k s r e l a t e d t o t h e r e f e r e n c e a s s e t s s yn t h e t i c a l l y ( B a r c l a ys , 2 0 0 2 ) .. 2.2.4.. Classification by Asset Class. A C o l l a t e r a l i s e d d e b t o b l i g a t i o n i s c o m m o n l y d e f i n e d i n t e r m s o f i t s a s s e t s . Th e g e n e r a l d e f i n i t i o n i s t h a t a C D O i s a s e c u r i t i s a t i o n o f ( c o r p o r a t e ) o b l i g a t i o n s . B y o r d e r o f vo l u m e , C D O s h a ve s e c u r i t i s e d ( o r r e - s e c u r i t i s e d ) a m o n g o t h e r s : c o m m e r c i a l l o a n s ; c o r p o r a t e b o n d s ; a s s e t b a c k e d s e c u r i t i e s ( A B S ) , r e s i d e n t i a l m o r t g a g e b a c k e d s e c u r i t i e s ( R MB S ) , a n d c o m m e r c i a l m o r t g a g e b a c k e d s e c u r i t i e s ( C MB S ) ; a n d e m e r g i n g m a r k e t d e b t . E ve n t r a n c h e s ( p a r t s ) o f C D O s h a ve b e e n r e - s e c u r i t i s e d i n t o C D O s o f C D O s . W h ic h we r e d u b b e d C D O - s q u a r e d ( C D O 2 ) o r C D O - c u b e d ( C D O 3 ) ( J . P . Mo r g a n S e c u r i t i e s I n c . , 2 0 0 1 ) .. 15.

(16) 2.2.5.. Classification by Country or Region. A f i n a l wa y t o c l a s s i f y C D O s i s b y d e f i n i n g t h e r e g i o n o f c o u n t r y o f t h e d o m i c i l e o f t h e obligors or the assets.. 2.3. How do CDO’s work? 2.3.1.. The structural components of a CDO. A t t h e c o r e o f t h e C D O i s a b a n k r u p t c y- r e m o t e s p e c i a l p u r p o s e v e h i c l e ( S P V ) , g e n e r a l l y r e g i s t e r e d a s c h a r i t a b l e t r u s t s ( t h e Tr u s t ) a n d u s u a l l y e s t a b l i s h e d i n a t a x- f r e e j u r i s d i c t i o n . Th e S P V i s e i t h e r c l a s s i f i e d a s e i t h e r a p a s s - t h r o u g h o r p a y - t h r o u g h structure. Pass-through structures pass the entire principal and interest proceeds o b t a i n e d f r o m t h e a s s e t s t o t h e i n v e s t o r s ( G i d d y, I . , 2 0 0 2 ) . P a y- t h r o u g h s t r u c t u r e s a r e m o r e a c t i ve l y m a n a g e d a n d a l l o w f o r r e i n ve s t m e n t o f c a s h f l o ws , r e s t r u c t u r i n g a n d t h e p u r c h a s e o f a d d i t i o n a l c o l l a t e r a l ( Ta va k o l i , 2 0 0 8 ) . Th e S P V i s s u e s t h e s e c u r i t i e s t o t h e i n ve s t o r s i n t h e f o r m o f s e ve r a l c l a s s e s o f n o t e s t h a t a r e d i vi d e d o r t r a n c h e d i n t o differently rated and some unrated securities. Each class of securities represents a d i f f e r e n t l e ve l o f r i s k a n d r e wa r d a s s o c i a t e d wi t h t h e a s s e t p o o l . Th e m o s t s e n i o r s e c u r i t i e s h a ve t h e c r e d i t r a t i n g s h i g h e r t h a n t h e a ve r a g e r a t i n g s o f t h e u n d e r l yi n g c o l l a t e r a l p o o l d u e t o t h e d i ve r s i f i c a t i o n o f r i s k a n d t h e s u b o r d i n a t i o n o f l o w e r r a t e d t r a n c h e s . Th e l o we r t r a n c h e s o f t h e C D O a r e b e i n g r a t e d b e l o w t h e s e n i o r s . T h e f i r s t - l o s s t r a n c h e i s u s u a l l y c a l l e d t h e e q u i t y ( o r p r e f e r r e d s h a r e s ) , e ve n t h o u g h , s t r i c t l y s p e a k i n g i t i s n o t e q u i t y. Th i s t r a n c h e i s t yp i c a l l y n o t r a t e d ( S t a n d a r d & P o o r ’ s , 2 0 0 2 ) . W i t h i n t h e structure of a CDO, risk and return share a lateral relation; the more senior or secure the note, the lower its return (Figure 2-).. Figure 2-3: Relation between risk and return for the CDO tranches). Source: NIBC, 2008-1. In anticipation of the expected proceeds from the sale of the notes, the asset manager of t h e S P V ’ s a s s e t s , wh o i s a p p o i n t e d b y t h e Tr u s t , s t a r t s t o a c q u i r e ( o r “ wa r e h o u s e ” ) a s s e t s 16.

(17) ( N I B C & B a k e r & Mc K e n zi e L L P , 2 0 0 8 ) . To o b t a i n e xp o s u r e t o t h e s e a s s e t s , e i t h e r d i r e c t l y b y b u yi n g t h e a s s e t s f r o m t h e m a r k e t o r t h e s p o n s o r i n g i n s t i t u t i o n ( o r i g i n a t o r ) o r s yn t h e t i c a l l y b y m e a n s o f C D S ( F i g u r e 2 - ) . Th i s p e r i o d i s t yp i c a l l y c a l l e d t h e p r e - c l o s i n g p e r i o d , a s i t c o ve r s t h e p e r i o d b e t we e n t h e i n i t i a t i o n a n d t h e c l o s i n g o f t h e t r a n s a c t i o n . O n t h e c l o s i n g d a t e o r , i n m o s t c a s e s , d u r i n g t h e “ r a mp - u p p e r i o d ” o f b e t w e e n 6 0 a n d 1 8 0 d a ys f o l l o w i n g t h e c l o s i n g d a t e , t h e S P V p u r c h a s e s t h e a s s e t s wi t h t h e p r o c e e d s f r o m t h e s a l e o f d e b t a n d e q u i t y ( N I B C & B a k e r & Mc K e n z i e L L P , 2 0 0 8 ) . S u b s e q u e n t l y, m a n y S P V s e n t e r i n t o h e d g i n g a g r e e m e n t s t o c u r e , a m o n g o t h e r s , m i s m a t c h e s b e t we e n p a ym e n t d a t e s o f i n t e r e s t r e c e i ve d o n t h e a s s e t s a n d t h e i n t e r e s t p a ya b l e o n t h e n o t e s . Figure 2-4: SPV purchases assets. Source: NIBC, 2008-1. Th e p u r c h a s e d a s s e t s r e m a i n i n t h e S P V u n d e r s u p e r v i s i o n o f a n a s s e t m a n a g e r . Th e asset manager is mandated by the charitable trust to manage the assets in accordance wi t h t h e t r a n s a c t i o n g u i d e l i n e s . O f t e n t h e a s s e t m a n a g e r h a s b r o a d d i s c r e t i o n t o p u r c h a s e a n d t r a d e c o l l a t e r a l a n d r e i n ve s t p r o c e e d s r e c e i ve d d u e t o p r e p a ym e n t s a n d a m o r t i s a t i o n o f t h e a s s e t s u n d e r m a n a g e m e n t . Th e a s s e t m a n a g e r t h e r e f o r e p l a ys a k e y r o l e i n e a c h CDO transaction. I n b a l a n c e s h e e t t r a n s a c t i o n s , h o we ve r , t h e a s s e t m a n a g e r , u s u a l l y a n a s s o c i a t e o f t h e i s s u i n g b a n k , p l a ys a m o r e l i m i t e d r o l e , wh i c h m o s t l y c o n s i s t s o f a d m i n i s t e r i n g a n d s e r vi c i n g a s s e t s t r a n s f e r r e d f r o m i t s b a l a n c e s h e e t . Th e w o r k i n g s o f a c a s h - f l o w C D O p r o c e s s i s s u m m a r i s e d i n. 17.

(18) Figure 2-.. 18.

(19) Figure 2-5: Cash flow securitisation Source: NIBC, 2008-1. 2.3.2.. The CDO mechanics. Interest proceeds D u r i n g t h e l i f e t i m e o f t h e C D O , t h e S P V wi l l r e c e i v e i n t e r e s t i n c o m e o n i t s a s s e t s a n d / o r p r e m i u m o n t h e s yn t h e t i c p r o d u c t s . Th e i n t e r e s t a n d p r e m i u m r e c e i ve d i s d i s t r i b u t e d t o the note holders according to the priority of payment, indicated by the CDO’s waterfall F i g u r e 2 - ) . Th e p u r p o s e o f t h e i n t e r e s t a n d p r i n c i p a l wa t e r f a l l s i s t o p r o t e c t t h e s e n i o r i t y o f t h e t r a n c h e s . I t i s t h e r e f o r e ve r y i m p o r t a n t t h a t i n ve s t o r s k n o w h o w t h e i n t e r e s t a n d p r i n c i p a l wa t e r f a l l s wo r k i n r e l a t i o n t o t h e t r a n c h e t h e y h o l d ( B a r b i c a n c o n s u l t i n g , 2 0 0 7 ) . I n s i m p l e t e r m s , t h e h i g h e r t h e t r a n c h e i s l o c a t e d o n t h e wa t e r f a l l , t h e l o w e r t h e r i s k r e l a t e d t o t h e n o t e a s t h e a m o u n t o f s u b o r d i n a t e d c o l l a t e r a l a n d p r i o r i t y o f p a ym e n t i s high.. 19.

(20) I n g e n e r a l i n t e r e s t p a ym e n t s f o l l o w t h e o r d e r o f p r i o r i t y, s u b j e c t e d t o t h e C D O t r a n s a c t i o n documentation (Barbican consulting, 2007): 1 . Tr u s t e e s f e e s 2. 3.. S wa p i n t e r e s t p a ym e n t s Asset management fees. 4. 5.. AAA interest Me z za n i n e i n t e r e s t. 6. 7.. Equity holders H o l d e r s o f a n y e xc e s s s p r e a d o r i n t e r e s t n o t e s. Figure 2-6: CDO waterfall. Source: NIBC, 2008-2. O ve r c o l l a t e r a l i s a t i o n ( O C ) t e s t I n o r d e r t o p a y i n t e r e s t t o t h e i n d i vi d u a l t r a n c h e s a n o ve r c o l l a t e r a l i s a t i o n ( O C ) a n d i n t e r e s t c o ve r a g e ( I C ) t e s t m u s t b e p a s s e d . Th e O C t e s t i s d e s i g n e d t o m a i n t a i n a m i n i m u m l e ve l o f s u b o r d i n a t i o n f o r e a c h t r a n c h e i n c a s e o f o n e o r m o r e d ef a u l t s i n t h e c o l l a t e r a l p o o l . S e n i o r t r a n c h e s w i l l h a ve a h i g h e r t h r e s h o l d l e ve l f o r t h e O C t e s t t h a n j u n i o r t r a n c h e s ( N I B C , 2 0 0 7 - 1 ) .. ܱ‫= ܺ ݁ݐ݋݊ ݂݋ ݐݏ݁ݐܥ‬. ‫݈݁ܿ݊ܽܽܤ ݈ܽ݌݅ܿ݊݅ݎܲ ܱܦܥ‬ ܰ‫ ݔ ݁ݐ݋݊ ݂݋ ݁ݑ݈ܽݒ ݈ܽ݊݋݅ݐ݋‬+ ܵ݁݊݅‫ݏ݁ݐ݋݊ ݃݊݅݇݊ܽݎ ݎ݋‬. Th e n u m e r a t o r i s C D O P r i n c i p a l B a l a n c e w h i c h i s m o d e l l e d a s t h e s u m o f p e r f o r m i n g a s s e t s a t p a r va l u e ( f a c e va l u e ) , d e f a u l t e d a s s e t s a t e xp e c t e d r e c o v e r y va l u e ( o r ze r o d e p e n d i n g o n t h e t r a n s a c t i o n ’ s d o c u m e n t a t i o n ) , a n d p r i n c i p a l p r o c e e d s . Th e d e n o m i n a t o r i s e q u a l t o t h e s u m o f n o t i o n a l a m o u n t s o f n o t e s s e n i o r a n d p a r i - p a s s u wi t h ( c a r r yi n g. 20.

(21) e q u a l r i g h t s a s ) t h e r e l e va n t n o t e ( N I B C , 2 0 0 7 - 1 ) . I f t h e t e s t i s b r e a c h e d ( e . g . wh e n t h e r e s u l t o f t h e d i vi s i o n i s b e l o w a p r e d e f i n e d l e v e l ) , i n t e r e s t p r o c e e d s , a n d t o t h e e xt e n t t h a t t h e y a r e i n s u f f i c i e n t , p r i n c i p l e p r o c e e d s wi l l b e d i ve r t e d f r o m s u b o r d i n a t e d i s t r i b u t i o n s t o r e d e e m s e n i o r n o t e s , i n o r d e r o f p r i o r i t y o f p a ym e n t s u n t i l t h e O C t e s t t h a t has been breached is brought back in compliance. Interest Coverage (IC) Tests. ‫= ݐݏ݁ݐܥܫ‬. ‫ݏ݀݁݁ܿ݋ݎ݌ ݐݏ݁ݎ݁ݐ݊݅ ݈ܾ݈݁ܽ݅ܽݒܣ‬ ‫ ݅ݎܽ݌ ݎ݋ ݎ݋݅݊݁ݏ ݏ݁ݐ݋݊ ݊݋ ݁ݑ݀ ݏݐ݊݁݉ݕܽ݌ ݐݏ݁ݎ݁ݐ݊݅ ݂݋ ݉ݑݏ‬− ‫ݐ݅ݓ ݑݏݏܽ݌‬ℎ ‫ݐ‬ℎ݁ ‫݁ݐ݋݊ ݐ݊ܽݒ݈݁݁ݎ‬. I n a d d i t i o n t o t h e O C t e s t s o m e C D O i n c l u d e s a n I C t e s t . Th e I C t e s t m e a s u r e s t h e C D O s a b i l i t y t o g e n e r a t e s u f f i c i e n t i n t e r e s t i n c o m e o n it s a s s e t s t o m e e t i t s l i ab i l i t i e s . F o r e a c h t r a n c h e a m i n i m u m I C r a t i o h a s t o b e m a i n t a i n e d . Th i s r a t i o i n c r e a s e s wi t h t h e s e n i o r i t y o f t h e n o t e . Th e I C r a t i o i s c a l c u l a t e d b y d i vi d i n g t h e i n t e r e s t p r o c e e d s b y t h e i n t e r e s t o n the more senior ranking tranches plus interest on the tranche itself. Mo r e s p e c i f i c a l l y; t h e n u m e r a t o r i s m o d e l l e d a s t h e t o t a l a m o u n t o f a va i l a b l e i n t e r e s t p r o c e e d s f r o m p o r t f o l i o a s s e t s ( a f t e r t h e p a ym e n t o f s e n i o r c o s t s ) . T h e d e n o m i n a t o r i s e q u a l t o t h e s u m o f i n t e r e s t p a ym e n t s d u e o n n o t e s s e n i o r o r p a r i - p a s s u wi t h t h e r e l e v a n t note (NIBC, 2007-1). If the test is breached, interest and principal proceeds, to the extent that interest p r o c e e d s a r e i n s u f f i c i e n t , wi l l b e d i v e r t e d f r o m s u b o r d i n a t e d i s t r i b u t i o n s t o r e d e e m s e n i o r notes, in order of priority until the IC test that has been breached is back in compliance. Non-interest related proceeds N e xt t o i n t e r e s t i n c o m e , t h e S P V w i l l r e c e i v e p r e s c h e d u l e d p a ym e n t s b a s e d o n t h e a m o r t i s a t i o n o f t h e a s s e t s a n d p r e p a ym e n t o n a s s e t s wh i c h a r e b e i n g l i q u i d a t e d . F u n d s r e c e i ve d a r e e i t h e r u s e d t o r e d e e m n o t e s , s t a r t i n g wi t h t h e m o s t s e n i o r a c c o r d i n g t o t h e C D O w a t e r f a l l , o r a r e r e i n ve s t e d , s u b j e c t t o a l l c o ve r a g e t e s t s b e i n g p a s s e d . R e i n ve s t m e n t s a r e m a d e b y t h e a s s e t m a n a g e r d u r i n g t h e p r e d e t e r m i n e d r e i n ve s t m e n t p e r i o d ( s ) p r o vi d e d t h a t t h e a s s e t m i x m e e t s t h e C D O ’ s i n ve s t m e n t g u i d e l i n e s ( O f f e r i n g 2. C i r c u l a r s 2 0 0 6 - 2 0 0 7 ) . R e i n ve s t m e n t o f u n s c h e d u l e d p r o c e e d s ( u s u a l l y c o m i n g f r o m p r e p a ym e n t s ) i s s o m e t i m e s a l l o we d a l s o a f t e r t h e r e i n ve s t m e n t p e r i o d , p r o vi d e d t h a t t h e W ei g h t e d. 2. A ve r a g e. Life. of. the. portfolio. does. not. e xc e e d. the. c o ve n a n t e d. va l u e .. H e r e w i t h i n “ O f f e r i n g C i r c u l a r s ” wi l l r e f e r r e r t o t h e i n f o r m a t i o n o b t a i n e d b y s t u d y i n g t h e o f f e r i n g. circulars of European CDOs of leveraged loans issued between January 2006 and June 2007. An overview of the relevant CLOs can be found in Appendix A.2. 21.

(22) Rol e of t he rat ing a g en ci es After reading the previous sections of this chapter it might seem that CDOs are inordinately complex structured financial products. Indeed, the structures of many present d a ys C D O s , c o m b i n e d w i t h va r i o u s s wa p s a n d d e r i va t i ve s , d o e n s u r e t h a t C D O s a r e m o r e c o m p l e x t h a n “ t r a d i t i o n a l b o n d s ” . H o w e ve r , e ve n t h e m o s t c o m p l e x s yn t h e t i c C D O s t h e o r e t i c a l l y i n vo l ve c a s h f l o w p r o j e c t i o n s wh i c h c a n b e q u a n t i t a t i ve l y m o d e l l e d ( O I C V O I S C O , 2 0 0 8 ) . S o p h i s t i c a t e d i n s t i t u t i o n a l i n ve s t o r s u s e t h e s e c a s h f l o w p r o j e c t i o n s t o va l u e t h e C D O ’ s n o t e s a n d c r e a t e t h e i r o wn s t r e s s s c e n a r i o s t o t e s t t h e b e h a vi o u r o f t h e C D O u n d e r d i f f e r e n t c o n d i t i o n s . B u t wh i l e t h e s e i n v e s t o r s o f t e n h a ve t h e c a p a b i l i t y t o a n a l ys e t h e r i s k c o m p r i s i n g t h e t r a n c h e s o f a C D O , d o i n g s o c a n b e t i m e c o n s u m i n g e ve n where risk modelling is almost entirely automated (OICV-OISCO, 2008). To f a c i l i t a t e t h e a n a l ys i s o f t h e r i s k a c c o m p a n yi n g a C D O m a n y i s s u e r s i n vo l ve r a t i n g a g e n c i e s ( R A ) . Th e s e r a t i n g a g e n c i e s f u n c t i o n a s a n o u t s i d e a n d i n d e p e n d e n t a g e n t h i r e d b y t h e i s s u e r t o p r o vi d e t h e i r o p i n i o n o f t h e f u t u r e a b i l i t y a n d l e g a l o b l i g a t i o n o f t h e C D O t o m a k e t i m e l y p a ym e n t s o f p r i n c i p l e a n d i n t e r e s t ( S & P , 1 9 9 8 ; Mo o d y’ s , 1 9 9 8 ) . To f o r m t h e i r o p i n i o n t h e R A m a y o b t a i n n o n - p u b l i c i n f o r m a t i o n f r o m t h e b o r r o we r s a n d i s s u e r s a s i n p u t f o r t h e q u a n t i t a t i ve m o d e l s u s e d a s p a r t o f t h e i r r a t i n g p r o c e s s ( O I C V - O I S C O , 2 0 0 8 ) . Th e r e b y t h e r a t i n g a g e n c i e s a l l e vi a t e t h e i n f o r m a t i o n a s ym m e t r y b e t w e e n t h e i n ve s t o r s a n d i s s u e r ( C o va l , J u r e k & S t a f f o r d , 2 0 0 8 ) a n d c o u l d p o t e n t i a l l y r e d u c e t h e a m o u n t o f e f f o r t i n ve s t o r s h a ve t o p u t i n t o t h e i r o w n r i s k a n a l ys i s ( C r o u g h y, G a l a i & Ma r k , 2000). In addition the opinion of the rating agencies makes the structured financial p r o d u c t s m a r k e t a c c e s s i b l e t o l e s s s o p h i s t i c a t e d i n ve s t o r s . Th o s e i n ve s t o r s u s e t h e R A ’ s o p i n i o n a s a s u b s t i t u t e f o r t h e i r o wn a n a l ys i s a n d i n t e r p r e t t h e r a t i n g a g e n c y’ s o p i n i o n a s a s e a l o f a p p r o va l ( O I C V - O I S C O , 2 0 0 8 ) . Th e o p i n i o n o f t h e r a t i n g a g e n c i e s i s u s u a l l y e xp r e s s e d i n t h e f o r m o f a c o m b i n a t i o n o f l e t t e r s a n d n u m b e r s s y m b o l i s i n g t h e p r o b a b i l i t y o f d e f a u l t a n d t h e l o s s g i ve n d e f a u l t ( T a va k o l i , 2 0 0 5 ; Me r t o n 1 9 7 4 ) . Th e m o s t we l l k n o wn r a t i n g a g e n c i e s , i n vo l ve d i n C D O s t r u c t u r i n g , a r e Mo o d y’ s , S & P a n d F i t c h I B MC . A n o v e r vi e w o f t h e i r r a t i n g s i s g i v e n i n Ta b l e 2 - 1 ( Ta va k o l i , 2 0 0 8 ) .. 2.3.3.. The credit rating process. E ve n t h o u g h s t r u c t u r e d f i n a n c i a l p r o d u c t s a n d c o r p o r a t e b o n d s a r e a s s i g n e d a s i m i l a r t yp e o f r a t i n g b y t h e r a t i n g a g e n c i e s t o i n d i c a t e t h e i r r e s p e c t i ve c r e d i t w o r t h i n e s s , t h e i r r a t i n g p r o c e s s c a n a p p e a r t o b e a l m o s t r e ve r s e d . Th i s p e r c e p t i o n i s n o t e n t i r e l y w i t h o u t m e r i t g i ve n t h a t a R A r a t i n g o f a s t r u c t u r e d f i n a n c i a l p r o d u c t i s q u a l i t a t i ve l y d i f f e r e n t f r o m a c o r p o r a t e b o n d r a t i n g . Th e o p i n i o n o f a R A o n a c o r p o r a t e b o n d i s t h e r e s u l t o f a n a n a l ys i s o f t h e i s s u e r ’ s p a s t f i n a n c i a l s t a t e m e n t s , wh i l e i n a s t r u c t u r e d f i n a n c e t r a n s a c t i o n , t h e R A p r o vi d e s t h e i n ve s t m e n t b a n k wi t h i n p u t i n t o h o w a g i ve n r a t i n g c a n b e a c h i e ve d ( i . e . , t h r o u g h c r e d i t e n h a n c e m e n t s ; t h e p r o c e s s o f r e d u c i n g c r e d i t r i s k b y r e q u i r i n g c o l l a t e r a l , i n s u r a n c e , o r o t h e r a g r e e m e n t s t o p r o vi d e t h e l e n d e r wi t h r e a s s u r a n c e t h a t i t wi l l b e c o m p e n s a t e d i f t h e b o r r o we r d e f a u l t e d ) ( O I C V - O I S C O , 2 0 0 8 ) . S t r u c t u r e d f i n a n c i a l p r o d u c t s a r e i n a s e n s e d es i g n e d f o r a p a r t i c u l a r c r e d i t r a t i n g . Th e i s s u e r o f a s t r u c t u r e d p r o d u c t o f t e n d e c i d e s b e f o r e h a n d wh a t r a t i n g i t w o u l d l i k e f o r e a c h 22.

(23) tranche (presumably within the limits of what is possible) and tailors the cash-flow risk – a s m e a s u r e d b y t h e l i k e l i h o o d o f d e f a u l t a n d l o s s g i ve n d e f a u l t – t o s a t i s f y t h e g u i d e l i n e s s e t f o r t h b y t h e c r e d i t r a t i n g a g e n c i e s ( C o va l , J u r e k , & S t a f f o r d , 2 0 0 8 ) . Th e i s s u e r e s t i m a t e s b a s e d o n q u a n t i t a t i ve m o d e l s a n d o t h e r f a c t o r s h o w m a n y o f t h e l o a n s i n t h e c o l l a t e r a l p o o l wo u l d b e e xp e c t e d t o d e f a u l t u n d e r t h e s t r e s s e s o f va r yi n g s e ve r i t y a p p l i e d b y t h e r a t i n g a g e n c i e s . Th i s a n a l y s i s a l s o i n c l u d e s a s s u m p t i o n s a s t o h o w m u c h p r i n c i p a l wo u l d b e r e c o ve r e d a f t e r a d e f a u l t e d l o a n i s f o r e c l o se d ( O I C V - O I S C O , 2 0 0 8 ) . Th e e xp e c t e d l o s s i s a p p l i e d t o d e t e r m i n e h o w m u c h c r e d i t e n h a n c e m e n t a g i ve n t r a n c h e s e c u r i t y wo u l d n e e d t o g e t a p a r t i c u l a r c r e d i t r a t i n g . F o r e xa m p l e , t h e s e ve r e s t s t r e s s i s r u n t o d e t e r m i n e t h e c r e d i t e n h a n c e m e n t r e q u i r e d f o r a A A A - r a t i n g . Th i s s t r e s s t e s t p r o vi d e s a n i n d i c a t i o n o f t h e r a t i n g a g e n c y’ s e xp e c t a t i o n o f t h e wo r s t c a s e s c e n a r i o which the structure should be able to withstand. P u t a n o t h e r wa y, t h e t r a n c h e s b e l o w A A A wo u l d n e e d t o b e s i ze d s u c h t h a t t h e y c o u l d incur a minimal percentage of loss in the aggregate principal of the collateral pool before any loss would be allocated to the AAA tranche (OICV-OISCO, 2008). The structure is t h e n t r a n c h e d a c c o r d i n g l y. Th e p r o c e s s o f a n a l ys i n g a n d t r a n c h i n g r e q u i r e s c l o s e c o o p e r a t i o n b e t we e n t h e r a t i n g a g e n c i e s a n d t h e i s s u e r a n d i s i n h e r e n t l y i t e r a t i ve i n n a t u r e . Th e r a t i n g a g e n c i e s a r e a c o n s t a n t s o u r c e o f n e c e s s a r y i n p u t s f o r t h e q u a n t i t a t i ve a n a l ys i s d u r i n g t h e s t r u c t u r i n g p r o c e s s . Mo s t l y t h e s e i n p u t s a r e r e l a t e d t o t h e s e v e r i t y o f t h e s t r e s s e s , e xp e c t e d r e c o ve r i e s a n d r e q u i r e d c r e d i t e n h a n c e m e n t . In the final step in the rating process, the tranching proposed by the issuer, based on the c o m m e n t s r e c e i ve d f r o m t h e R A , i s va l i d a t e d b y t h e r a t i n g a g e n c y b y r u n n i n g i t s o wn q u a n t i t a t i ve m o d e l s . W he n t h e R A f e e l s c o m f o r t a b l e wi t h t h e s t r u c t u r e , i t wi l l p r o vi d e t h e d e s i r e d c r e d i t r a t i n g s t o t h e d i f f e r e n t t r a n c h e s . O t h e r wi s e t h e i s s u e r wi l l h a ve t o a m e n d t h e s t r u c t u r e , f o r e xa m p l e b y i n c r e a s i n g t h e a m o u n t o f c r e d i t e n h a n c e m e n t , a n d p r o p o s e t h i s n e w t r a n c h i n g t o t h e R A . T h e R A wi l l c o n s e c u t i ve l y t e s t t h e s t r u c t u r e a n d p r o vi d e i t s o p i n i o n . Th i s i t e r a t i ve p r o c e s s i s c o n t i n u e d u n t i l t h e R A f e e l s s e c u r e t o p r o vi d e t h e desired rating to the updated structure.. 23.

(24) T able 2- 1: C re dit R at ing s Moody's. Long Term Prime. High grade. Upper medium grade. Short Term. AAA. Aa1. AA+. Aa2. speculative. Highly Speculative. Substantial risks Extremely speculative. Short Term. Fitch. Long Term. A-1+. AA+ AA. Aa3. AA-. AA-. A1. A+. A2. A P-2. Baa2. A-. A-1. BBB. A+. A-2. A-. A-3. BBB. BBB-. BBB-. Ba1. BB+. BB+. Ba2. BB. BB. Ba3. BB-. B1. B+. B+. B2. B. B. B3. B-. B-. Caa1. CCC+ Not Prime. A1. A2. BBB+. Baa3. Caa2. A1+. A. BBB+ P-3. Short Term. AAA. AA. P-1. Baa1. Non Investment grade. Long Term. Aaa. A3. Lower medium grade. S&P. B. BB-. A3. B. CCC. In default with little C prospect for recovery. Caa3. CCC-. Ca. CC. C. In default with little prospect for recovery. CCC. / In default. DDD /. / /. D. DD. /. D. 24.

(25) S&P’s Long-term ratings definitions. ‘AAA’: An obligation rated ‘AAA’ has the highest rating S&P assigns. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong. ‘AA’: An obligation rated ‘AA’ differs from the highest-rated obligations onl y to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong. ‘A’: An obligation rated ‘A’ is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher rated categories. However, the obligor’s capacity to meet its financial commitment on the obligation is still strong. ‘BBB’: An obligation rated ‘BBB’ exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more lik ely to lead to a weak ened capacity of the obligor to meet its financial commitment on the obligation.. Obligations. rated. ‘BB’,. ‘B’,. ‘CCC’,. ‘CC’,. and. ‘C’. are. regarded. as. having. significant. speculative. characteristics. ‘BB’ indicates the least degree of speculation, and ‘C’ the highest. W hile such obligations likel y will have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposure to adverse conditions.. ‘BB ’: An obli gati on rated ‘BB ’ is less vulnerable to non-paym ent than other specul ative issues. H owever, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions that could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation. ‘B ’: An obl igati on rated ‘B’ i s more vulnerabl e to non-paym ent than obli gati ons rated ‘BB’ , but the obl igor currentl y has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions lik ely will impair the obligor’ s capacity or willingness to meet its financial comm itm ent on the obligation. ‘CC C’: A n obli gation rated ‘ C CC’ i s vulnerabl e to non-payment wi thi n one year, and depends on favourabl e business, financial, and economic conditions for the obligor to meet its financial. commitment on the. obligation. In the event of adverse business, financial, or economic conditions, the obligor is unlikel y to have the capacity to meet its financial commitment on the obligation. ‘ C C ’ : A n o b l i ga t i o n r at e d ‘ C C ’ c u rr e nt l y i s hi g hl y v u l n e r a bl e t o n o n -p a ym e n t . ‘C’: The ‘C’ rating is also used when a bankruptcy petition has been filed or similar action has been taken but paym ents on this obli gation are bei ng conti nued. ‘C’ is al so used for a preferred stock that i s i n arrears (as well as for junior debt of issuers rated ‘CCC-’ and ‘CC’). ‘D’: Default; ‘SD’: Selective default. The ‘D’ and ‘SD’ ratings, unlik e other ratings, are not prospective; rather, they are used only when a default actuall y has occurred—not when default is only expected.. Plus (+) or minus (-): The ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.. Source: S&P 2008. 25.

(26) 2.4. Why would anyone buy a CDO? Th e q u e s t i o n s a b o ve a r i s e f r o m t h e r e c o g n i t i o n t h a t t h e c o s t o f C D O t r a n c h e s e xc e e d s t h e c o s t o f C D O a s s e t s . Th e d i f f e r e n c e g o e s t o p a y p r o f e s s i o n a l s a s s o c i a t e d wi t h t h e t r a n s a c t i o n : s e c u r i t y f i r m s , a s s e t m a n a g e r s , t r u s t e e s , r a t i n g a g e n c i e s , a t t o r n e ys , a n d a c c o u n t a n t s . W h y d o i n ve s t o r s b u y C D O s t h a t c o s t m o r e t h a n t h e a s s e ts t h e C D O h o l d s ? ( J . P . Mo r g a n S e c u r i t i e s I n c . , 2 0 0 1 ) I n t h e l i t e r a t u r e a va r i e t y o f r e a s o n s c a n b e f o u n d w h y i n ve s t o r s b u y C D O s . Th e m o s t i m p o r t a n t r e a s o n s a r e r e l a t e d t o i n c r e a s e d yi e l d p o t e n t i a l , m a r k e t s e g m e n t a t i o n a n d r i s k d i ve r s i f i c a t i o n . F o r m a n y i n ve s t o r s a s e c u r i t i s e d i n s t r u m e n t h o l d s t h e p r o m i s e o f a s i g n i f i c a n t yi e l d 3. p r e m i u m o ve r e q u a l l y r a t e d , a n d t h e r e f o r e a s s u m e d t o b e e q u a l l y r i s k y , i s s u e s s u c h a s s o ve r e i g n g o ve r n m e n t b o n d s ( G i d d y , 2 0 0 2 ) . Th e d i ve r s i f i e d p o r t f o l i o a n d t h e c r e d i t enhancement techniques used in the structured products are deemed to ensure the timely p a ym e n t o f t h e i n t e r e s t a n d r e p a ym e n t o f t h e p r i n c i p l e p r o c e e d s , w h i l e p r o m i s i n g a h a n d s o m e r e t u r n o n i n ve s t m e n t . Th e l a c k o f o t h e r s e e m i n g l y s o u n d a n d h i g h l y r a t e d i n ve s t m e n t s m a d e i n ve s t o r s f l o c k t o t h e m a r k e t f o r A B S . O t h e r i n ve s t o r s we r e l a r g e l y m o t i va t e d b y t h e o p p o r t u n i t y C D O s p r o vi d e d t o d i ve r s i f y t h e i r a s s e t p o r t f o l i o . R u l e s a n d r e g u l a t i o n s p r o h i b i t s p e c i f i c c l a s s e s o f in ve s t o r s , m o s t l y 4. p e n s i o n f u n d s , t o i n ve s t i n s u b - i n ve s t m e n t g r a d e c o m m e r c i a l p a p e r ; r e s u l t i n g i n m a r k e t s e g m e n t a t i o n ( O I C V - O I S C O , 2 0 0 8 ) . B y d i s a l l o wi n g t h e s e i n ve s t m e n t s s u c h r e g u l a t i o n s e ve r e l y l i m i t s t h e i n v e s t o r s ’ a b i l i t y t o d i ve r s i f y r i s k s o ve r a va r i e t y o f a s s e t c l a s s e s , industries or countries. Th e s e c o n s t r a i n s a r e m i t i g a t e d b y t h e C D O t r a n c h e d s t r u c t u r e . T h i s s t r u c t u r e a l l o ws f o r t h e c r e a t i o n s o f c u s t o m e xp o s u r e s , r e g a r d l e s s o f t h e u n d e r l yi n g a s s e t s , t h a t i n ve s t o r s d e s i r e a n d c a n n o t a c h i e ve a n y o t h e r wa y. Th e r e f o r e t h e s e c u s t o m e xp o s u r e s f i t i n t o i n ve s t o r s va r i o u s r i s k a p p e t i t e s a n d c a p i t a l c o n s t r a i n t s . A n a d d i t i o n a l e xp l a n a t i o n f o r t h e d e m a n d f o r C D O s i s b a s e d o n t h e o b s e r va t i o n t h a t t h e C D O s t r u c t u r e a l l o ws e q u i t y i n ve s t o r s t o e a r n l e ve r a g e d r e t u r n s o n t h e u n d e r l yi n g a s s e t s a t t h e c o s t o f b e a r i n g g r e a t e r r i s k ( J . P . Mo r g a n S e c u r i t i e s I n c . , 2 0 0 1 ) . B y p u r c h a s i n g t h e j u n i o r o r f i r s t l o s s t r a n c h e o f a C D O t h e e q u i t y i n ve s t o r o b t a i n s a l e ve r a g e d e xp o s u r e t o t h e a s s e t s i n t h e a s s e t p o r t f o l i o . Th e i n v e s t o r o b t a i n s t h i s l e v e r a g e d e xp o s u r e w i t h o u t h a vi n g t o b o r r o w f u n d s f r o m e xt e r n a l p a r t i e s .. 3 4. Obviously this assumption proved to be invalid during the financial crisis. For example, Rule 2a-7 of the Investment Company Act specifies that money market funds can. only purchase commercial paper if it is of sufficiently high rating.. 26.

(27) 2.5. Conclusion In this chapter the concepts behind a CDO were introduced and the first research q u e s t i o n wa s a n s w e r e d . I t wa s f o u n d t h a t a C D O i s b a s i c a l l y a s t r u c t u r e d f i n a n c i a l p r o d u c t c o n s i s t i n g o f a p o o l o f a s s e t s b a c k i n g s e ve r a l l i a b i l i t i e s , n o t u n l i k e a r e g u l a r mutual fund. In order to purchase this pool of assets, the CDOs issuer creates number of d i f f e r e n t n o t e s , e a c h wi t h i t s d i s t i n c t i ve r i s k a n d r e wa r d p r o f i l e . E ve r y c a t e g o r y o f r a t e d n o t e s i s d u b b e d a t r a n c h e . Th e s e n o t e s , t h e C D O s l i a b i l i t i e s , a r e r a t e d b y t h e r a t i n g a g e n c i e s a n d s o l d t o d i f f e r e n t i n ve s t o r s . U n d e r n o r m a l c o n d i t i o n s t h e i n c o m e r e c e i ve d o n the assets is sufficient to pay interest to the CDOs liabilities. Structural mechanisms i n c l u d e d i n t h e C D O s h o u l d e n s u r e t h a t e ve n u n d e r i r r e g u l a r c o n d i t i o n s t h e s a f e t y o f t h e n o t e s r e m a i n s u n q u e s t i o n a b l e . Th e s o u n d n e s s o f t h e C D O s t r u c t u r e i s t e s t e d b y t h e r a t i n g a g e n c i e s , wh i c h e xp r e s s t h e i r o p i n i o n s i n t h e f o r m o f a c r e d i t r a t i n g . Th e r a t i n g p r o vi d e s a d d i t i o n a l c o n f i d e n c e i n t h e a b i l i t y o f t h e C D O t o f u l f i l i t s l i a b i l i t i e s a n d i s a p r e r e q u i s i t e f o r c e r t a i n g r o u p s o f i n ve s t o r s t o b e a b l e t o p u r c h a s e t h e o f f e r e d n o t e s . Th e r e wi t h t h i s a n s we r e d .. introductory. chapter. is. concluded. and. the. first. research. question. Now that the concept of a CDO has been properly introduced, the risk related to these s t r u c t u r e d f i n a n c i a l p r o d u c t s wi l l b e e xp l a i n e d i n t h e n e xt c h a p t e r . I n a d d i t i o n t h i s c h a p t e r wi l l p r e s e n t t h e c o n c e p t o f a va r i a b l e f u n d i n g n o t e ; a r e vo l vi n g f a c i l i t y u s u a l l y u s e d t o hedge against foreign exchange risk.. 27.

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