CDO

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Um collateralized debt obligations (CDOs) é um tipo de asset-backed security ou crédito estruturado. Os CDOs compram exposição a um portfolio de empréstimos e dividem o rico de crédito por diversas tranches: tranches sénior (com rating de crédito AAA), tranches mezzanine (rating de AA a BB), e tranches de equity (sem rating). As perdas sustidas pelo portfolio de crédito são tomadas por ordem inversa de senioridade, pelo que por um lado as tranches júnior recebem cupões (taxas de juro) mais elevadas, e por outro sofrem as primeiras perdas do portfolio.

Os CDOs são um veículo importante de financiamento no mercado de empréstimos com risco.


Mercado, história e crescimento

Primeiramente emitidos no final dos anos 80, os CDOs emergiram uma década mais tarde como o sector de maior crescimento dentro do mercado de asset-backed securities sintéticas. Este crescimento pode reflectir:

Um factos no crescimento dos CDOs foi a aplicação do Modelo de Gaussian copulas que permitiu um preçar rápiodo de CDOs. Esta técnica foi introduzida em 2001 por David X Li.

According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totalled USD $157 billion in 2004, USD $249 billion in 2005, and USD $489 billion in 2006.

Concept

CDOs vary in structure and underlying collateral, but the basic principle is the same. First, a CDO entity acquires its inventory - such as income securities asset-backed securities. Then, the CDO entity sells rights to the cash flows from the inventory along with associated risk. The sold rights are called tranches in accordance with the cash flow and risk assignment rules of the CDO: senior (rated AAA) tranches are paid first followed by mezzanine (AA to BB) tranches and, last of all, equity tranches (unrated).

As seen from above, investors have taken a position not in the mortgages or asset backed securities, but in an entity that has defined risk and reward. Therefore, the investment is dependent on not just the quality of the inventory but also of the quality of the metrics and assumptions used for defining the risk and reward of the tranches. The latter can trump the former just as the inventory can trump the investment.

The manufacturer of this entity, typically an Investment Bank, itself takes a cut of the value of the inventory and obtains management fees. It is the very existence of an intermediary, defining risk and reward parameters for a shareholding in that entity, that moves a CDO tranche holder farther from investing in an asset backed security and more towards investing in the promises and the mathematics model the manufacturer of a CDO used. CDOs are not mortgages. CDOs are not mortgage backed securities (MBS).

In essence, we should view an investment in a CDO entity's tranche much as an investment in a perfume manufacturing company. Even though the perfume company uses lavender (mortgage) as an ingredient, no one would call it an agricultural company (mortgage backed). The same holds true when considering how a CDO entity changes the true character of its raw inventory (asset backed securities, mortgages)

Typically, the highest CDO tranche income rates are paid to those that will accept the highest credit default risks.

The loss of an investor's principal is applied in reverse order of seniority (i.e., highest credit risk tranches to lowest). The senior tranche is protected by the subordinated security structure; thus, it is the most highly rated tranche. The equity tranche (also known as the first-loss tranche or "toxic waste") is most vulnerable, and has to offer higher coupons to compensate for the higher risk.

The "arbitrage"<ref>Arbitrage in finance refers to a riskless profit. CDOs do not present underwriters with riskless profits, yet this term is used for CDOs and approximately 85% of the cash CDOs that underwriters arrange are created using the arbitrage concept.</ref> of a CDO involves the spread between the income generated from the higher-yielding assets the CDO holds in its portfolio and the lower-yielding liabilities the CDO issues. Since the CDO issues mostly high-rated debt, the cost of the debt is less than the before-default cash flow generated by the CDO's assets. The yield on the CDO's assets minus the cost of the CDO's liabilities and expenses is called "excess spread", i.e.,

excess spread = yield - \sum interest payable to each tranche - management fees and expenses

Most of the excess spread is made available to equity investors in the CDO. The excess spread of the CDO must be sufficiently large to generate an attractive return for equityholders and this is a key consideration in the structuring of the CDO during the underwriting process. If losses on the CDO's assets are low, the spread can be substantial and lead to equity returns of 10% or higher but even a low number of defaults on the CDO's assets can eliminate the CDO's excess spread and cause equityholders to lose up to their entire investment. If losses exceed the size of the equity tranche, losses are next applied to the most junior debt tranche and so on in reverse order of seniority.

The distribution of cash flow from the CDO's assets to the CDO's tranches is modeled in cash flow waterfalls. There are separate waterfalls for interest and principal. Cash flow is first used to cover top-priority expenses such as administrative fees and hedge costs. Next, cash flow is distributed sequentially from the most senior tranche to the most junior tranche.

CDOs are subject to certain interest coverage or overcollateralization tests. For instance, an overcollateralization coverage test may require the CDO to maintain a minimum ratio of assets in portfolio to senior debt outstanding. If the ratio is not maintained, cash flow is diverted to pay principal on the senior tranche. Missed interest payments to mezzanine tranches that result may not lead to default as many mezzanine tranches include pay-in-kind features, in which missed cash interest payments are added to the principal of the tranche.

CDOs may include subordinate management fees and subordinate expenses.

Structures

CDO is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follows:

Source of funds -- cash flow vs. market value
  • Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDO's assets. Cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio.
  • Market value CDOs attempt to enhance investor returns through the more frequent trading and profitable sale of collateral assets. The CDO asset manager seeks to realize capital gains on the assets in the CDO's portfolio. There is greater focus on the changes in market value of the CDO's assets. Market value CDOs are longer-established, but less common than cash flow CDOs.
Motivation -- arbitrage vs. balance sheet
  • Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. The majority, 86%, of CDOs are arbitrage-motivated<ref>[1]</ref>.
  • Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A bank may wish to offload the credit risk on a large amount of loans in order to reduce its balance sheet's credit risk. Using a synthetic balance-sheet CDO, the bank can achieve that result without selling the assets.
Funding -- cash vs. synthetic
  • Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a special purpose vehicle) issuing the CDO's tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006.
  • Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swaps, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss on a specific asset in the event that asset experiences a default or other credit event.) Like a cash CDO, the risk of loss on the CDO's portfolio is divided into tranches. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche pays a periodic payment (the swap premium), with the junior tranches offering higher yields.
A synthetic CDO tranche may be either funded or unfunded. A funded tranche requires investors to fund their credit exposure. Under the swap agreement, the tranche could have to pay up to a certain amount of money in the event of a credit event on assets in CDO's reference portfolio. This credit exposure is funded at the time of investment by the tranche's investors. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund their exposure. At maturity, the funding minus any realized losses is returned to investors. In contrast, senior tranches are usually unfunded since the risk of loss is much lower. Unlike a cash CDO, investors in a senior tranche receive periodic payments but do not place any capital in the CDO when entering into the investment. Instead, the investors retain continuing liability exposure and may have to make a payment to the CDO in the rare event the portfolio's losses reach the senior tranche. Funded synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time to create. Cash assets do not have to be purchased and managed, and the CDO's tranches can be precisely structured.
  • Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional assets.
Single-tranche CDOs
The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke CDOs) where the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches are never sold but held by the dealer based on valuations from internal models. Residual risk is delta-hedged by the dealer.
Variants
Unlike CDOs, which are terminating structures that typically wind-down or refinance at the end of their financing term, Structured Operating Companies are permanently capitalized variants of CDOs, with an active management team and infrastructure. They often issue term notes, commercial paper, and/or auction rate securities, depending upon the structural and portfolio characteristics of the company. Credit Derivative Products Companies (CDPC) and Structured Investment Vehicles (SIV) are examples, with CDPC taking risk synthetically and SIV with predominantly 'cash' exposure.

Types of CDOs

The two main types of CDOs are:

  • Collateralized loan obligations (CLOs) -- CDOs backed primarily by leveraged bank loans.
  • Structured finance CDOs (SFCDOs) -- CDOs backed primarily by asset-backed securities and mortgage-backed securities (In 2006, 54% of CDOs were backed by structured finance and 35% were backed by leverage loans [2])

Other types of CDOs include:

  • Commercial Real Estate CDOs (CRE CDOs) -- backed primarily by REIT assets
  • Collateralized Insurance Obligations (CIOs) -- backed by insurance or, more usually, reinsurance contracts
  • CDO-Squared -- CDOs backed primarily by the tranches issued by other CDOs.
  • CDO^n -- Generic term for CDO^3 (CDO cubed) and higher, where the CDO is backed by other CDOs/CDO^2/CDO^3. These are particularly difficult vehicles to model due to the possible repetition of exposures in the underlying.

Types of Collateral

The collateral for cash CDOs include:

  • Leveraged loans
  • Emerging-market sovereign debt
  • Project finance debt
  • Trust Preferred securities

Transaction Participants

Participants in a CDO transaction include investors, the underwriter, the asset manager, the trustee and collateral administrator, accountants and attorneys.

Investors

Investors have different motivations for purchasing CDO securities depending on which tranche they select. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities (e.g. corporate bonds) of a similar rating or credit profile. They also benefit from the diversification of the CDO portfolio and the expertise of the asset manager. Investors include banks and insurance companies as well as investment funds. Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Mezzanine and equity tranches offer yields that are not available in many other fixed income securities. Risk is higher and one can sometimes say 'unknown' as the gyrations of the CDO manufacturing process obscure defects in the model or assumptions. Investors include hedge funds and wealthy individuals.

Underwriter

The underwriter, typically an investment bank, acts as the structurer and arranger of the CDO. Working with the asset management firm that constructs the CDO's portfolio, the underwriter structures debt and equity tranches including selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche.

Other responsibilities include working with a law firm and creating the special purpose legal vehicle (typically a trust incorporated in the Cayman Islands) that will purchase the assets and issue the CDO's tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading restrictions that will be included in the CDO's prospectus. Such restrictions outline how and when the asset manager can sell an asset and limit the ability of the asset manager to change the asset class or credit rating composition of the portfolio at different times during the life of the CDO. An audited prospectus is prepared for investors.

The final step is to price the CDO (e.g. set the coupons for each debt tranche) and place the tranches with investors. The priority in placement is finding investors for the risky equity tranche and junior debt tranches of the CDO. It is common for the underwriter and asset manager to retain a piece of the equity tranche. This is often at the behest of investors in the CDO as equityholders have an economic incentive in ensuring that the CDO performs well. In addition, the underwriter is generally expected to provide some type of secondary market liquidity for the CDO.

According to Thomson Financial, the top underwriters are Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America Securities. CDOs are more profitable for underwriters than conventional bond underwriting due to the complexity involved. The underwriter is paid a fee when the CDO is issued.

The Asset Manager

The asset manager often has broad discretion to purchase and/or trade collateral and plays a key role in each CDO transaction even after the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDO's portfolio. The manager can maintain the credit quality of a CDO's portfolio through trades as well as maximize recovery rates when defaults on CDO assets occur.

The asset manager's role begins before the CDO is issued. Months before a CDO is issued, a bank will usually provide financing to enable the manager to purchase some of the collateral assets that may be used in the forthcoming CDO in a process called warehousing.

Even by the issuance date, the asset manager often will not have completed the construction of the CDO's portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend for several months after the CDO is issued. For this reason, some senior CDO notes are structured as delayed drawdown notes, allowing the asset manager to drawdown cash from investors as collateral purchases are made.

The asset manager's role continues even after the ramp-up period ends. During the CDO's "reinvestment period", which usually extends several years past the issuance data of the CDO, the asset manager is authorized to reinvest principal proceeds from maturing assets in the CDO's portfolio. Within the confines of the trading restrictions specified in the CDO's prospectus, the asset manager can also make trades to maintain the credit quality of the CDO's portfolio. The manager's prominent role throughout the life of a CDO underscores the importance of the manager and his or her staff.

There are approximately 300 asset managers in the marketplace. Some collateral managers are active whilst some are nothing more than placebos where the investor will be at risk to the underlying portfolio. Asset Managers make money by virtue of the senior fee (which is paid before any of the CDO investors are paid) and subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative business for asset managers. These fees, together with underwriting fees, administration{approx 1.5 - 2%} by virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.

Predefinição:See also

The Trustee and Collateral Administrator

The trustee holds title to the assets of the CDO for the benefit of the noteholders. In the CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and distributes noteholder reports, performs various compliance tests regarding the composition and liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall models. Two notable exceptions to this are Virtus Partners and Wilmington Trust Conduit Services, a subsidiary of Wilmington Trust, which offer collateral administration services, but are not trustee banks. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:

Accountants

The underwriter or trustee will hire an independent professional services firm to perform due diligence on the CDO's collateral pool. This entails vertifying certain attributes, such as credit rating and coupon/spread, for each collateral security. Source documents or public sources will typically be used to tie-out the collateral pool information that the underwriter or asset manager provides. In addition, the firm will verify that the collateral pool is in compliance with the rules and covenants set forth in the indenture. These covenants may limit the amount of low-rated assets that can be placed in the collateral pool.

The firm may also perform offering document due diligence. Offering documents contain various collateral stratification tables (e.g. the percentage of CDO collateral with different credit ratings). This information may be independently verified. Also, offering documents disclose the characteristics of the tranches the CDO is issuing such as yield, weighted-average life, and duration. The professional services firm may be asked to model the CDO's cash flows and confirm such numbers.

Attorneys

Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction documents. Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory requirements to disclose certain information to investors. This will be circulated to investors. It is common for multiple counsels to be involved in a single deal due to the number of parties to a single CDO from asset management firms to underwriters.

Subprime fiscal crisis

Predefinição:Citecheck Predefinição:Main Predefinição:See also From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. In 2006, $200 billion in mezzanine ABS CDOs (mezzanine ABS CDOs are mainly backed by the BBB or lower-rated tranches of mortgage bonds) were issued with an average exposure to subprime bonds of 70%.Predefinição:Fact As delinquencies and defaults on subprime mortgages continue to rise to record levels, CDOs backed by significant mezzanine subprime collateral are expected to experience severe rating downgrades and possibly losses in the coming months and years.

As the mortgages underlying the CDO's collateral decline in value, banks and investment funds holding CDOs face difficulty in assigning a precise price to their CDO holdings. Many are recording their CDO assets at par due to the difficulty in pricing CDOs.Predefinição:Fact The pricing challenge arises because CDOs do not actively trade and mortgage defaults take time to lead to CDO losses.

In June 2007, two hedge funds managed by Bear Stearns Asset Management Inc., an asset management company affiliated with a top U.S. investment bank, faced cash or collateral calls from lenders that had accepted CDOs backed by subprime loans as loan collateral. More losses are expected in the coming months.Predefinição:Fact

Bear Stearns, the fifth-largest U.S. securities firm, said July 18, 2007 that investors in its two failed hedge funds will get little if any money back after "unprecedented declines" in the value of securities used to bet on subprime mortgages.Predefinição:Fact

The extent of the declines in assets such as those at Basis Capital, an Australian securities firm, and Bear Stearns is being masked by the reluctance of investors to buy or sell the illiquid securities.Predefinição:Fact

Investors have criticized S&P, Fitch Ratings and Moody's Investors Service, saying their ratings on bonds backed by U.S. mortgages to people with limited credit didn't reflect the gaining default rate. They often gave top ratings to the securities. Some bonds have lost more than 50 cents on the dollar this year while their credit ratings haven't changed.

The new issue pipeline for CDOs backed by asset-backed and mortgage-backed securities is expected to slow significantly in the second-half of 2007 due to weakness in subprime collateral and the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds. This in turn could limit the availability of mortgage credit that is available to homeowners. CDOs purchased much of the riskier portions of mortgage bonds, helping to support issuance of nearly $1 trillion in mortgage bonds in 2006 alone. Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners are trying to refinance out of mortgage experiencing payment shock (e.g. adjustable-rate mortgages with rising interest rates).<ref>McLean, Bethany (2007-03-19), "[The dangers of investing in subprime debt {{{3}}}] ()", Fortune, http://money.cnn.com/magazines/fortune/fortune_archive/2007/04/02/8403416/index.htm </ref>

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