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Collateralised debt obligations

Private equity firms in Europe are following the lead of their US counterparts by pricing collateralised debt obligations. An expert in the field, Jason Nelson, explains the world of CDOs and the risks attached to these transactions.

Financial Securities Data reports that high-yield issuance totalled over $50bn in 1999. Of course, savvy investors are familiar with the direct relationship between risk and return. So how can investors play the high-yield market while minimizing the inherent risk? The answer: collateralised debt obligations (CDOs).
 
How did collateralised debt obligations originate?

Collateralised debt obligations are privately placed securitisations that were created in the late 1980s. A securitisation, in abstract terms, is a reallocation of risk. Securitisation is the process of converting assets into securities backed by those assets and is used for:

• Lower funding costs
• Accounting purposes
• Accessing the capital markets
• Generating fees—servicing and underwriting

CDOs borrowed their structural template from another structured product—collateralised mortgage obligations (CMOs). The CMO structure was established in the 1970s and proved readily adaptable to different collateral types because of its ability to repackage and redistribute risk, thereby achieving equivalent returns through higher-rated securities.
 
In short, this structuring technique creates a special-purpose entity (SPE) to hold underlying collateral. The SPE then issues securities backed by the underlying collateral pool. The underlying collateral's cash flows are then used to pay interest and principal on the issued securities.
 
The subsequent securities' higher credit quality is due in part to a fundamental concept in portfolio management theory - diversification. However, diversification is only part of the story.
 
Tranching

Diversification redistributes risk by "pooling" numerous underlying collateral risk-return profiles, thereby creating a single risk-return profile on the underlying collateral pool (the assets). Securitisations go one step further and seek to redistribute liability risk through a process known as tranching—taking the underlying collateral cash flow and dividing it among numerous tranche interest and principal components.
 
In layman's terms, this means creating different classes of securities (the liabilities), each of which carry a different risk component defined by its payment priority and timing. Tranching creates multiple securities that appeal to different investors given the investor's risk-return threshold.
 
For example, highly rated securities will have a lower return and can appeal to institutional investors like pension funds. Lower-rated securities will have a higher return and can appeal to hedge fund managers who are willing to sacrifice safety for the juicier yields (up to 30 per cent annually). Thus, the underlying collateral pool's single risk-return profile (created through diversification) is transformed into multiple risk-return profiles on the newly created securities (liabilities).
 
In the end, a less attractive investment on the collateral side—even though risk is mitigated through diversification—is transformed into a more attractive investment opportunity by tranching.
 
CDO tranches do not resemble their underlying collateral in credit quality or performance. Each newly-created note tranche offers unique payment characteristics.
 
What are the types of CDOs?

CDOs come in a variety of flavours but generally employ one of the following structures:

• Cash Flow Structure: ongoing cash flow from the underlying collateral pool serves as the repayment of interest and principal on the securities; or 
• Market Value Structure: ongoing cash flow proceeds from the sale of underlying collateral serves as the repayment of interest and principal on the securities.

Cash flow structures are the dominant CDO form in terms of issuance volume. These are commonly broken down into arbitrage and off-balance sheet transactions. Arbitrage structures are the most common cash flow form and capture the positive spread between a portfolio of high-return, high-risk assets and lower-cost, highly-rated securities (liabilities) issued to purchase the underlying collateral portfolio.
 
The second cash flow structure -- off-balance sheet transactions -- was created to reduce regulatory capital constraints by securitising balance sheet assets. However, off-balance sheet CDOs are now used to increase lending capacity and lower funding costs. Market value structures -- as opposed to cash flow structures -- trade the underlying collateral to realize positive gains for the payment of liability interest and principal. Market value structures are "trading portfolios."
 
What is CDO collateral?

The following definitions are helpful before reading further:

• Collateralised Bond Obligation (CBO): backed by a portfolio of bonds.
• Collateralised Loan Obligation (CLO): backed by a portfolio of loans.
• Collateralised Debt Obligation (CDO): backed by a portfolio of bonds, loans and other assets.

Because almost all transactions created today contain a mix of several collateral types, CDO is generally the most applicable term. CDO collateral may be comprised of the following assets (this list is not exhaustive):
 
CDO collateral types

What are the motivations for CDOs?

CDOs are attractive because the structure reduces risk through diversification and tranching. It is important to note that these are not the only risk management tools used in CDOs but are highlighted here for entry-level understanding. CDOs employ many credit enhancement features including:

• Overcollateralisation;
• Cash collateral/reserves;
• Excess spread/interest;
• Amortizing and insured tranches; and
• Hedges (interest rate swaps).

The motivation for each party in a CDO transaction can be very different. These are summarized in the table below.

CDO motivations

CDOs are complex financial structures that can quickly go awry without established portfolio-management guidelines. These guidelines can be presented under many structural forms depending upon the overall purpose of the issuance.
 
Regardless of the contractual form, the contract itself can be thought of as a "rulebook" for the CDO. This rulebook specifies:

• Collateral quality and coverage testing parameters for the portfolio;
• Acceptable collateral types;
• Performance metrics;
• Trading parameters;
• Payment distribution priority waterfall; and
• Default and liquidation triggers.

Summary

Structured products -- including CDOs -- continue to evolve. At their genesis in the late 1980s, the primary CDO collateral types were high-yield bonds and loans. Today, CDOs hold mortgage-backed securities, asset-backed securities, real-estate investment trusts (REITS) and even tranches of other CDOs. Thus, even though 2000 high-yield issuance is off its blistering 1999 pace, the addition of these new collateral types signals even more asset choices for the future.
 
The result: a more complicated financial product for the rating agencies to contend with but continued yield for investors. Given the fact that only 1.2 per cent of all CDOs have been downgraded and there has never been a default, there is no end in sight for this type of securitisation.
 
Notes
"Global CBO/CLO Criteria," Standard and Poor's Structured Finance (1999.)

Harris, Dandra, Kitto, Thomas, Nelson, Soody, Tesher, David and Widemik, Anna, "An Introduction to Cash Flow CBOs/CLOs and Market Value Transactions," Standard and Poor's Conference, Miami, Florida (April 1999).

Hurst, R. Russell, "The Myth and Reality of Collateralised Debt Obligations -- Growth and Stability Continue," First Union Securities, Inc., Asset-Backed Research (October 1999).

Lee, Dan and Chen, Wei, "Securitization: An Overview of Arbitrage and Tranching," The Securitization Conduit, Vol. 1, No. 1 (1998).

"New Assets are Tweaking Old Vehicles Amid Dearth of High-yield Bonds," Wall Street Journal (June 12, 2000).

With kind permission of © smartpros.com

Jason C. Nelson is an expert on collateralised bond obligation (CBO) and collateralised loan obligation (CLO) administration. After entering the market with Chase Manhattan Bank, he founded a collateralised debt obligation (CDO) group with First Union Securities. Nelson is available for consulting and can address numerous CDO issues, including system requirements for deal administration, contractual review and negotiation, new business generation, tax reporting and organizational design. For more information please contact jcnelson@email.com