Chap 25 - CDO Structuring of Credit Risk

Question 1

The key to the use of the CDO structure in the case of credit risk is that a large portion of the financing of the CDO (i.e., the security tranches) can be in the form of senior tranches, which contain relatively little credit risk compared to the CDO’s underlying collateral portfolio. Thus, a large portion of a capital structure financing high-yield debt (or other credit-risky assets) can be rated as investment grade by the rating agencies. The use of CDO structuring can transform undesirable securities (high-yield debt) into desirable securities (highly rated senior tranches).

Answer 1

The high credit ratings given to senior tranches when the underlying collateral pool consists of non-investment-grade bonds are based on three primary justifications: (1) the senior position; (2) the diversification inherent in the collateral portfolio; and (3) credit enhancements that were structured into the deal, such as a major bank providing additional safety features.

Question 2

What are the 6 investor motivations for structured products ?

Answer 2

1. Risk management: Investors may be better able to manage risk through structured products.
2. Return enhancement: Investors may be better able to establish positions that will enhance returns if the investor’s market view is superior.
3. Diversification: Investors may be better able to achieve diversification through structured products.
4. Relaxing regulatory constraints: Investors may be able to use CDO structures to circumvent restrictions from regulations.
5. Access to superior management: Investors may obtain efficient access to any superior investment skills of the manager of the CDO.
6. Liquidity enhancement: Tranches of CDOs can be more liquid than the underlying collateral pool.

Question 3

What is the CDOs three-period life cycle ?

Answer 3

1- The ramp-up period, during which the CDO trust issues securities (tranches) and uses the proceeds from the CDO note sale to acquire the initial collateral pool (the assets).

2- The revolving period, during which the manager of the CDO trust may actively manage the collateral pool for the CDO, potentially buying and selling securities and reinvesting the excess cash flows received from the CDO collateral pool.

3- The amortization period, the manager of the CDO stops reinvesting excess cash flows and begins to wind down the CDO by repaying the CDO’s debt securities. As the CDO collateral matures, the manager uses these proceeds to redeem the CDO’s outstanding notes.

Question 4

The sponsor of the trust establishes the trust and bears the associated administrative and legal costs. At the center of every CDO structure is a special purpose vehicle. A special purpose vehicle (SPV) is a legal entity at the heart of a CDO structure that is established to accomplish a specific transaction, such as holding the collateral portfolio.

Answer 4

SPVs are often referred to as being bankruptcy remote.Bankruptcy remote means that if the sponsoring bank or money manager goes bankrupt, the CDO trust is not affected.

Question 5

What is the reference portfolio ?

Answer 5

The underlying portfolio or pool of assets (and/or derivatives) held in the SPV within the CDO structure is also known as the collateral or reference portfolio. Every CDO active manager must balance risk and return. The risk and return of credit-risky collateral assets are often described using three major terms: weighted average rating
factor, weighted average spread, and diversity score.

Question 6

What is the weighted average rating factor (WARF) as described by Moody ?

Answer 6

The weighted average rating factor (WARF), as described by Moody’s Investors Service, is a numerical scale ranging from 1 (for AAA-rated credit risks) to 10,000 (for the worst credit risks) that reflects the estimated probability of default. The rating factor increases nonlinearly, with small numerical differences between the higher ratings and large numerical differences between the lower ratings.

Question 7

What is a diversity score ?

Answer 7

A diversity score is a numerical estimation of the extent to which a portfolio is diversified. Portfolios of 100 securities can have substantially different levels of diversification, depending on the extent to which the securities are correlated. The diversity score is designed to indicate the number of uncorrelated securities
in a hypothetical portfolio that would have the same probabilities of losses as the portfolio for which the diversity score is being computed.

If a portoflio of 100 securities are all perfectly correlated, it would have a diversity score of 1. If all 100 of the securities were uncorrelated, the diversity score would be 100.

Question 8

What is the weighted average spread (WAS) ?

Answer 8

The weighted average spread (WAS) of a portfolio is a weighted average of the return spreads of the portfolio’s securities in which the weights are based on market values. The spread of each security is computed as the excess of the security’s yield over a specified reference rate, such as LIBOR, with a specified maturity.

Question 9

Historically, there is a very strong positive relation between rating factors and credit spreads. An active manager of a CDO can increase the WARF to get more yield (WAS). Conversely, the manager may increase the creditworthiness of the CDO collateral pool (lower the level of WARF), but only at the expense of yield (a lower WAS).

Question 10

What is the tranche width ?

Answer 10

The tranche width is the percentage of the CDO’s capital structure that is
attributable to a particular tranche. It is a positive percentage that is computed as the distance between those two points. Thus, a 10%/25% tranche would have a tranche width of 15% (i.e., 25% − 10%). The process of structuring a CDO typically involves altering the risk of the structure’s assets and the widths of various tranches in an attempt to earn credit ratings for the more senior tranches that allow those tranches to be sold to investors at attractive financing rates.

Question 11

Balance sheet CDOs are created to assist a financial institution in divesting assets from its balance sheet. Arbitrage CDOs are created to attempt to exploit perceived opportunities to earn superior profits through money management.

Question 12

Why would a financial institution use a balance sheet CDO to divest assets ?

Answer 12

(1) to reduce its credit exposure to a particular client or industry by transferring those risks to the CDO.

(2) to get a much-needed capital infusion.

(3) to reduce its regulatory capital charges. By selling a portion of its loan or bond portfolio to a CDO, the institution can free up regulatory capital required to support those credit-risky assets.

Question 13

Arbitrage CDOs are designed to make a profit by capturing a spread for the equity investors in the CDO and by earning fees for money management services. Put differently, an arbitrage profit is earned if the CDO trust can issue its tranches at a yield substantially lower than the yield earned on the bond collateral contained in the trust, such that the equity tranche of the trust receives expected residual income disproportionate to its risk.

Answer 13

Further, money management firms earn fees on the amount of assets under management. By creating an arbitrage CDO, an investment management firm can increase both its assets under management and its income.

Question 14

What are the 3 direct financial motivations for a manager of an arbitrage CDO ?

Answer 14

1- The money manager can earn a transaction fee for selling its high-yield portfolio to the CDO trust.

2- The CDO sponsor is usually also the manager of the CDO trust and can therefore earn management fees for its money management expertise.

3- As an equity investor in the CDO trust, the money manager can earn the spread or arbitrage income from the CDO trust between the CDO collateral income and the payouts on the CDO notes.

Question 15

How can Synthetic balance sheet CDOs differ from the cash-funded ?

Answer 15

Synthetic balance sheet CDOs differ from the cash-funded variety in several
important ways. First, cash-funded CDOs are constructed with an actual sale and transfer of the loans or assets to the CDO trust. Ownership of the assets is transferred from the bank or other seller to the CDO trust in return for cash. In a synthetic CDO, however, the sponsoring bank or other institution transfers the risks and returns of a designated basket of loans or other assets via a credit derivative transaction, usually a credit default swap (CDS) or a total return swap. Therefore, the institution transfers the risk profile associated with its assets but does not give up the legal ownership of the assets and does not receive cash from selling assets.

Question 16

However, one advantage of a cash-funded CDO to a bank is that it can be used to completely replace risky assets with cash on the bank’s balance sheet, rather than synthetically removing only the risk through derivatives.

Answer 16

Consider a bank with a $500 million loan portfolio that it wishes to sell. It must hold risk-based capital equal to 8% to support these loans. If the bank sponsors a CDO trust in which the trust purchases the $500 million loan portfolio from the bank for cash, how much reduction in risk-based capital will the bank receive if it finds outside investors to purchase all of the CDO securities?

Since the bank no longer has any exposure to the basket of commercial loans, it has now freed $40 million of regulatory capital (8% × $500 million=$40 million) from needing to be held to support these loans.

Question 17

What is a cash-funded CDO ?

Answer 17

A cash-funded CDO involves the actual purchase of the portfolio of securities serving as the collateral for the trust and to be held in the trust. In other words, physical ownership of the assets is acquired by the CDO.

Question 18

What is synthetic CDO ?

Answer 18

In a synthetic CDO, the CDO obtains risk exposure for the collateral pool through the use of a credit derivative, such as a total return swap or a CDS. Physical ownership of the underlying basket of securities is not transferred to the CDO, only the economic exposure. In effect, the CDO trust sells credit protection on a referenced basket of assets. For this protection and in the case of a CDS, the CDO receives income in the form of CDS payments from the credit protection buyer. The credit protection payments are then divided up among the CDO’s investors into tranches, based on the seniority of the securities issued by the CDO.

Question 19

Typically, the CDO invests the proceeds from issuing tranches in assets such as Treasury securities. The interest from the collateral combines with the CDS payments from the credit protection buyer to form a total return that should approximate the total return that would be received from physical ownership of the reference assets.

Question 20

What are 3 advantages and 2 disavantages from a synthetic CDO compared to a cash-funded ?

Answer 20

Advantages :

1- A synthetic CDO is less burdensome than the transfer of assets required
for a cash-funded CDO. Commercial loans may require borrower notification and consent before being transferred to the CDO trust (time consuming).

2- Synthetic CDO trusts can be used to provide economic exposure to credit-risky assets that may be relatively scarce and difficult to acquire in the cash market.

3- Synthetic CDO trusts can employ leverage by using derivatives to sell credit protection on assets of a size that is greater than the level of assets in the collateral pool.

Disavantages:

1- Potential exposure to counterparty risk. The CDO is exposed to the risk of bankruptcy by counterparties to the credit derivatives at the same time that the credit derivatives have positive market values.

2- Reduction in bankruptcy remoteness. When the CDO has direct ownership and physical possession of the credit risky collateral assets (cash funded), there are reduced potential legal entanglements than when the CDO has a relationship with an entity through one or more credit derivatives (synthetic).

Question 21

What is a cash flow CDO ?

Answer 21

In a cash flow CDO, the proceeds of the issuance and sale of securities (tranches) are used to purchase a portfolio of underlying credit-risky assets, with attention paid to matching the maturities of the assets and liabilities. Typically, there is a fixed tenor (maturity) for a cash flow CDO’s liabilities that coincides with the maturity of the underlying CDO portfolio assets. Cash inflows are anticipated to be received in time
to meet the cash outflows required by the tranche holders. Thus, the CDO portfolio is managed to wind down and pay off the CDO’s liabilities through the collection of interest and principal on the underlying CDO portfolio.

Question 22

What is a market value CDO ?

Answer 22

In a market value CDO, the underlying portfolio is actively traded without a
focus on cash flow matching of assets and liabilities. The liabilities of the CDO are paid off through the trading and sale of the underlying portfolio. In a market value CDO, the portfolio manager is most concerned with the market value of the assets and the volatility of those market values, because precipitous declines in the CDO’s portfolio reduce the CDO’s ability to redeem its liabilities. In market value CDO structures, the return earned by investors is linked to the market value of the underlying collateral contained in the CDO trust.

Question 23

What is an internal credit enhancement ?

Answer 23

An internal credit enhancement is a mechanism that protects tranche
investors and is made or exists within the CDO structure, such as a large cash position. Generally, credit enhancements are made at the expense of lower coupon rates paid on the CDO securities.

Most CDO structures contain some form of credit enhancement to ensure that the majority of the securities issued to investors will receive an investment-grade credit rating.

Question 24

What is subordination ?

Answer 24

Most common form of credit enhancement. Subordination is the process of protecting a given security (i.e., tranche) by issuing other securities that have a lower seniority to cash flows.

Question 25

What is Overcollateralization ?

Answer 25

Overcollateralization refers to the excess of assets over a given liability or group of liabilities.Overcollateralization of a senior tranche occurs when there are subordinated tranches in a CDO. It is an internal credit enhancement.

Ex: CDO trust with a market value of collateral trust assets of $100 million. 3 tranches: Tranche A is the senior: $70 million of securities Tranche B of $20 million of subordinated fixed-income securities and is paid after the senior tranche is paid in full Tranche C is a $10 million equity tranche with the lowest seniority.

The overcollateralization rate for the senior tranche in this example is $100/$70=143%.

Question 26

What is spread enhancement ?

Answer 26

The average coupon on the assets may exceed the average coupon on the tranches such that in the absence of default, the CDO should be able to receive more cash than it is required to distribute. This excess interest may be retained and serve to enhance the credit-worthiness of the outstanding tranches. This excess spread may be used to cover losses associated with the CDO portfolio. If there are no losses on the loan portfolio, the excess spread accrues to the equity tranche of the CLO trust.

It could arise because :

1- CDO trust earn a premium for illiquidity or because the assets are of lower credit quality than the CDO securities.

2- A sloped term structure and mismatched assets and liabilities.

Question 27

What is an external credit enhancement ?

Answer 27

An external credit enhancement is a protection to tranche investors that is provided by an outside third party, such as a form of insurance against defaults in the loan portfolio. This insurance may be a straightforward insurance contract, the purchase of a put option by the CDO, or the negotiation of a CDS to protect the downside from any loan losses.

Question 28

Distressed debt CDO uses the CDO structure to securitize and structure the risks and returns of a portfolio of distressed debt securities, in which the primary collateral component is distressed debt.

Answer 28

The CDO securities can receive a higher investment rating than the underlying distressed collateral through diversification, subordination, and one or several of the other credit enhancements. . Investors are then able to diversify into the distressed debt market and to do so more effectively by choosing a distressed debt CDO tranche that matches their level of risk aversion.

Question 29

What is a collateralized fund obligation (CFO) ?

Answer 29

A collateralized fund obligation (CFO) applies the CDO structure concept to the ownership of hedge funds as the collateral pool.

Question 30

What is a Single-tranche CDO ?

Answer 30

Single-tranche CDOs provide a highly targeted structure of credit risk exposure. In a single-tranche CDO, the CDO may have multiple tranches, but the sponsor issues (sells) only one tranche from the capital structure to an outside investor ( keep the rest for its balance sheet).

Question 31

What is Financial engineering risk ?

Answer 31

Financial engineering risk is potential loss attributable to securitization, structuring of cash flows, option exposures, and other applications of innovative financing
devices.

Question 32

What is Risk shifting ?

Answer 32

Risk shifting is the process of altering the risk of an asset or a portfolio in a manner that differentially affects the risks and values of related securities and the investors who own those securities.

Question 33

Ownership of junior tranches can actually encourage risk taking.

Answer 33

An equity tranche position in a CDO may be viewed as a call option. As a call option, equity tranches, and to a lesser extent other highly subordinated tranches, can actually benefit from increases in the risk of the collateral pool.

Increases in the risks of the CDO’s assets tend to transfer wealth from the holders of more senior tranches to the holders of less senior tranches. It is intuitively obvious that senior tranches become less valuable as the volatility of the CDO’s assets rise (with asset values held constant). The senior tranches have less probability of being fully paid while the coupons remain fixed.

The most junior tranche may be viewed as a long call option on the collateral assets. The most senior tranche may be viewed as a long riskless bond and short an out-of-the-money put option on the collateral assets. Higher volatility of the collateral pool helps the tranches that are long options (i.e., long vega) at the expense of the tranches that are short options.

Question 34

Higher risk in the collateral asset pool can occur both from higher-risk assets and from higher return correlations among the assets (i.e., reduced diversification). Thus, a lower diversity score can shift wealth from senior tranches to junior tranches even when the WARF is held constant. Note that a very well diversified portfolio will generate a low but constant default rate. A low but constant default rate will spare senior tranches from losses, as all of the losses will be absorbed by the junior tranches. A very poorly diversified portfolio gives senior tranche holders an increased chance of losses (when the assets experience very large losses) and junior tranche holders an increased chance of bearing few or no losses (when assets experience minimal losses).

Question 35

What are some of CDO risks ?

Answer 35

1- A risk due to the difference in payment dates arises from a mismatch between the dates on which payments are received on the underlying trust collateral and the dates on which the trust securities must be paid. Solution: Use of a swap agreement with an outside party, in which the trust swaps the payments on the underlying collateral in return for interest payments that are synchronized with those of the trust securities.

2- Basis risk occurs when the index used for the determination of interest
earned on the CDO trust collateral is different from the index used to calculate the interest to be paid on the CDO trust securities. The risk in this case is when a mismatch occurs and the indices underlying cash income from the collateral assets differ from the indices underlying payments to the tranche holders.

3- CDO tranches suffer when the collateral pool performs poorly. This can be cause by: The market prices of collateral assets respond immediately to shifts in the levels, slope, or curvature of the yield curve of riskless rates.

Question 36

What is a copula approach to analyzing the credit risk of a CDO ?

Answer 36

A copula approach to analyzing the credit risk of a CDO may be viewed like a simulation analysis of the effects of possible default rates on the cash flows to the CDO’s tranches and the values of the CDO’s tranches.

The idea behind the copula model of CDO default risk is that defaults are generated by two normally distributed factors: an idiosyncratic factor and a market factor. The idiosyncratic factor takes on a different value for each credit risk (i.e., bond) and generates hypothetical defaults whenever the factor’s value for that particular bond is sufficiently high. The market factor is common to all credit risks in the CDO portfolio and reflects the tendency of defaults to occur in unison.

Question 37

A parameter set by the user of the copula model determines the relative weights of the two factors (i.e., idiosyncratic versus market). Taken together, along with a user-specified expected default rate, the model allows simulation of the probabilities
of various default levels for the collateral pool. The estimated probabilities of various default levels are then combined with a user-supplied loss rate given default
(i.e., 1 – recovery rate) to estimate the probabilities of losses to each of the tranches in the CDO structure.