collateralized debt obligations kellogg securitization colloquium may 5, 2003

Collateralized Debt Obligations

Kellogg Securitization Colloquium

May 5, 2003

www.mayerbrownrowe.com/cdo


Introduction

Market history

Market overview

CDOs are “process” not “asset class”

CDOs are an application of securitization technology under rating agency methodology to underlying assets to result in rated securities


CDOs include:

Collateralized Bond Obligations (CBOs);

Collateralized Loan Obligations (CLOs);

Collateralized Fund Obligations (CFOs); and

Synthetic Collateralized Debt Obligations (SCDOs or CSOs).


CDOs include:

Bonds

Loans

Emerging Market Debt

Trust Preferred

Project Finance

Distressed Debt

Middle-Market Loans

Private Equity Hedge Funds

Convertible Bonds

CDOs may soon include: Municipal Bonds


CDOs began in 1988 with Continental Bank’s

FRENDS deal, followed by NatWest’s ROSE deals

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

However, minimal CDO activity until 1993, when

market started to take off

2002 CDO estimated issuance was $210Billion

CDO estimated current “opportunity”

is $350Billion


CDOs are “balance sheet” or “arbitrage”

Balance sheet CDOs are a funding alternative and may have regulatory capital benefits, but are “linked” to sponsor

Arbitrage CDOs are motivated by true arbitrage


CDOs are “cash flow” or “market value”

Cash flow CDOs use an overcollateralization (OC) ratio that measures the par amount of collateral adjusted for defaulted items

Market value CDOs use an OC ratio that measures the market value of collateral adjusted for defaulted items


CDOs are “cash” or “synthetic” or a combination thereof

A cash CDO sells debt and equity securities and uses the proceeds thereof to acquire collateral

A synthetic CDO acquires credit exposure through credit derivatives


CDOs use a “waterfall” to allocate “interest proceeds” and “principal proceeds”

CDOs use “eligibility criteria” and “portfolio profile” to regulate eligible collateral

CDOs use collateral tests (an OC ratio and an interest coverage ratio) to regulate collateral quality


Underlying collateral affects the CDO

Ramp up

Collateral eligibility and profile criteria

Trading and reinvestment


Global CDO issuance rose 38% YoY

Collateralized Debt Obligations grew 74% YoY ($208BN)

Banc Of America Securities’ 2002 CDO Data


Cash CDOs ($60.6BN):


35%

31%

12%

9%

8%5%

MS CDOs

HY CLOs

Other

BS CDOs

IG CDOs

HY CDOs


Collateralized Debt Obligations (SCDOs):


51%

38%

11%

Static Arbitrage

Balace Sheet

Managed Arbitrage


CDOs dramatically affect markets for underlying collateral

In 2002, CLOs represented 50% of the leveraged loan market

ABS CDOs greatly facilitate the related ABS by providing the required illiquid mezzanine capital

Previously CBOs represented over 25% of the high-yield bond market


Synthetic Collateralized Debt Obligations (SCDOs) utilize credit derivatives

Total credit derivatives are over $2TN and projected to grow to $4TN by 2005

There are active and liquid markets for CDS on prime companies in the US and Europe

But note the so-called 200/200 tiering


Credit derivatives are an extremely sophisticated and powerful financial product

However, their flexibility and novelty often makes their characterization more difficult

Specifically, issues regarding whether the credit derivative is insurance for tax purposes or does it require insurance company status/regulation


Synthetic CDOs use credit derivatives to acquire credit exposure w/o transfer or, in some cases, funding of asset

CDOs, including SCDOs, are an application of securitization technology under rating agency methodology to underlying assets to result in rated securities


Credit derivatives are

Total Return Swaps or TRS

Credit Default Swaps or CDS

Credit-Linked Notes or CLNs

Basic Total Return Swap

Total Return

Bank pays Customer the total return on the referenced

assets. Bank has reduced credit risk to reference assets,

but acquires credit risk of Customer.

Basic Total Return Swap

Financing Charge

Customer pays Bank a specified financing charge and

acquires credit risk of reference asset.

Basic Credit Default Swap

Bank/Customer “buys” credit protection on a referenced

entity and pays a credit spread therefor.

Credit Protection

Basic Credit-Linked Note

Credit Linked Note

Bank issues a credit linked note that pays (or, if a credit

event occurs, doesn’t pay) the principal of, and interest on, a

reference asset. Bank has reduced exposure to credit risk

of referenced asset.

Basic Credit-Linked Note

Credit Linked Note

Customer purchases the note and acquires credit risk of

reference asset.


ISDA’s 1999 Credit Derivative Definitions and elective Supplements regarding

Convertible, Exchangeable and Accreting Obligations

Successor and Credit Events

Restructuring

Draft 2002 Credit Derivative Definitions Adoption expected 05/03


Advantages

Avoid transfer issues (consents, etc.)

Quicker execution?

Simpler documentation?


Disadvantages

More complex accounting (FAS133 and DIG/ED D2 model) and tax (NPC or financing)

Precision?

Legal?


3 Types of SCDOs

Balance Sheet SCDOs

Tranched Basket/Portfolio SCDOs

Managed Arbitrage SCDOs


Bank CDO

ClassA

ClassB

ClassC

CDS

Notes/Swaps

Bank obtains economic and regulatory capital relief. Investors obtain credit exposure and return

Balance Sheet SCDOs


Issuer CDO

ClassA

ClassB

ClassC

CDS

Notes/Swaps

Issuer reduces credit exposure

Investors obtain credit exposure and arbitrage return

Tranched Basket/Portfolio SCDOs


Bank CDO

Manager

ClassA

ClassB

ClassC

CDS

Notes/Swaps

Manager selects and manages portfolio to enhance arbitrage opportunity

Managed Arbitrage SCDOs


Feature Static Managed

Trading CDS Long Only

No removal or substitution

CDS Long/Short

Exposures added and/or removed

Excess Spread Fixed CDS premium

Credit-related premium

Excess spread released, trapped or used to offset losses

CDS premium reflects credit and management

Comparison of Static and Managed SCDOs



Liquidity Credit Events Credit Events

Trading losses

Counterparty Risk

Single CDS counterparty

Exposure to protection buyers only

One or more CDS counterparties

Exposure to protection buyers and/or sellers




Portfolio Initial guidelines only

Minimum WARF, WARR and/or WAS

Limits on total CDS short and offset exposure, trading and concentrations

Structure Credit enhancement only

OC and IC tests

Limits on counterparties and required CDS documentation

Ramp-up restrictions and minimum notional balance

Excess spread trigger/trap



Trading Criteria

Minimum CDS reference entity ratings

Minimum CDS premiums

Required CDS documentation

Maximium total CDS notional balance

Maximum loss threshold (after which ‘switchback’ to static)

Identical CDS terms for offset

Mitigated market and counterparty risk

Required CDS removal for rating downgrade/negative watchlist

Permitted substitution if portfolio improvement/maintenance


Conclusion

Questions

collateralized debt obligations kellogg securitization colloquium may 5, 2003

Documents

eligible collateral

cdo data slide

collateral quality slide

reinvestment slide

market value cash flow

sponsor arbitrage cdos

market value of collateral

rated securities slide