Collateralized Debt Obligations and Structured Finance : New Developments in Cash and Synthetic Securitization

✍ Scribed by Janet M. Tavakoli

• Publisher: Wiley
• Year: 2003
• Tongue: English
• Leaves: 355
• Category: Library

✦ Synopsis

The volume of collateralized debt obligations has ramped up so rapidly in recent years that the level of expertise needed to transact business in these products competently is very uneven. Experts often disagree on the basic terminology. Both of these related problems are linked to a third problem - opportunities for fraud. Tavakoli addresses this market's growing pains in this book.

Tavakoli tackles terminology at the very beginning and objects to the lazy practice of using the term "arbitrage" to refer to any hedged position that has made money such as referring to a long bond position being "arbitraged" by a short sale. A true arbitrage is a risk-free profit opportunity. Arbitrage language in the CDO context helps parties hide from themselves the fluctuating nature of the profit (and loss) conditions that they actually face. This is also true of "delta" hedging.

This is a recurring theme in this book: Participants first need to get the words right in order to get the concepts right, and they have to do both in order to get the numbers right. Another example is the "dual currency swap." A borrower receives one currency, pays coupons in another currency and has a final exchange of principal in a third currency. "Borrowers often perform this swap when they want to lower their all-in borrowing costs by taking on more currency risk," Ms. Tavakoli explains.

But the term "dual currency swap" also is used quite broadly for transactions in which fixed-rate bonds denominated in one currency simply are swapped for floating-rate bonds denominated in another. Ms. Tavakoli suggests that her readers should not assume that market professionals know the correct terminology. "Ask for the cash flow structure in writing, so you can determine the cash flows to see if they are consistent with the terminology as you understand it."

Tavakoli introduces a valuable distinction between timing and frequency, both terms important to the clear understanding of the cash flow that a contemplated transaction will produce. "It is not sufficient to state that I will get all of my cash back within the year," Ms. Tavakoli writes, explaining the distinction. "This is merely the timing of my ultimate receipt of cash flows. I want to know the frequency. Will I receive the cash flow in one lump sum toward the year-end, in equal monthly payments, or in a varied stream of payments over the course of the year? I'm not indifferent. This is why I emphasize timing and frequency."

This is an intriguing book. The market in collateralized debt obligations is complicated, subject to a miasma of human frailties. Hedge funds have entered this market in droves, particularly the synthetic market, and banks curry their favor as customers and competitors. As Tavakoli points out "find ways to become comfortable with alternative investors ... because this customer base is a key consumer of leveraged risk. They do not have the same regulatory capital constraints as banks."

✦ Table of Contents

Collateralized Debt Obligations and Structured Finance......Page 1
Acknowledgments......Page 8
Contents......Page 10
Introduction......Page 18
Estimated Market Size......Page 23
CHAPTER 2 The Origins of Securitization......Page 31
The CDO “Arbitrage”......Page 32
Portfolio Diversification and Credit Events......Page 34
True Sale, Hybrid, and Synthetic Structures......Page 40
Credit Enhancement......Page 42
CDO Classifications......Page 44
Market Value CDOs......Page 46
Cash Flow CDOs......Page 47
The Origins of U.S. Securitization......Page 48
Collateralized Mortgage Obligations......Page 57
CHAPTER 3 Structured Finance and Special Purpose Entities......Page 64
SPCs and Historical Abuse......Page 66
SPEs and SPVs......Page 72
Example of a Multiple Issuance Entity (MIE)......Page 74
Cayman Domiciled SPEs......Page 77
Repackagings to Satisfy Investor Demand......Page 79
CLNs and Funding Costs......Page 80
Principal Protected Notes (PPNs)......Page 84
First-to-Default Notes......Page 85
Liquidity......Page 87
Unwind Triggers Linked to Derivatives Transactions......Page 88
DAX-Linked Note with Triggers......Page 90
Master Trusts......Page 92
Owner Trusts......Page 93
REMICs......Page 94
Multiseller and Single Seller Conduits......Page 95
Domestically Domiciled Corporations......Page 97
Bankruptcy Remote?......Page 99
Risks to Portfolio Value......Page 102
CDSs......Page 104
Are You Hedged?—The Regulatory Viewpoint......Page 105
Digital Cash Payment—Alternate Termination Payment......Page 108
Initial Value × (Par – Market Value): Alternate Termination Payment......Page 109
Hedge Costs in Cash and Synthetic CDOs......Page 110
Deliverables: CDOs and the “Cheapest to Deliver” Option......Page 111
Convertible Bonds and Asset Swaps......Page 112
Default and Recovery Rate......Page 117
Default Language for Sovereign Debt......Page 121
Default Language for Nonsovereign Debt: Controversy and CDOs......Page 122
Comments on CDS Prices......Page 126
Total Rate of Return Swaps (Total Return Swaps)......Page 127
Pricing TRORS on Levered CDO Tranches......Page 129
TRORS versus Repos......Page 131
CDS versus TRORS......Page 132
Comparison of Managed Arbitrage CDO Features: Cash versus Synthetic Deals......Page 134
The Arranger and the Manager......Page 136
Deal Assembly......Page 137
Selecting the Portfolio and Impact on Rating......Page 138
Rating Criteria and Restrictions......Page 140
Warehousing Assets......Page 148
Reinvestment Period......Page 149
Non-Call Period......Page 150
Legal Final Maturity......Page 151
Tranching and the Synthetic Arbitrage Advantage......Page 152
Waterfalls for Cash versus Synthetic Arbitrage CDOs......Page 153
Payment-in-Kind (PIK) Tranches......Page 157
Psychic Ratings: Rating Agency Treatment of PIK Tranches......Page 158
CDS versus Cash Asset Spreads......Page 159
Simplified Examples of Interest Rate Swaps and Asset Swaps......Page 160
Hedging the CDO Portfolio Cash Flows......Page 166
Settlement in the Event of Default or Credit Event......Page 173
Cash versus Synthetic Arbitrage CDO Equity Cash Flows......Page 175
Sample Cash Flows......Page 178
Summary of Cash Arbitrage CDOs versus Synthetic Arbitrage CDOs......Page 187
CHAPTER 6 Cash Flow Caveats......Page 188
Conventional Wisdom......Page 189
Accruing Errors......Page 191
Probability of Receipt......Page 194
Equity Structures......Page 195
Equity Investor Injects Cash as Overcollateralization......Page 198
Rated Equity: Static Deal......Page 201
Equity Investor Earns a Stated Coupon on the Remaining Equity Investment......Page 205
Conflict of Interest between the Residual Holder and Senior Tranche Investors......Page 211
Unfunded Equity Investments—Ultimate Leverage......Page 213
Actively Traded and Limited Substitution Synthetic Arbitrage CDOs......Page 215
Interest Subparticipations (ISPs): When Equity Isn’t First Loss......Page 216
Participation Notes (PNs)......Page 219
Combination Notes (CNs)......Page 220
Investor Motivation......Page 221
Principal Protected Structures......Page 222
True Sale (“Fully Funded”): Delinked Structure......Page 226
Linked Nonsynthetic Structures......Page 230
Linked Black Box Credit Linked Note (CLN) CDOs......Page 232
Synthetic Structure with SPE (BISTRO)......Page 234
Partially Synthetic Linked CDOs......Page 237
Fully Synthetic CDOs......Page 238
Small to Medium-Size Enterprises (SMEs)—Europe......Page 240
SMEs: United States versus Europe......Page 244
Secured Loan Trusts......Page 245
Regulatory Capital—The Model Advantage......Page 249
Regulatory Capital—BIS II......Page 255
Loans and Other Exposures......Page 260
New Structured Finance Deals......Page 264
Fraud......Page 265
Enron, J.P. Morgan, and Offshore Vehicles......Page 268
Participation Notes......Page 274
Equity Total Rate of Return Swaps (TRORS)—Loans Disguised as Capital Injections......Page 275
The Trading Book Parking Lot: Regulatory Capital Arbitrage......Page 276
Trading Books and CDOs: Short Mezzanine and Long Equity......Page 278
Hedge Funds as Investors......Page 282
Structured Finance and Accounting (Kidder Peabody)......Page 285
The Sarbanes-Oxley Act of 2002......Page 288
Will Sarbanes-Oxley Make a Difference?......Page 292
CHAPTER 9 Super Senior Sophistry......Page 294
The AAA Rip-Off......Page 296
Rating Agencies—Moody’s Tranching......Page 299
AAA Basket with 2 Percent First-Loss Tranche......Page 301
Super Senior Attachment Point......Page 302
Super Senior Pricing......Page 303
Super Seniors or Senile Seniors?......Page 304
Where Are the Regulators?......Page 306
Junior Super Seniors......Page 307
Super Senior “Investors”......Page 308
Final Thoughts on Super Seniors......Page 309
Future Flows: Payment Rights Securitizations......Page 311
Emerging Market Caveats......Page 315
Multisector CDOs: CDOs(2)......Page 318
Structured Investment Vehicles (SIVs): Credit Arbitrage Funds......Page 319
Hedge Funds and Collateralized Fund Obligations (CFOs)......Page 320
First (and nth)-to-Default Basket Swaps......Page 322
Portfolio Swaps......Page 327
Multiline Insurance Products: Disappointment and Promise......Page 328
Lexington (AIG) and Hollywood Funding......Page 330
Transformers......Page 332
Playing the Game with BIS II......Page 335
Trend to Risk Distribution......Page 337
Acronym Key......Page 340
Selected Bibliography......Page 344
Interesting Web Sites......Page 346
Index......Page 348