Collateralized Debt Obligations
Meaning of CBOs/ CLOs:
There is no basic distinction between generic securitisations and the CBO/ CLO issuance and the usual asset backed securities - the difference is one of collateral. In case of CDOs, the collateral is a portfolio of debt securities, loans or similar obligations. The purpose of most CDOs is could, however, be much different from traditional ABS - it is to create arbitrage by pooling together a portfolio of debt securities, and raising liabilities by structured funding.
A CDO as a pool of debt securities might look similar to a mutual fund - however, with a significant difference. CDOs are primarily based on liability funding - the equity is simply a credit enhancement to support the liabilities. The purpose of a CDO is to redistribute the returns from the collateral to the rated debt liabilities commensurate with their ratings, and to reap the rest of the returns for the equity holders. Thus, the purpose of CDOs is to build a highly leveraged structure to maximise the returns on equity.
Portfolio diversification balances out the leverage. Thus, the essential economics of a CDO lies in mitigating leverage by diversification and maximising the otherwise flat returns of a diversified portfolio by leverage. Mutual funds or usual investment vehicles essentially depend on diversification - CDOs are somewhere between mutual funds and hedge funds in trying to balance out both diversification and leverage.
The terms CLO and CBO respectively distinguish between loan collateral and bond collateral - the two together are referred to as CDOs.
Difference between normal securitisations and CDO structures:
Though there is no basic difference in terms of the essential structure, some differences arise by the very nature of the collateral and the motives of the issuer. The important points of difference are:
- The number of obligors in the collateral pool are not many: unlike mortgage portfolios or auto loans portfolios having thousands of obligors, CDO pools will have 100 -200 loans.
- The loans/ bonds are mostly heterogenous. The originator might try to bunch together loans which do not exhibit any mutual correlation, to provide benefits of a diversified portfolio.
- Most CDO structures use a tranched, multi-layered structure with a substantial amount of residual interest retained by the originator.
- Generally, CDO issues will use a reinvestment period and an amortisation period. Some tranches might have a "soft bullet" repayment (meaning a bullet repayment that is not guaranteed by any third party).
- A common practice in CDO market is arbitraging, where larger banks buy out loans from smaller ones and securitise them, making arbitrage revenues in the process.
Motives in CBO/ CLO issuance:
Banks would resort to securitisation essentially with 4 motives, in different combinations: sourcing cheaper funds, attaining higher regulatory capital, better asset-liability management, and reduced non-performing or under-performing assets.
There is yet another class of CDOs is called arbitrage CDOs where the originating bank buys loans/bonds from the market and securitizes the same for gaining an advantage on the rates. Since the motive of such securitizations is arbitraging, such CDOs are called arbitrage CLOs/ CBOs . To distinguish these from the ones where a bank securitizes its own receivables, the latter are called balance sheet CLOs/ CBOs.
Yet another variety of CLOs is developing fast : synthetic CLOs. Here the originating bank retains the loans on its balance sheet but merely securitizes the inherent credit risk. Synthetic CLOs repackage the underlying loans into cashflows that suit the needs of the investors and are not dependant on the repayment structure of the underlying loans. For more on credit derivatives, see Vinod Kothari's credit derivatives website.
Types of CDOs:
As the above discussion reveals, CDOs could basically be of two types: balance sheet CDOs and arbitrage CDOs. Balance sheet CDOs are those which result into transfer of loans from the balance sheet and hence, which impact the balance sheet of the originator. Arbitrage CDOs are those where the originator is merely a repackager: buying loans or bonds or ABS from the market, pooling them together and securitising the same. The prime objective in balance sheet CDOs is the reduction of regulatory capital, while the evident purpose in arbitrage CDOs is making arbitraging profits.
Balance sheet CLOs could be further classed into two: cashflow CDOs, and synthetic CDOs.
Cashflow CDOs are the usual CDO tranches where the originating bank transfers a portfolio of loans into an SPV. Master trust structures are commonly employed in CDOs to enable the bank to keep transferring loans into the pool on a regular basis without having to do complex documentation everytime.
Commerical loans are not regular-repaying in the sense of mortgage loans or auto loans. Hence, there is no question of regular retirement of CDOs like pass throughs in the mortgage market. Most of the cashflow CDOs repay by way of bullet repayments, and hence they need to have a reinvestment period during which the cash collected will be reinvested.
Synthetic CDOs do not intend to raise cash by transferring loans, but instead merely transfer the risk inherent in the loans. For more on synthetic CDOs, see below.
Market and transactions:
Most bank CLOs have been very large transactions-typically ranging above USD 1 billion and have been issued by large international banks, including banks based in the United States, United Kingdom, Japan, France, Belgium, Canada and the Netherlands.
Most CLOs use stratified structures for credit enhancements. The junior-most tranches are normally re-acquired by the originating bank.
CDO market in 2001:
Standard and Poor reports that in first half of 2001, the CDO activity globally was substantially higher than the comparative period last year. However, there is increased focus on arbitrage CDOs while the balance sheet CDO volumes have suffered. See the data and the report here.
CDO market in 1999:
A report from rating agency Duff and Phelps (DCR) says that "1999 was a year that witnessed considerable maturation and change in the CDO market. Last year CDO's crossed the line from "esoteric" assets to "mainstream" assets in the minds of many market participants. The maturation of the market is evidenced by the leveling off of new issuance and spreads, the changing nature of the investor base, and the development of the new innovations and niches."
The new issue volume in 1999 in USA was estimated by DCR at USD 78 billion.
The issue of regulatory arbitrage in bank securitisations:
Regulatory arbitrage - do banks try to parcel out good assets?: Added 4 Feb., 2000
Bank loan securitization is not only gaining popularity all over the world, it is also catching the regulators' attention due to failures of certain banks in the USA recently for alleged lapses in securitization accounting. It is alleged that banks put arbitrary values to the retained interests in securitised assets and thus painted a rosy picture of their otherwise weak financials. The other regulatory issue on securitization is whether it is tempting banks to parcel out their premium assets and be left with junk. These issues have been covered on a regular basis on this site - click here for a collection of links to the various items on this site.
An article in The Economist recently commented that US banks may not be as healthy as they seem to be, and one of the several reasons cited was the tendency to securitise. [ For details and link to an article by Bank for International Settlements, refer to a news item on our Securitisation news page.]
Despite skepticism about the impact of securitisation on banks, the fact remains that nearly 40% of all new non-investment-grade loans originated by U.S. banks is now being sold to collateralized loan obligations (CLOs), retail loan funds, and insurance companies, among others. It is also contended that banks that are accessing the CLO market have become more profitable with increased returns on equity of 3% to 7% on their loan portfolios.
Of late, the most popular device used in CDO transactions is synthetic. A synthetic CDO creates assets synthetically, that is, not by buying the asset in question by selling protection with reference to the reference entity. If it is a balance sheet synthetic CLO, the originating bank does not transfer the loans off its books but merely transfers the credit risk in the loans by issue of credit linked notes. The referenc asset is the loans held by the bank - as the credit risk in the loans is transferred to the SPV and from there on to the investors, the originating bank achieves regulatory capital relief.
The technique in a synthetic CDO consists of an SPV issuing credit linked notes to investors. The proceeds of the securities do not come to the originator, but are instead invested in AAA rated securities, to ensure that the repayment of principal to the investors is secured. The SPV in turn writes a credit default swap with the originating bank. For more on credit default swaps and other credit derivatives, see our site on credit derivatives. The loans remain on the books of the originating bank. The bank keeps paying credit default swap premium to the SPV. Should there be any default event with the originating bank, the bank would seek a payment from the SPV, in which case the investors of the SPV would suffer losses. As long as the default event does not take place, investors get returns equal to (a) returns from the AAA-rated investments and (b) the default swap premium.
Synthetic CLOs have a very substantial advantage over traditional CLOs - as there is no transfer of the loans itself, the legal issues associated with notice to obligors and perfection of legal transfer are all completely avoided.
As regards regulatory capital relief on synthetic CLOs, the US FRB issued a supervisory statement no. 99 -32 dated 15th Nov.,1999. The said circular provides that for the purposes of risk-based capital, the originator may treat the cash proceeds from the sale of credit linked notes that provide protection against underlying reference assets as cash collateralizing these assets. This would permit the reference assets, if carried on the sponsoring institution’s books, to be assigned to the zero percent risk category to the extent that their notional amount is fully collateralized by cash. This treatment may be applied even if the cash collateral is transferred directly into the general operating funds of the institution and is not deposited in a segregated account. The synthetic CLO would not confer any benefits to the sponsoring banking organization for purposes of calculating its Tier 1 leverage ratio because the reference assets remain on the organization’s balance sheet.
JP Morgan's Bistro is supposed to be first example of a synthetic securitisation. Subsequently, there have been several instances, listed below.
Morgan Stanley had recently come out with an interesting synthetic securitization structure called Sequils. For a brief description of the deal, click here to go to our News page. In such cases, the regulatory relief is to the extent of the securities into which the SPV investors, which are pledged with the originator.
More on CLOs/ CBOs:
Securitisation by banks:
- A very detailed research-based article by THOMAS W. ALBRECHT and SARAH J. SMITH : CORPORATE LOAN SECURITIZATION: SELECTED LEGAL AND REGULATORY ISSUES, click here
General articles/ detailed commentaries on CDOs
- One of best primers on CDOs in plain language, interesting style by Mark Adelson
- Triton Partners' research and articles on CDOs
- An excellent article by very good article by William J. Hannigan, CFA and Diane C. Nordin, CFA: From CMOs to CBOs: Three Generations of Fixed Income Investments, June 1997 - click here
- Collateralized Loan Obligations: A Powerful New Portfolio Management Tool for Banks, by Kenneth E. Kohler - click here
- Collateralized Debt Obligations: New Technology for MBS and Other Real Estate Assets by Jeffrey Stern & Erik Klingenberg [This is a PDF file] - click here
- Management of credit risk by CLOs - The "New" Science of Credit Risk Management at Financial Institutions By Janet L. Yellen Member, Board of Governors of the Federal Reserve System - click here
Investing in CDOs:
- Investing in CDOs: Arthur M Berd and Sunita L Ganapati of Lehman Brothers discuss performance of CDO equity tranches, in a managed and an unmanaged context- click here
Synthetic CDOs/ CLOs:
- Excellent article by Michael Gibson of the FRB on Understanding the Risk of Synthetic CDOs
- Standard and Poor's article on synthetic CDOs
- A brief and simple article on : Securitisation - Synthetic Structures by Chris Moore, Deloitte and Touche Oct 2000 http://www.gtnews.com/articles4/2394.html
- On Synthetic CLOs and other credit derivatives, visit Vinod Kothari's credit derivatives website.
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