Collateralized Debt Obligations Kellogg Securitization Colloquium May 5

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Collateralized Debt Obligations Kellogg Securitization Colloquium May 5, 2003 Collateralized Debt Obligations Kellogg Securitization Colloquium May 5, 2003

www. mayerbrownrowe. com/cdo www. mayerbrownrowe. com/cdo

Collateralized Debt Obligations Introduction Market history Market overview CDOs are “process” not “asset class” Collateralized Debt Obligations 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

Collateralized Debt Obligations CDOs include: Collateralized Bond Obligations (CBOs); Collateralized Loan Obligations (CLOs); Collateralized Collateralized Debt Obligations CDOs include: Collateralized Bond Obligations (CBOs); Collateralized Loan Obligations (CLOs); Collateralized Fund Obligations (CFOs); and Synthetic Collateralized Debt Obligations (SCDOs or CSOs).

Collateralized Debt Obligations CDOs include: Bonds Trust Preferred Loans Emerging Market Debt Project Finance Collateralized Debt Obligations CDOs include: Bonds Trust Preferred Loans Emerging Market Debt Project Finance Distressed Debt Middle-Market Loans Private Equity Hedge Funds Convertible Bonds CDOs may soon include: Municipal Bonds

Collateralized Debt Obligations CDOs began in 1988 with Continental Bank’s FRENDS deal, followed by Collateralized Debt Obligations CDOs began in 1988 with Continental Bank’s FRENDS deal, followed by Nat. West’s ROSE deals 2002 CDO estimated issuance was $210 Billion 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 CDO estimated current “opportunity” is $350 Billion

Collateralized Debt Obligations CDOs are “balance sheet” or “arbitrage” Balance sheet CDOs are a Collateralized Debt Obligations 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

Collateralized Debt Obligations CDOs are “cash flow” or “market value” Cash flow CDOs use Collateralized Debt Obligations 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

Collateralized Debt Obligations CDOs are “cash” or “synthetic” or a combination thereof A cash Collateralized Debt Obligations 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

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

Collateralized Debt Obligations Underlying collateral affects the CDO Ramp up Collateral eligibility and profile Collateralized Debt Obligations Underlying collateral affects the CDO Ramp up Collateral eligibility and profile criteria Trading and reinvestment

Collateralized Debt Obligations Banc Of America Securities’ 2002 CDO Data Global CDO issuance rose Collateralized Debt Obligations Banc Of America Securities’ 2002 CDO Data Global CDO issuance rose 38% Yo. Y Collateralized Debt Obligations grew 74% Yo. Y ($208 BN)

Collateralized Debt Obligations Banc Of America Securities’ 2002 CDO Data Cash CDOs ($60. 6 Collateralized Debt Obligations Banc Of America Securities’ 2002 CDO Data Cash CDOs ($60. 6 BN):

Collateralized Debt Obligations Banc Of America Securities’ 2002 CDO Data Collateralized Debt Obligations (SCDOs): Collateralized Debt Obligations Banc Of America Securities’ 2002 CDO Data Collateralized Debt Obligations (SCDOs):

Collateralized Debt Obligations CDOs dramatically affect markets for underlying collateral In 2002, CLOs represented Collateralized Debt Obligations 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

Collateralized Debt Obligations Synthetic Collateralized Debt Obligations (SCDOs) utilize credit derivatives Total credit derivatives Collateralized Debt Obligations Synthetic Collateralized Debt Obligations (SCDOs) utilize credit derivatives Total credit derivatives are over $2 TN and projected to grow to $4 TN by 2005 There active and liquid markets for CDS on prime companies in the US and Europe But note the so-called 200/200 tiering

Collateralized Debt Obligations Credit derivatives are an extremely sophisticated and powerful financial product However, Collateralized Debt Obligations 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

Collateralized Debt Obligations Synthetic CDOs use credit derivatives to acquire credit exposure w/o transfer Collateralized Debt Obligations 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

Collateralized Debt Obligations Credit derivatives are Total Return Swaps or TRS Credit Default Swaps Collateralized Debt Obligations Credit derivatives are Total Return Swaps or TRS Credit Default Swaps or CDS Credit-Linked Notes or CLNs

Basic Total Return Swap Bank pays Customer the total return on the referenced assets. Basic Total Return Swap Bank pays Customer the total return on the referenced assets. Bank has reduced credit risk to reference assets, but acquires credit risk of Customer. Total Return

Basic Total Return Swap Customer pays Bank a specified financing charge and acquires credit Basic Total Return Swap Customer pays Bank a specified financing charge and acquires credit risk of reference asset. Financing Charge

Basic Credit Default Swap Bank/Customer “buys” credit protection on a referenced entity and pays 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 Bank issues a credit linked note that pays (or, if a Basic 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. Credit Linked Note

Basic Credit-Linked Note Customer purchases the note and acquires credit risk of reference asset. Basic Credit-Linked Note Customer purchases the note and acquires credit risk of reference asset. Credit Linked Note

Collateralized Debt Obligations ISDA’s 1999 Credit Derivative Definitions and elective Supplements regarding Convertible, Exchangeable Collateralized Debt Obligations 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

Collateralized Debt Obligations Advantages Avoid transfer issues (consents, etc. ) Quicker execution? Simpler documentation? Collateralized Debt Obligations Advantages Avoid transfer issues (consents, etc. ) Quicker execution? Simpler documentation?

Collateralized Debt Obligations Disadvantages More complex accounting (FAS 133 and DIG/ED D 2 model) Collateralized Debt Obligations Disadvantages More complex accounting (FAS 133 and DIG/ED D 2 model) and tax (NPC or financing) Precision? Legal?

Collateralized Debt Obligations 3 Types of SCDOs Balance Sheet SCDOs Tranched Basket/Portfolio SCDOs Managed Collateralized Debt Obligations 3 Types of SCDOs Balance Sheet SCDOs Tranched Basket/Portfolio SCDOs Managed Arbitrage SCDOs

Collateralized Debt Obligations Balance Sheet SCDOs Notes/ Swaps CDS Bank CDO Bank obtains economic Collateralized Debt Obligations Balance Sheet SCDOs Notes/ Swaps CDS Bank CDO Bank obtains economic and regulatory capital relief. Investors obtain credit exposure and return Class A Class B Class C

Collateralized Debt Obligations Tranched Basket/Portfolio SCDOs Notes/ Swaps CDS Issuer CDO Issuer reduces credit Collateralized Debt Obligations Tranched Basket/Portfolio SCDOs Notes/ Swaps CDS Issuer CDO Issuer reduces credit exposure Investors obtain credit exposure and arbitrage return Class A Class B Class C

Collateralized Debt Obligations Managed Arbitrage SCDOs Class A Notes/ Manager Swaps Bank CDS Manager Collateralized Debt Obligations Managed Arbitrage SCDOs Class A Notes/ Manager Swaps Bank CDS Manager selects and manages portfolio to enhance arbitrage opportunity CDO Class B Class C

Collateralized Debt Obligations Comparison of Static and Managed SCDOs Feature Static Managed Excess Spread Collateralized Debt Obligations Comparison of Static and Managed SCDOs Feature Static Managed Excess Spread Ø CDS Long Only Ø CDS Long/Short Ø No removal or substitution Trading Ø Exposures added and/or removed Ø Fixed CDS premium Ø Excess spread released, trapped or used to offset losses Ø Credit-related premium Ø CDS premium reflects credit and management

Collateralized Debt Obligations Comparison of Static and Managed SCDOs Feature Liquidity Static Ø Credit Collateralized Debt Obligations Comparison of Static and Managed SCDOs Feature Liquidity Static Ø Credit Events Managed Ø Credit Events Ø Trading losses Counterparty Risk Ø Single CDS counterparty Ø Exposure to protection buyers only Ø One or more CDS counterparties Ø Exposure to protection buyers and/or sellers

Collateralized Debt Obligations Comparison of Static and Managed SCDOs Feature Portfolio Structure Static Managed Collateralized Debt Obligations Comparison of Static and Managed SCDOs Feature Portfolio Structure Static Managed Ø Initial guidelines only Ø Minimum WARF, WARR and/or WAS Ø Credit enhancement only Ø OC and IC tests Ø Limits on total CDS short and offset exposure, trading and concentrations Ø Limits on counterparties and required CDS documentation Ø Ramp-up restrictions and minimum notional balance Ø Excess spread trigger/trap

Collateralized Debt Obligations Trading Criteria Minimum CDS reference entity ratings Minimum CDS premiums Required Collateralized Debt Obligations 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

Collateralized Debt Obligations Conclusion Questions Collateralized Debt Obligations Conclusion Questions




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