In light of recent developments involving SEC and Goldman Sachs, I reckon it might he extremely helpful for my readers to witness the entire structuring process involving a High Grade Asset-Backed Securities Collateralized Debt Obligations (HG ABS CDO) deal. For the sake of simplicity, let’s assume that our CDO transaction is labeled “Pyramid”, and the three stakeholders involved in this deal are: an investment bank – the “Arranger”, a portfolio manager – the “Collateral Manager” and a series of investors. To make things easier, I would replicate the same numbers from the previous two articles on structuring and securitization. The CDO liability bonds – the “Notes” will be issued by a newly formed Special Purpose Vehicle (SPV) – the “Issuer”, called Pyramid Limited and incorporated in Cayman Islands for tax purpose.
Once the arranger and the collateral manager agree on the transaction, a six-month warehousing period kicks-in, when assets are added gradually to the bank’s balance sheet until the closing date is reached. On closing date, the entire portfolio is transferred from the arranger to the SPV and all notes are issued. The purchasing policy is dictated by the portfolio manager and it follows a very precise set of eligibility criteria. The Pyramid’s assets deal consists of $1 billion collateral portfolio of MBS bonds paying a weighted average coupon (WAC) of LIBOR plus 80 basis points. During the warehousing period, the investment bank works together with S&P’s and Moody’s at rating the notes, in exchange for a $500,000 fee. At closing, five different Notes (CDO tranches) are sold:
$800 MM of Class A, rated AAA, paying LIBOR + 20 bps
$70 MM of Class B, rated AA, paying LIBOR + 70 bps
$60 MM of Class C, rated A, paying LIBOR + 120 bps
$60 MM of Class D, rated BBB, paying LIBOR + 220 bps
The fifth security sold in the amount of $10 MM is called the Equity tranche and it represents the Subordinated Notes that do not get rated by the rating agencies. Generally, the AAA notes are purchased by the arranger and placed into an offshore investment account. The AA notes are generally bought by the insurance companies, while the other rated tranches are acquired by investors. The hardest tranche to be sold remains the equity slice which is purchased by investors willing to accept the highest ratio of risk and reward.
The interest and principal coming from the collateral portfolio are paid sequentially, starting with Class A and ending with the equity tranche. Under a waterfall mechanism, only once Class A has been paid what its due does Class B get paid, and so on. Assuming LIBOR at 0.30%, our portfolio of MBS bonds would pay 1.10% per year in interest. The CDO deal owes interest on the tranches it sold:
Class A: $4.0 MM (0.50% interest on $800 MM principal)
Class B: $0.7 MM (1.00% interest on $70 MM principal)
Class C: $0.9 MM (1.50% interest on $60 MM principal)
Class D: $1.5 MM (2.50% interest on $60 MM principal)
If we add the portfolio manager fees of 0.20%, the CDO has a total of $1.9 MM left-out. That passes through to the equity entirely marking a 19.0% internal rate of return (IRR).
Once the deal is running, there are few tests that Pyramid has to pass: interest coverage test (IC) and over-collateralization test (OC). The IC test has the total interest earned in the numerator, and the total interest cost of a given tranche and all tranches senior as the denominator plus fees. So, the IC on Class B at the onset of the deal would be $11/ ($4.0+$0.7+$2.0) =164%. The OC test is similar, except the numerator is the principal value of the portfolio and the denominator is the outstanding amount of a given tranche and all bonds senior. So, the OC on Class B would be $1,000/ ($800+$70) =115%. Some trigger levels are established at the closing, and if the IC/OC falls below that trigger, some remedy is required.
While the riskiest CDO tranches are sold to investors, the Super Senior CDO tranche is retained by the arranger. For capital release, the investment bank executes an AB CDS transaction with insurance companies like AIG. When other banks have invested in CDO bonds without any insurance, any mark-down in the bond value had to be booked as losses and subtracted from bank equity. Ultimately, the cumulated writedowns have led to additional capital requirements, which led in most of the cases to insolvency.
Weapons Of Mass Destruction (III)
Published on May 26, 2010 in Capital Markets Products Tags: CDO, CDS, MBS, Rating Agency.
looking forward to part IV
Do you need more detail on this? If yes, what would that be?
Toni,
When Buffett said “weapons of mass destruction” he mainly referred to CDO MBS or CDS ? Or he meant derivatives in general ?He called them like that because of their high interlinks and if one would default would cause a cascade effect right ?
Raul
Raul,
He had a good hunch on this. He did not understand the CDO products, so he called the CDS products WMD.
Toni,
Could one CDS issuer get involved with another CDS insurer let’s say for GM to default or not ? Do you know some if the case ? After all you can get in a deal not necessarily to hedge like if you borrow $x to somebody and want to sleep tight … so not having anything to do directly with the borrower.
BMM
Bogdan,
Yes it is possible. Let’s say Lehman Brother could have bought CDS protection on a given bond offered by Ambac.
Toni,
Thx … What about AMBAC buying a CDS from FGIC (or AIG from FGIC) to speculate on GM bankruptcy? Like me, the cds issuer I want to make money on GM probable default with a policy from another CDS issuer and will cash in due to the very same product I’m selling to ensure other people …
). Nothing wrong right ?
BMM
Bogdan,
I am not saying it is impossible, but less of a norm. Instead, JPM could sell and buys CDS from GS…that is a BAU.
I think it would be useful to see at the same level of detail what happened to each of the tranches when things turned ugly, all the way back to the underlying mortgages. For example how come “pyramid” passed the two “safety tests” you mentioned only to fail later, which model assumptions were wrong, in the end was it mainly a liquidity problem or a solvability problem etc. Everybody knows the big picture by now, but I guess interesting things are still hiding in the details. Thanks for the articles.
That could be a good idea. There are so many things to be said. Definitely I needed at least 3 episodes to make things understandable.
Toni,
Could you please detail a bit the “BAU” one …
Raul
Sorry…BAU = business as usual
Toni,
Thx I did not know that wall street acronym.
Is this CDS market exclusively through the side bets and (otherwise I understand they can be very useful in mitigating risk) equivalent of the buying fire insurance on your neighbor’s house analogy. In fact it is like insuring your neighbor’s house N times. It makes it tempting to set your neighbor’s house on fire ? Does the analogy work in some way ? I mean not necesarily through CDS but also other derivatives …
Thx
Raul,
CDS market is straight forward. The buyer makes money when the insurance (CDS protection) premium goes up and yhe seller makes money when the premium goes down. The reference obligation could a a list of things, but the analogy with your neighbor’s house is very stretched. Stick to what you kniw and forget about what you read in all kinds of newspapers…
Toni,
Thx … why politicians enjoy the idea of baning the purchase of naked credit default swaps … what’s the deal ?
Raul
Raul,
You should have known by now that in most cases, politicians have no clue about the financial markets. By banning naked CDS contracts they hope investors will stop betting against Greece & Co. Don’t worry, that will not transform them overnight from heavy bears into heavy bulls.
Toni,
Is it true that Freddie Mac was leveraged more than 70x their net worth ?
Raul
Raul,
I do not know but I could find out.
Toni,
Let’s say just for the purpose of the example
- there is X pension fund holding a A+ or BB+ bond but because it buys a CDS from AIG which was AAA, the bond actually is an AAA
- thus the charter of the pension fund allows to buy these A+ bonds by converting them in an AAA through the CDS deal
- another bond covered by AIG goes bankrupt so AIG pays a lump sum to the CDS holders
- since that occurs, rating agencies downgrade AIG from AAA to a lower rating;
- now the pension fund does not hold anymore the AAA bond the investment policy requires
What can/does the pension fund in this case ?
Raul
Raul,
I am sorry but your example does not hold water. If you buy a CDS on a junk bond, that bond does not become AAA.
Toni,
Well it does not become AAA but I mean if the pension fund’s charter will allow then on its books an investment that is a BB rating from Corporation X, but by buying a CDS from an AAA insurer, maybe it could …. at least that is what I understood … I heard the example myself and not create it actually.
Raul
Raul,
It is very simple: when you buy a bond you are long risk. When you buy a CDS you are short risk. Except the basis risk, you are credit hedged if you buy both. However, you have two different counterparty risks, assuming you bought the bond from a dealer and the CDS from another dealer. If this is clear, what is your question now?