New . Morgan Securities 29, 2001Global Structured Finance ResearchDouglas Lucas (1-212) @ Structured Finance HandbookOverviewCONTENTSOverview . . . . . . . . . . . . . . . . . . . .1Global CDO issuance has averaged $137 billion per year for the last three . . . . . . . . . . . . . . . . . . .2In the context of asset-backed securities (ABS), this figure is about one-half ofAssets, Tranches, Purposes, Creditpublic and private . issuance. This sustained level of activity is remarkable,Structures . . . . . . . . . . . . . . . . . . . .4Tgiventhatannual volume never exceeded $4 billion until 1996. We estimateypical Structures . . . . . . . . . . . . . .8Why Do CDOs Exist aonudt sWtahnyd Dinog CDO volume at $500 billion. The current status of CDOs is due toInvestors Buy Them? . . . . . . . . . . .11the acceptance of the product by investors and credit risk Value Credit Structure . . . .15Cash Flow Credit Structure . . . . . .18This report is a comprehensive introduction to CDOs. It addresses:Synthetic CDOs . . . . . . . . . . . . . .24Parties to a CDO . . . . . . . . . . . . . .27 the structural components of CDOs;Legal Considerations . . . . . . . . . . .31Accounting Consideratio n tsy .p . .a .l .C37DOs;Tax Considerations . . . . . . . . . . . .40 why CDOs exist;Glossary and Notes . . . . . . . . . . . .42Rating Agency Publications . . . . . .49 the cash flow and market value credit structures;Asset Managers and Sellers . . . . . .50 synthetic CDOs;CHRISTOFLPHANEARGAN the asset manager and other parties to a CDO;Head, Global Structured Finance legal, accounting, and tax considerations;ResearchCDOES ERARCH CDO Lucas(1-212) @ 1Thomas Sam(1-212)C 6D48O-6 I7s9s4uancesam_thomas@(US$ billions)ASSE-BTACKREDSEARCH$160Ryan Asato(1-212) $@$120Linda Feinne(1-212) 648-2580feinne_l@$100Christophe(r1 F-2la1n2a)g @$m80Carmen Gellineau(1-212) 648-3837$60gellineau_carmen@$40ing Ko(1-212) @$20Amy Sze(1-212) 648-6769sze_amy@$0Dmitry Yakimchuk(1-212) 648-6781yakimchuk_dmitry@ Yu, CFA(1-212)@: JPMorgan, MCM Corporate Watch, Fitch, Moody's Investors Service, and ARELARCHEdward Reardon(44-20) 7325-3528reardon_edward@ Toya(813) 5573-1331toya_kazuhiko@ of this report is restricted in certain countries. Important information concerning these and other restrictionsis set forth at the end of this
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 2Douglas Lucas (1-212) 834-55351IntroductionAperson new to collateralized debt obligations (CDOs) is faced with bewilderingterminology:Arbitrage CBOBalance Sheet CLOMarket Value CDOCash Flow CDOEMCBORepacksCBO of ABSSynthetic CDORe-REMICsSynthetic Arbitrage CLOInvestment Grade CBOCBO of Real EstateThese names, for different types of CDOs, reflect the variety of features and forms a CDOcan take and still be called a CDO. ACDO can hold bonds, loans, emerging market debt,ABS, RMBS, and CMBS. It can also gain exposure to these assets synthetically. TheCDO can issue floating or fixed rate obligations tranched in a variety of ways with respectto seniority and payment. Its obligations can be revolving, have delay draw features, andbe guaranteed by a third party. CDOs are done for one of two different purposes and useeither of two distinct credit structures or a combination of the two credit CDO names above do not fully describe any CDOs structure and are not mutuallyexclusive from one another. We think the easiest way to both classify and understandCDOs is by taking a component or a la carte approach. ACDO can be pretty completelydescribed by the choices made with respect to its:(1) underlying assets;(2) tranche structure;(3) purpose;(4) credit at CDOs this way will also allow future innovations to be placed in the context ofan existing conceptual next section of this paper discusses these four structural components. The fourthsectionof this paper describes the most typical CDO structures existing today or, to stretch the menuanalogy, the most popular prix fixe CDO combinations. In these two sections, we hope toprovide a flexible definition of CDOs and a description of current market fifth through twelfth sections of this report address specific CDO topics. The sectionsare stand alone; they can be read in any order and sections can be skipped if they are notof current interest. These sections are: Why do CDOs exist and why do investors buy them?; Market value credit structure; Cash flow credit structure; Synthetic CDOs; Parties to a CDO; Legal considerations; Accounting considerations; Tax author would like to thank Ade Adetayo, Andrew Chalnick, Jeremy Gluck, Bob Grossman, Ji-Mei Ma, BillMay, Edward Mayfield,Roger Merritt, Pat O'Brien, Allen Reiser, Marie Stewart, David eTlpes ihner, Katrina Tormey, and Lenny Zuckerman for their generous hpreparing this report.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 3Douglas Lucas (1-212) 834-5535AGlossary and Notes section defines italicized terms in the text and discusses topicsremoved from the main concern of the paper. The two final sections of the report listuseful articles published by rating agencies and the names of CDO asset managers andasset note that CDO refers to the special purpose vehicle (SPV) that holds assets andissues obligations. CDO also refers specifically to the obligations the SPVissues, leadingto the seemingly circular phrase the CDO issues CDOs. Finally, CDO is an umbrella termencompassing the various subclasses, including the CDO species listed above.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 4Douglas Lucas (1-212) 834-5535Assets, Tranches, Purposes, and Credit StructuresAssetsIts assets, more than anything else, make a CDO a CDO. The general definition is that a CDO2is a securoitfi zcaotripoonrate obligations. By order of volume, CDOs have securitized (orre-securitized) commercial loans; corporate bonds; ABS, RMBS, and CMBS; and emergingmarket debt. Even tranches of CDOs have been re-securitized into CDOs of 2The trend year-to-date in 2001 has beenCDO Underlying Assetsfor bonds and loans to make up a slightly1987 through 2000smaller share (76%) of CDO assets thanhas been the case historically. The use ofStructuredinvestment grade bonds and loans has9%grown, however, and those assets nowmake up 42% of CDOs. ABS, RMBS, Bondsand CMBS have also increased, and now25%comprise 9% of underlying assets. CDOassets are more and more diverse -to-date, 36% of CDO assets are . %Emerging MarketBut CDOs do not always own these assets3%outright. Sometimes a CDO achievesexposure to these assets synthetically bySources: JPMorgan, MCM Corporate Watch, Fitch, Moody'sInvestors Service, and into a credit default swap. In acredit default swap, the CDO receives aperiodic payment from a counterparty that seeks protection against the default of areferenced asset. In return for this payment, the CDO must pay the protection buyerdefault losses on the referenced asset if the obligor of the referenced asset defaults. Theexact definitions of "default" and "default losses" can be negotiated to suit therequirements of the CDO and the protection buyer, but typically follow standard protection-buying counterparty in a credit default swap is usually exposed to thereferenced credit by, for example, having made a loan to the name. Any credit loss thecounterparty sustains from its dealings with the referenced credit is offset by a paymentfrom the CDO. As the CDO assumes credit exposure to the referenced asset withoutbuying it, the protection buyer gets rid of credit risk without selling the asset. ACDOmight have a few synthetic exposures or be comprised entirely of synthetic 14% of CDO underlying exposures are produced issue muolft iepqlue ictyla asnseds debt that are tranched with respect to seniorityin bankruptcy and timing of repayment. The equity tranche, sometimes called juniorsubordinated notes, preferred stock or income notes, is the lowest tranche in the CDOscapital structure. The equity tranche sustains the risk of payment delays and credit lossesfirst in order to make debt tranches less credit-risky. It receives whatever cash flows areleft after the satisfaction of debt tranche claims. Chart 3 shows a typical CDO see the Glossary and Notes below for more on specialized issuing one trancrheep arcek agSgeeinnee olys
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 5Douglas Lucas (1-212) 834-5535Chart 3Typical CDO TranchingTRANCHESRATINGSA-1A-2Floating RatFeixed RateTriple-A or Double-ARevolving FacTilriatyncheB-1B-2Floating RatFeixed RateSingle-ATrancheTrancheCTriple-BFixed or FloTartaincgh Reate DDouble-BFixed or FloTartaincgh Reate EquityNot Rated(Most SubTorradn)icnhaeteSource: are sized to minimize funding costs within the constraints of investor most CDOs, the top-most tranche provides the majority of the vehicles financing. Otherdebt tranches are sized around 5% to 15%. Equity is generally around 2% to 15% of theCDOs capital structure, depending on the credit quality and diversity of the can also be created synthetically outside the CDO structure by the terms of acredit default swap so that the protection buyer retains a first loss position. The CDO'spayment under the credit default swap might occur only if losses on referenced assetsexceed some set amount. This first loss carve out might be expressed on a per-name basis(losses up to $X per name) or on an overall portfolio basis (losses up to $X across theentire portfolio). In the language of insurance, the protection-buying counterparty in thecredit default swap essentially has to meet a deductible before being able to make a claimunder the credit default CDO debt tranches protect more senior debt tranches against credit lossesand receive a higher coupon for taking on greater credit risk. Coupon payments onsubordinated tranches might be deferrable if the CDO does not have sufficient cash flow orif it is in violation of certain a CDO senior debt tranche is structured with a delayed draw feature. This isuseful if the CDOs assets are to be purchased over time, as draws against the facility canbe taken as they are needed. Arevolving tranche might serve to allow the CDO to adjustits leverage. Often a double structure of tranches is used where the same seniority trancheis comprised of separate fixed and floating rate sub-tranches. Finally, debt tranches aresometimes guaranteed by third parties, such as bond are classified as either balance sheet or arbitrage CDOs, depending on themotivation behind the securitization and the source of the CDOs assets. Balance sheetCDOs are initiated by holders of securitizable assets, such as commercial banks, which
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 6Douglas Lucas (1-212) 834-5535desire to sell assets or transfer the risk of assets. The motivation may be to shrink thebalance sheet, reduce required regulatory capital, or reduce required economic most straightforward way to achieve all three goals is the cash sale of assets to theCDO. But for a variety of reasons, the risk of the assets might be better transferred to theCDO synthetically, as described above. This second method can reduce required capital,but cannot shrink the balance sheet. Nevertheless, we refer to synthetic CDOs done toadjust required capital as balance sheet CDOs, in contrast, are inspired by asset managers and equity tranche tranche investors hope to achieve a leveraged return between the after-default yieldon assets and the financing cost due debt tranches. This potential spread, or funding gap,is the arbitrage of the arbitrage CDO. The asset manager gains a management fee frommonitoring and trading the CDOs arbitrage CDOs assets are purchased from a variety of sources in the open market, overa period that may stretch for months from a warehousing period before the CDO closes to aramp-up period after the CDO closes. The asset manager often invests in a portion of theCDOs equity tranche or subordinates a significant portion of its fee to debt and equitytranches. There is generally more trading in an arbitrage CDO than in a balance sheet CDO,where trading of the portfolio is not allowed or limited to replacement of amortized number, 74% of CDOs are arbitrage transactions, but because balance sheet transactionsare typically larger, the division is almost perfectly 50%-50% by distinction commonly drawn between balance sheet and arbitrage CDOs ignores the factthat the asset seller in a balance sheet CDO also enjoys potential arbitrage profits fromretention of the equity tranche. After the close of the transaction, there is nothing verydifferent between the economic position of an equity investor in a CDO that buys assets in theopen market and the equity investor in a CDO that buys assets the equity investor CDO purpose has been discussed since the inception of the CDO market in 1987,but realized only recently. While CDOs have been ever-increasing purchasers of primarymarket issues, until 1998 no CDO had been created to purchase new issues specificallyoriginated to be sold to a CDO. This occurred first in CDOs that bought Japanese bankcapital obligations and later in rated CDOs that purchased the capital obligations of . banks. In light of these CDOs, we would like to suggest origination CDO as a thirdCDO purpose and method of obtaining CDO the most practical distinction between balance sheet, arbitrage, and originationCDOs is how likely the proposed CDOs are to be accomplished. The key to the successfulclosing of a CDO is the placement of the CDOs equity. Abalance sheet CDO often hasthe advantage of a pre-packaged investor for most or all of the equity tranche. Thus, atypical balance sheet CDO is more likely to close than the typical arbitrage CDO where theasset manager only commits to a portion of the equity tranche.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 7Douglas Lucas (1-212) 834-5535Credit StructuresACDO can have either a market value or a cash flow credit structure, depending upon theway the CDO protects debt tranches from credit losses. In a market value structure, theCDOs assets are marked-to-market periodically. The mark-to-market value is then haircut,or reduced, to take into account future market value fluctuations. If the haircut value ofassets falls below debt tranche par, CDO assets must be sold and debt tranches repaid untilhaircut asset value once again exceeds debt tranche contrast, there is no market value test in a cash flow CDO. Subordination is sized sothat after-default interest and principal cash flow from the CDOs asset portfolio isexpected to cover debt tranche requirements. This expectation is based on assesment ofdefault probability, default correlation, and loss in the event of default. Acommon cashflow structuring technique is to divert cash flow from subordinated tranches to seniortranches if the quality of CDO assets diminishes by some objective measure. But while the manager of a troubled cash flow CDO can sell CDO assets, and the senior CDOobligation holders can sell CDO assets after a CDO default, there is generally never arequirement to sell CDO assets. Nine out of ten CDOs, both by number and volume, usethe cash flow credit À la Carte CDO MenuAtable of these four CDO attributes appears below in Chart 4. Awide variety of CDOs canbe constructed by picking one attribute from each menu column, but in actual practice, CDOstend to fall into three common prix fixe combinations as discussed in the next 4À la Carte CDO MenuASSETSLIABILITIESPURPOSECREDSTITR UCTUREHigh Yield CorporaDtei fBfeornednst numbeBr aolfance Sheet TransMacatriokne:t Value:tranches possibAle seller desired to sThheed haasisrectust value of CDOto shrink its balance asshseeetts aisn dperiodicallyCommercial and IndustrialSadjust economic caonmdpared to CDO trancheequential, fast/slow, orLoanscontemporaneouregulatory Isft ihnagircut assets are lesss paydownassets are transferretdh atno trhaenche par, CDOof principalEmerging Market CorporateCDO and the seller oasftsents t amkuest be sold andand Sovereign DebtCoupon can be fixedb arcakte t hoer CDO's motsrtanches ratesubordinate , CMBS, RMBS andCash Flow:other CDOsVariety of portfolioA trebsittsr taoge Transaction:CDO subordinate tranchesdivert cash flow Afr omoney manager wants toare sized so that seniorInvestment Grade Debtsubordinate to senieoxrpand assets undertranches can survive assetmanagement and equitydefault losses. If portfolioDistressed SecuritDieeslay draw tranchesinvestors desire non-recoursequality dteriorates, assetpossibleleverage. Assets may becash flow may be redirectedpurchased over warehousingEqufom subordinate tranches toityRevolving tranche paonsds irbalmep-up senior can be purchased orGuarantee by a thOirdr ipgainrtaytion Transactions:exposure can be gainedpossible(not a recognized term)syntheticallyUnderlying CDO assets areissued specifically for a : JPMorgan.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 8Douglas Lucas (1-212) 834-5535Typical StructuresThe two ways a CDO can gain exposure to assets, by cash purchase or synthetically; thetwo main CDO purposes, arbitrage or balance sheet; and the two CDO credit structures,cash flow or market value; would lead to eight types of CDOs (two times two times two)without considering different types of underlying assets. Market value transactions,however, are never done, at least now, for balance sheet purposes and have not been done,at least yet, with synthetic negative correlation between the market value credit structure and the balance sheetpurpose is ironic, as the first five CDOs ever done, in 1987 and 1988, combined thatpurpose with that credit structure. But the cash flow credit structure, introduced in 1988,superseded the market value approach because it allowed greater leverage. Evolvingaccounting standards for retained CDO interests probably would have doomed balance-sheet market-value CDOs anyway. With respect to synthetic securitization, thecomparative illiquidity of synthetic assets has prevented their use in market value fact that market value transactions are almost always cash asset and arbitrage purposeCDOs reduces the number of CDO structural combinations to five. Here are their marketshares by value of assets, out of total CDO issuance from 1987 through 2000 of half atrillion dollars:Table 1StructurePercent of Volume 1987 - 2000Cash, arbitrage, cash flow36%Synthetic, arbitrage, cash flow4%Cash, balance sheet, cash flow41%Synthetic, balance sheet, cash flow9%Cash, arbitrage, market value10%Sources: JPMorgan, MCM Corporate Watch, Fitch, Moodys, S&P, and the first balance-sheet market-value CDOs in 1987 and 1988, balance-sheet cash-flow CDOs reigned briefly in 1989 before arbitrage cash-flow CDOs took over from 1990through 1995. In 1996, CDO issuance rose to $36 billion, more than twice the volume ofthe previous nine years combined. The explosion of CDO issuance was led by balance-sheet cash-flow the assets side, 1996 was also the first time loan-backed CDOs exceeded bond-backedCDOs. The former assets were associated with balance-sheet cash-flow CLOs. Over thehistory of CDOs, loans have been the most prominent asset, followed by CDOs are currently increasing market share while emergingmarket CDO issuance peaked in 2StructurePercent of Volume 1987 - 2000Loans63%Bonds25%ABS/RMBS/CMBS9%Emerging market3%Sources: JPMorgan, MCM Corporate Watch, Fitch, Moodys, S&P, and Bloomberg.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 9Douglas Lucas (1-212) 834-5535While CDOs sponsored by commercial banks have caused loans to be the primary asset forbalance sheet CDOs, loans are also a large factor in arbitrage CDOs. Bonds, in contrast,are almost always found in arbitrage 3StructurePercent of Volume 1987 - 2000Cash and synthetic, arbitrage, cash flowBonds19%Loans16%Emerging market3%ABS/RMBS/CMBS2%Cash and synthetic, balance sheet, cash flowLoans45%Bonds3%ABS/RMBS/CMBS2%Cash, arbitrage, market valueABS/RMBS/CMBS4%Loans3%Bonds3%Sources: JPMorgan, MCM Corporate Watch, Fitch, Moodys, S&P, and 4 goes into more detail on these typical CDO 4CDO Structural Prix Fixe Menu Arbitrage CaBsha lFanlocwe Sheet Cash FlowArbitrage Market ValuePurposeArbitrage: LevBearalagnecde sheet:A Rrebdituracgee: Leveragedreturn to equitbya hlaonldcer sh veieat orer truerqnu tiore edquity holdersnon-recourse tecrmonomic and vreiag unloanto-reycourse termfinancing, feesc atop iatassletfinancing, fees to assetmanager managerCredit structurCeash flow: SuCboarsdhi nflaotiwo:n SubMoardrkineat tvioanlue: Assets areis sized so thati sa siszeet'ds saoft ethr-ats oalsds eatn'sd debt tranchesdefault interesat fatnerd-default inrteepraeisdt aifn tdhe market valueprincipal repayp rdinebcitpal repayo fd aesbstets declines tootranchestranchesmuchSource of asseAtsssets are purTchaes ebda liannce shAesest eotsf are purchased inprimary or secsoindgaler yfinanciapl riinmstairtyu toior nsecondarymarketmarketSponsorAsset managerC orm inmseurrcainacl ebAansks et manager orcompanyinsurance companySpeculative grade bondsAssetsBank loans, soWmiedtiem reasn gtoe of assetsand commercial convertibles,Emerging market debt isSome ond anedquity and distressed debtdecreasing andABS/RMBS/CMBSABS/RMBS/CMBS versus syMntahye thiacve a feIwn csryenatshinegtilcy arHeardly ever has syntheticexposureexposures amocnogm dpolemteinlya nstynetxhpeotiscurescash assets or becompletely syntheticSpecial tranchMe faeya thuarvees a deMlaayye dh advraew a reLvoiklveilnyg to have atranche as assetrtsa nacrhe eo tfote anccoremvmolovdinagte tranche aspurchased overe av oralvminpg u bpanka slsoeatnss are adjusted toperiodmeet OC tests
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 10Douglas Lucas (1-212) 834-5535Table 4CDO Structural (PCroixn tFinixue dM)enu Arbitrage CaBsha lFanlocwe Sheet Cash FlowArbitrage Market ValueEquity investoSrsome retainedO bfyte ans sretainedS boym aes sretained by assetmanagersellermanagerLeverage7 to 12 times20 to 50 times4 to 5 timesInterest rate deSrwivaaptisv aensd capNs ootf utesnually usSedw asipnsc aend caps oftenused to bridgea bsesetwtse aerne typicuasleldy to bridge betweenfixed rate asseftlso antidng ratefixed rate assets andfloating rate liabilitiesfloating rate liabilitiesDeal size$200 to 400 m$il1l itoon 10 billion$500 million to for bonds, $300 to billion600 million for loansTrading activiRtyestrictedLittle or noneGreatestTenorFive-year reinBveasstemde onnt remaFinivine gy eliafre life withperiod followeodf boyri gainal asseatms orrtization over the lastseven-year amdourrtiaztaiotino nof synththreeti cmonths. Callableperiod. Seniorin tsratrnucmhentafter two or three yearsaverage life seven to ninewith premium to fixedyears, mezzanine 10-13rate . Callable afterthree years with premiumto fixed rate share b4y0 %volume50%10%Source: JPMorgan.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 11Douglas Lucas (1-212) 834-5535Why Do CDOs Exist and Why Do Investors Buy Them?The Sum of the PartsThe questions above arise from the recognition that the cost of CDO tranches exceeds thecost of CDO assets. The difference goes to pay professionals associated with thetransaction: security firms, asset managers, trustees, rating agencies, attorneys, andaccountants. Why do investors buy CDOs that cost more than the assets the CDO holds?We believe it is because the CDO structure creates custom exposures that investors desireand cannot achieve any other way. These custom exposures fit into investorsvarious riskappetites and capital constraints. Some investors are more efficient holders of speculative-grade assets and some have a comparative advantage holding investment-grade assets. TheCDO separates the credit risk of its portfolio into tranches and sells each to the investormost suited to hold that aggregate price of CDO tranches is bounded at the low end by the cost of thecollateral and the minimum amount necessary to entice professionals to create CDOs. Atthe high end, the aggregate price of the CDO is bounded by the utmost value each CDOtranche investor places on receiving their preferred risk in its distilled form. As moreprofessionals have entered the CDO business, fees have declined and the cost of CDOtranches has steadily declined within the above-described InvestorsIn an arbitrage CDO, equity tranches allow investors to achieve non-recourse termfinancing of the CDOs underlying assets. If the CDOs assets perform poorly, debttranche holders have no recourse, other than to the CDO assets, and cannot make a furtherclaim against the equity tranche. This is in contrast to the repo market where financing isshort term and the creditor has recourse to the borrower if the collateral is insufficient toextinguish the debt. Equity tranche holderspurpose is to gain a favorable leveraged returnbetween the after-default yield on CDO assets and the financing cost due debt Chart 5, we compare the yield on . high yield bonds to the cost of funds raised viaCBO debt tranches. The difference is a rough measure of the gross spread available toCBO equity holders. This gross spread is reduced by fees, trading losses, and defaultlosses; and subject to calls on the CBO assets and de-leveraging of the CBO.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 12Douglas Lucas (1-212) 834-5535Chart 5Normalized "Funding Gap" Between High Yield Bonds and CDO Tranches109876543210We take yield data from the JPMorgan High Yield Index and suppose an asset distribution of 50% double-B bonds and 50% single-B bonds. We subtract from this gross asset yield CBO funding costs assuming CBO spreads supplied by our traders and aCBO capital structure comprised of 70% triple-A, 10% single-A, 5% triple-B, and 5% double-B tranches. We avoid false precisionby standardizing the results on a scale from zero to ten; setting the highest historical funding gap equal to : , asset spreads are comprised of expected credit losses, a risk premium, and aliquidity premium. Equity tranche holders bet that actual credit losses compare favorablyto expected credit losses and that they will also capture risk and liquidity premiums. Thelevel of expected credit losses embedded in asset prices is irrelevant; what matters is thedifference between expected and experienced credit purchase of the equity tranche of a CDO is first a decision in favor of the underlyingasset class, second a decision in favor of leverage relative to that asset class, and finally, adecision in favor of the sheet CDOs, at the time of execution, are driven by an asset sellers working,economic, and regulatory capital considerations and the availability and expense ofalternative methods of managing those considerations. In the longer view, a balance sheetsponsors decision to gather assets with the intent to securitize them in a CDO is verysimilar to the decision of an arbitrage equity holder. In the future, balance sheet issuancewill be affected by the new Basel capital guidelines for commercial banks and the growinguse of single-name and basket credit default swaps. These two factors will change the costof holding and hedging InvestorsDebt tranche investors are attracted to CDOs because of their higher yields as compared toalmost all corporates and many asset-backeds of the same maturity and rating. Forexample, in the first four months of 2001, seven- to ten-year AAA-rated credit card-backeddeals were priced from about 17 to 30 basis points above Libor. During the same period,high yield debt-backed CDOs of the same maturity and rating ranged in price from 43 to55 basis points above
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 13Douglas Lucas (1-212) 834-5535Chart 6AAACDO Spreads to USD Libor2001 YTD Issuance(basis points)7060504030201035791Weighted Average Life in YearsHYB&ALBSEMIGB&ULK LoansSource: JPMorgan. Like ABS and MBS debt tranches, CDO debt tranches have narrower default lossdistributions than individual corporate bonds. If an individual corporate bond defaults, the loss to investors is usually quite high; 47% of par on average, as measured by a recent4recoveryB sutut dity possible for a CDO debt tranche to be a little bit in default.Suppose that defaults in the CDO asset portfolio have been so high that the CDO debttranche now depends upon the performance of each and every one of the names in itsportfolio. The debt tranche is still supported by a portfolio comprised of multiple additional default of one of those credits has a relatively small percentage effect ondebt tranche return. And the probability of incremental collateral defaults is less and lesslikely. In comparison to the drastic loss a corporate bond sustains if it defaults, a CDOmight sustain a relatively mild 7CDO Spreads to USD Libor2001 YTD Issuance(basis points)800700600500400300200100013579113Weighted Average Life in YearsBBBBBAAAAAASource: JPMorgan. 4Hamilton, DaDveidfa ,t eatn adl ,R ecovery Rates of MCoropdoyr'as tIen Bveosntdo rIss sSueerrvsi:c e2,0 00,February 2001.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 14Douglas Lucas (1-212) 834-5535Because of their different default severities, corporate bonds and CDO debt tranches mustbe compared on an expected loss basis. Expected loss is the product of default probabilityand loss in the event of default, and therefore incorporates both those risks in theevaluation of an investments credit , CDO debt tranches may help diversify an investment portfolio by providingexposure to a new asset class. By definition, an investment grade investor cannot gainexposure to speculative grade assets other than through the first loss protection offered viaa CDO. The CDO debt tranche provides the investment grade investor with exposure tonew industries or countries, while still maintaining investment grade credit Credit QualityIt would seem that investors prefer the extremes of credit risk, either highly rated triple- anddouble-Acredit or unrated equity. The initial securitization of consumer and corporateobligations stretches the middling credit quality of these assets across the credit qualityspectrum into triple-Ato unrated equity tranches. The re-securitization of the middle, triple-Btranches of these securitizations again stretches middling credit quality into triple-Ato unratedequity tranches. Middle credit quality is stretched and stretched again into the does not mean however, that investor portfolios are also heading for the may be taking a barbell approach to credit and liquidity risk by constructingportfolios of highly liquid and creditworthy assets along side positions of concentratedcredit and liquidity risk. The investor who changes from a portfolio completely comprisedof high yield bonds to a portfolio of equity CDO tranches and Treasuries might maintainthe same expected credit loss but improve liquidity, eliminate extreme downside credit risk,and gain regulatory capital relief.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 15Douglas Lucas (1-212) 834-5535Market Value Credit StructureAdvance Rate MechanismAs briefly discussed above, the credit quality of market value debt tranches depends uponthe ability of the CDO to sell assets and pay off debt tranche principal and accrued market value of CDO assets is periodically calculated. Asset market values are thenmultiplied by advance rates (a number less than 100%) to arrive at haircut asset rates are spTeacbilfei 5c toSample Advance Ratesparticular asset categories (.,performing high-yieCldo lblaotnerdasl,Adv Rateperforming bank loans, distressedPerforming bank loans valued more than 90%-yield bonds, disDtirsetrsessesedd bbank loans valued more than 85% high-yield bonds rated , and distressed equities). ThePerforming high-yield bonds rated rate is the amount of trancheDistressed bank loans valued less than 85% and interest the CDO asset canPerforming high-yield bonds rated , expressed aDs iast rpeessrecde Bntoangdes assets market value. Advancerates decline the highSoeurr cteh: Me oroadtyi'ns Ign voesntors CDO debt tranche and the lessdiverse the CDO 5 shows sample advance rates Moodys requires for a 20-issuer, five-industry CDOportfolio seeking a Aa2 rating on its senior debt sum of haircut asset values is then compared to debt tranche par and accrued interest inthe over-collateralization (OC) test. In other words, the sum of each assets market value,times each assets advance rate, must be greater or equal than debt tranche par and accrued:S{Market V)a lxu eA(Advsasnetce) }R a>t=e( DAesbset ttranche par and market value losses have caused the portfolio to fall below this minimum requirement,the CDO has failed its OC test and must sell assets until the structure regains theprescribed ratio. Alternatively, the equity holders of the CDO can contribute assets to theCDO to cause the CDO to pass its OC test. If the CDO cannot right itself by either ofthese methods within the cure period, it is an event of default and senior-most trancheholders may take control of the CDO and its value CDOs often have a quarterly net worth test, net worth being the value of theequity tranche, defined approximately as the excess of collateral market value over the parand accrued interest of all debt tranches. If net worth becomes too small, in absolute orpercentage terms, the CDOs collateral must also be sold until all debt tranches are net worth test might terminate the CDO while the CDO passes its OC trigger is anticipated that in the normal course a market value CDO will liquidate itself by thevoluntary and orderly sale of assets over the final months of its prescribed life.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 16Douglas Lucas (1-212) 834-5535The Effectiveness of the Market Value Credit StructureThe credit quality of debt tranches in a market value CDO depends upon the effectivenessof its OC test. In a scenario where the market value of CDO assets is declining, thedecline in market value must be recognized early enough and the assets must be soldquickly enough so that debt tranche holders can still be repaid. The two time intervals ofconcern are: the time between valuation tests; the cure period, or time given for assets to be sold after a test is a trade off between the conservatism of the advance rates and the combined lengthof the above two intervals. In some combination, a longer time period is acceptable withlower advance rates and higher advance rates are acceptable with a shorter time period. Inusual practice, the asset portfolio is marked to market daily or weekly and the collateralmanager is allowed a two-week cure period to rectify any shortfall in the OC market value voTlabtillei t6y of CDOCrdit Spread Volatility assets is affected by the volatility ofTe-YearMaturit Industrial Indexesgeneral interest rates and the volatility(basis points)of credit spreads. While generalRange of Two Week Std Devinterest rate volatility affects all CDORatingCredit Spreadof Credit Spreadassets equally, lower quality assets notTriple-A6025only have larger credit spreads, butDouble-A6726also greater credit spread volatility, asSingle-A8834shown in the Table -B10037Double-B27793Single-B596163The diversity of the market valueTriple-C1547447CDO portfolio is important because aSource: -diversified portfolio will haveTable 7 lower market value volatility than aYield Volatility of JPMorgan High Yield USD Indexpoorly diversified portfolio andvs. Constituent Parts perhaps be more resistant to liquidityStandrd Deviation of Two Week Total problems, as shown in Table 7. Returns of Index202 bpsHowever, the analysis of portfolioAverage Standard Deviation of Two Week diversity is a difficult task. In timesTotl Returns of Index's 25 Industry Categories224 bpsof market turmoil, market value andSource: trends have exhibitedstartling uniformity across asset type,industry sector, and issuer domicile. In assessing portfolio diversity, investors often look atthe industry distribution of . and European names and the geographic distribution ofemerging market , a CDO has restrictions with respect to concentrations by single name, industry,issuer domicile, and other collateral attributes. Collateral value in excess of concentrationlimits is not counted in the OC test. But given this, it is usual for a market value assetmanager to have latitude to invest in a wide range of assets. The debt tranche investormust be comfortable with the allowable set of assets and their associated advance rates.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 17Douglas Lucas (1-212) 834-5535Since the credit quality of the market value CDO structure depends upon the actual saleof assets, should it become necessary, a concern arises over whether a sale can becompleted at the assetsvalue. This is referred to as liquidity risk, and its suppositionsuggests a contradiction: if a sale cannot be completed at the assets value, is thatindeed the assets value?Nevertheless, bid-ask spreads do vary by asset type and over time. Asellers ability toachieve the best price for an asset is also hindered by the urgency with which the asset mustbe sold. It is felt that certain assets are more susceptible to losing liquidity. Liquidity risk isassumed to be highest for more credit risky assets and for less well-known or less widely-traded names. Regulatory or legal restrictions on ownership can also make an asset lessliquid and more apt to become less liquid still. Investor familiarity with asset type is anotherfactor; bank loans are considered less liquid than bonds, all other factors being debt tranche protection derives from the ability to sell CDO assets, the cash flowcharacteristics of market value CDO assets are irrelevant. For example, assets with alonger tenor than the CDO are welcomed in a market value CDO. In a cash flow structure,they might be prohibited. Similarly, equity, zero-coupon bonds, and even defaulted debtcan be put into a market value CDO. However, the ability to get transactionable marketprices for an asset is critical. Without credible market valuations, an asset cannot receivecredit in a market value a multiple tranche structure, each debt tranche has its own array of asset advance rates,set according to the desired credit quality or rating of the tranche. But the cure forbreakage of any tranches OC trigger is repayment of the senior-most tranche. Thus, thecredit requirements of subordinate tranches might call for repayment of the senior-mosttranche when the senior-most tranches OC tests are being passed. All of the following factors: over-collateralization, market value volatility, liquidity risk,portfolio diversity, and the interaction of tranche OC tests and the CDOs net worth testmust be analyzed by the market value debt tranche 8Market Value Credit FactorsPrimary FactorsSecondary FactorsOver-Collateralization TestLevel of advance ratesCushion between the haircut value of assets and tranche par and accruedTime between OC testsCure period to sell assetsMark to Market VolatilityInterest rate volatilityCredit spread volatilityPropensity for credit and other eventsLiquidity RiskCredit qualityOwnership restrictionsMarket familiarity with name and size of outstanding issuanceMarket familiarity with asset typeSeller desperation, ., timing constraintsPortfolio DiversityIndustry diversificationGeographical diversificationOther known and unknown correlation factorsConvergence of market value movements in times of stressInteraction of Tranche Advance Tranche size and differences in advance ratesRates and Net Worth TestSource: JPMorgan.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 18Douglas Lucas (1-212) 834-5535Cash Flow Credit StructureAs briefly discussed above, the credit quality of cash flow debt tranches depends upon theability of the CDO to withstand portfolio default losses and still pay its debt tranches. Thetwo factors that affect the credit quality of cash flow debt tranches are the riskiness of theCDOs assets and the protectiveness of its RisksWith respect to CDO assets, the credit risk of debt tranches is determined by three factors: default probability; default correlation; default define these factors briefly, default probability is the likelihood that an asset will defaultover a given time period. Obviously, an asset will either default or not default; there is nomiddle ground. What is meant, for example, by a 2% estimate of default probability is thatover repeated trials we expect an average of 2% of such assets in such trials to implication of higher default probability in a portfolio is correlation addresses the distribution of defaults in the portfolio given individualasset default probability. If the credits tend to default together, they are positivelycorrelated with respect to default. If credits tend to default separately, they are negativelydefault correlated. For example, suppose that the default probability of each CDO asset is5% over a certain time horizon. Maximum positive correlation would mean that 5% of thetime the entire portfolio defaults and 95% of the time no credits default. Maximumnegative correlation would mean that 5% of the portfolio always defaults over the giventime implications of these two distributions, brought about by extremely different defaultcorrelations, are very different. In the first scenario, both equity and debt tranches are atrisk for massive losses that occur infrequently. In the second scenario, the equity tranche issure to sustain losses but debt tranches are completely insulated from loss. Default severity is the loss in the event a default occurs. It can be measured as the marketvalue of the asset after it defaults or as the present value of all after-default cash severity, and its complement, recovery amount, is usually represented as apercentage of par. It varies by industry and the type of assets the credit owns. Recoveryalso varies by legal jurisdiction depending on how quickly local law allows a creditor to be put into bankruptcy and how strictly seniority is combination of all these factors produces a probability distribution of total CDOdefault losses over the life of the CDO. However, the timing of losses is also importantbecause earlier asset defaults deny coupon cash flow to the CDO. To be complete, theprobability distribution of aggregate losses must take into account the timing of in this theoretical framework with default and recovery assumptions specific to aCDOs portfolio is difficult. Investors use rating agency ratings, default studies, ratingtransition studies, and recovery studies. Other credit consultants offer default probability
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 19Douglas Lucas (1-212) 834-5535and default correlation products. Investors should look at the managers track record, notonly for experienced defaults and recoveries, but also for sales of assets at significant lossrelated to credit deterioration. They should also consider trends in both economicconditions and the credit quality of recent new issues in the targeted asset classes. Therobustness of the new issue calendar is important for arbitrage CDOs because it dictateshow choosy the manager can be in selecting credits. The underwriting quality of the assetseller and the selection process for including assets in the CDO are relevant for balancesheet ProtectionsAsset defaults and recoveries affect the different tranches of the cash flow CDO accordingto the subordination of the tranches. There are two kinds of subordination, priority inbankruptcy and priority in cash flow in bankruptcy in a CDO is almost always strict, meaning that in bankruptcy theproceeds from liquidated CDO assets will first be used to satisfy the claims of the seniordebt tranche and only then, if there are any remaining proceeds, the next most seniortranche. The absolute seniority of CDO tranches is discussed in the section below on legalconsiderations affecting credit within and outside the world of CDOs, priority of cash flow often trumps priority inbankruptcy. Cash flow distributed to subordinated tranches is lost to more senior tranchesno matter how poorly the entity does subsequently. With corporate debt, an early-maturingsubordinate bond can be a better credit risk than a later-maturing senior , a cash flow CDO employs several mechanisms to maintain tranche priority incash flows. The first is the sequential principal paydown of tranches, meaning thatprincipal payments are made to tranches in order of priority. This has the effect, as theCDOs assets amortize, of increasing the percentage subordination below senior the portfolio becomes smaller, less diverse, and more susceptible to defaultvariability, subordination protection increases 9Typical Sequential Paydown Structure Initial StructureAfter 50% Collateral PaydownTrancheTranchSeu Sbiozred (i$nMatMion)Tranche Size ($MM)SubordinationA$6238%$1276%B$1028%$1056%C$1018%$1036%Equity$18NA$18NATotal Assets/Total L$1ia0b0ilities$50Source: outstanding CDOs use a fast pay/slow pay structure where the bulk of principalpayments go to senior tranches while a smaller amount goes to subordinated CDOs also make pro-rata distributions of principal to their second mechanism to maintain tranche priority in cash flows is the use of collateralcoverage tests. These tests divert cash flows from subordinate tranches, prevent
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 20Douglas Lucas (1-212) 834-5535reinvestment in new CDO assets, and cause senior tranches to be paid down. The two maincollateral coverage tests are the over-collateralization test and the interest coverage simplified form, the over-collateralization test is the ratio of CDO asset par to tranche the test, defaulted assets are counted at an assumed recovery rate or at the lower of thatassumption or market value. Note that this is a par to par test, not a market value stylemarket value to par test. In simplified form, the interest coverage test is the ratio of CDOasset interest to CDO tranche coupon. Scheduled coupons from defaulted assets are excludedfrom the test. Sometimes the deterioration of CDO asset credit quality, as determined bysome objective measure, such as credit ratings, is also used to divert cash 8OverCollateralization Collateral Coverage Tests Tranche AOver-collateralization TestA: sset ParCDO Tranche AParTranche B Over-collateralization TestA:sset ParCDO Tranche Aand B ParTranche C (& etc.) Over-collateralizaAtiosnse Tt ePsatr:CDO Tranche A, B, and C (Etc.) ParWhere: CDO Asset Par equals the par of CDO assets deemed not to be in default and a recovery assumptioncredit applied to defaulted : 9 Interest Collateral Coverage Tests Tranche AInterest Coverage Test:Asset CouponCDO Tranche ACouponTranche B Interest Coverage Test:Asset CouponCDO Tranche Aand B CouponTranche C (& etc.) Interest Coverage ATseset:t CouponCDO Tranche A, B, and C (Etc.) CouponWhere the CDO Asset Coupons are actual coupons received and scheduled coupons from non-defaultedcollateral over the current interest payment period and Tranche Coupons are calculated over the same : priority of payments schedule, or waterfall shows how sequential principalpaydown and coverage tests work together to enhance senior tranche credit quality byassuring priority in cash flows:Interest proceeds are used to pay:1. Base fees and expenses of the CDO, including trustee, custodian, and paying agent . The net periodic coupon due any swap . Base asset manager . Interest on Class Atranche and any termination amount due any swap counterpartycaused by the CDOs default.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 21Douglas Lucas (1-212) 834-55355. If the Class Atranche coverage tests are not met, redemption of Class Atranche until thecoverage tests are . Interest on Class . If the Class B tranche coverage tests are not met, first the redemption of Class Atrancheand then, if necessary, the redemption of Class B tranche until the Class B coveragetests are . Class B interest accrued but not previously paid.(Steps six and eight are repeated for each debt tranche.)9. Termination amount due any swap counterparty caused by the swap counterpartystermination or default. (Sometimes included in step 4 above.)10. Any additional fees to the trustee and . Additional asset manager . Equity tranche until it achieves a particular . Remainder divided between equity and the asset proceeds are used to pay:1. Amounts due in one through eight above not met with interest . During the reinvestment period, reinvestment in new . After the reinvestment period, paydown of tranches in . Amounts in 9 through 13 that the above waterfall specifies that all principal proceeds, including proceeds fromasset sales, be used to pay down debt tranches in sequence unless the CDO is both (1) inits reinvestment phase and (2) all tranches are meeting their coverage tests. In that caseonly, principal proceeds can be used to purchase new assets. Importantly, principal cashflow cannot usually reach equity holders until all debt tranches are flow CDOs also have trading prohibitions that restrict reinvestment These tradingrules revolve around collateral quality tests, or objective measures of certain portfoliocharacteristics, such as: industry or geographical diversity; average rating; average life; prospective average recovery; minimum weighted average coupon or concentration tests address the presence in the portfolio of large single issuers, loanparticipations, triple-C credits, deferred interest instruments, and the like.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 22Douglas Lucas (1-212) 834-5535In order to reinvest principal proceeds, the CDO must pass its collateral coverage tests asdescribed above and also maintain these quality and concentration measures above theirthresholds or, if a measure is already below its threshold, maintain or improve the the portfolio is not always in place at closing, and since the portfolio can be tradedanyway, the CDO is often evaluated as if all collateral quality and concentration tests wereat their thresholds. To maintain trading flexibility, the initial portfolio is chosen to surpassquality and concentration thresholds by a significant margin. Thus, the actual CDOportfolio is better than the theoretical one used to size subordination aspect of the collateral quality and concentration tests is that they areusually applied independently. Aproposed trade must cause the portfolio to satisfy eachquality and concentration test without allowing for acceptable trade-offs among theseportfolio characteristics. An exception to this is that many deals now incorporate a matrixof acceptable combinations of factors such as issuer and industry diversity, average rating,prospective average recovery, or yield tranche investors examine the cash flow waterfall, collateral coverage tests, andcollateral quality requirements closely to assess their priority in cash flows. They alsoscrutinize possible trading actions that could be taken by managers and frequently ask formodifications. For example, in some CDOs, an appreciated asset can be sold and theproceeds used to purchase the same amount of par at lower cost. The difference betweensale proceeds and purchase price can then be put into the interest proceeds waterfall where,if collateral coverage tests are met, cash flow is eventually available to the equity a situation allows the asset manager to sell credit-improved assets and skim off theprice appreciation from those if other assets have suffered price deterioration, and presumably decreased creditquality, the selling of winners and retention of losers causes the average credit quality ofthe portfolio to suffer. This scenario is now addressed in most CDOs by requiring capitalgains to be reinvested unless the CDOs initial over-collateralization ratios are , it is still widely the case that a manager can trade a defaulted asset, which isgiven no credit in a CDOs interest coverage test and only partial credit in the CDOs over-collateralization test, for a performing security that trades at the same price as the defaultedsecurity. Under certain circumstances, this might improve coverage tests and permit thedistribution of proceeds to subordinated tranches that would otherwise be restricted. Buthas the trade actually improved the credit quality of the CDO? Such trading scenarios, and their significance, must be placed in the context of the CDOs trading restrictions as a Asset Risk and Structural ProtectionThe purchaser of a cash flow CDO debt tranche must balance the default characteristics ofthe assets against subordination levels and the effectiveness of the coverage, quality, andconcentration tests that redirect asset cash flows and control trading. As with market value CDOs, the investor must also consider how asset characteristics might changebecause of trading.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 23Douglas Lucas (1-212) 834-5535Table 10Cash Flow Asset Risks and Structural ProtectionsAsset RiskStructural ProtectionsDefault probabilitySubordinationDefault correlationCash flow distribution before breech of coverage testsDefault lossThe trigger levels and effectiveness of coverage tests in redirecting cash flowsProtection afforded by quality and concentration testsSources: JPMorgan.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 24Douglas Lucas (1-212) 834-5535Synthetic CDOsAs an alternative to purchasing bonds or loans, a CDO might gain market exposure to anobligor synthetically by entering into a credit default swap. In a credit default swap, theCDO receives a periodic payment from a counterparty that seeks protection against thedefault of a referenced asset. The payment is based on the credit spread of the referencedasset. In return for this payment, the CDO must pay the protection buyer default losses onthe referenced asset if the obligor of the referenced asset defaults. An analogy can bemade to insurance where one party pays premiums and the other provides loss exact definitions of default and default losses can be customized to suit the desiresof the CDO and the protection buyer, but typically follow standard ISDAdefinitions. Thetenor of the swap can be shorter than the tenor of the referenced 10Credit Default SwapPeriodic PaymentCDOIPROTECTIONCDOBUYERDefault Losses on Referenced Asset in theEvent of its DefaultSource: JPMorgan Synthetic Balance Sheet CDOsIn a synthetic balance sheet CDO, the protection buyer entering into the credit default swapwith the CDO owns the referenced asset, or has exposure to the referenced obligor via, forexample, a letter of credit or a swap receivable position. The protection buyer is trying tooffset a credit loss it might sustain with a payment from the CDO in that event. As theCDO assumes credit exposure to the referenced obligor without buying an asset, theprotection buyer gets rid of credit risk to the referenced obligor without selling an are balance sheet transactions only in that they reduce the protection buyerseconomic and regulatory required capital; they do not remove assets from the balance credit default swap in a balance sheet CDO can reference more than one asset orunderlying obligor. It can also be structured to incorporate loss thresholds that must beexceeded before the CDO makes a payment. This threshold might be expressed on a per-asset basis (losses exceeding X amount per asset) or on an overall portfolio basis (lossesexceeding X amount over the entire portfolio). The protection buyer essentially has tomeet a deductible before being protected from credit losses on the referenced default swaps are a popular means of hedging credit risk from loans because of thedifficulty or reluctance commercial banks have in selling loans they have extended. Inmany circumstances, loans cannot be sold without notifying or gaining the approval of theborrower and other lenders. In other cases, loans are simply not saleable at all. Finally, asdiscussed below in the Legal Considerations section, the purchase or participation in loansmight create credit complications from the point of view of the CDO.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 25Douglas Lucas (1-212) 834-5535Credit default swaps also separate the funding of an asset from the assumption of its creditrisk. Abank can use a credit derivative to shed risk while still maintaining fundingadvantages it might Arbitrage CDOsCredit default swap-backed CDOs are increasingly associated with arbitrage CDOs. Themotivation for a synthetic arbitrage CDO typically comes from a party that seeks leveragedcredit exposure to a portfolio of names. It might be the case that the CDO cannot achieveexposure to the names other than through a credit derivative. To date, almost all syntheticCDOs have been based on static reference portfolios. In the future, we anticipate activetrading of underlying reference names in synthetic arbitrage CDOs. Synthetic arbitrageCDOs will enter into a number of individual credit default swaps with and Unfunded CDOsAn important aspect of credit default swaps is that they do not require cash investment bythe CDO. In cases where investors want to buy a funded note, the CDO must thereforefind other uses for the cash it receives from tranche investors. The method of JPMorganBistro transactions of 1997 and 1998 was for the CDO to purchase a highly credit worthy5asset, such as triple-Arated credit card-bTahcek eadss seetcurities as shown in Chart selected to mature at the termination of the credit default swap. If referenced obligorshave defaulted under the swap, proceeds from the security are used to pay the amounts are then available to tranche holders. Another alternative is to create afunded position by embedding the credit default swap in a credit-linked note of a well-rated 11Synthetic CDO with Highly-Rated Asset and Credit Default Swap Periodic PaymentCDOICOMMERCIAL(OWN HISGH-LRAYTEDBON PDORTF)OLIOBANKDefault Losses on Referenced Asset in theEvent of its DefaultInitialPurchaseof CashAssetHighly RatedTRANCHECash AssetsHOLDERSSource: JPMorgan 5See the Glossacryre ednit-rlyin ufkonerd ea nr d oetescription of an alternate method of investing cash proceeds.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 26Douglas Lucas (1-212) 834-5535In more recent synthetic CDOs, cash investment has become optional and the CDOinvestor can simply enter into a credit default swap with the sponsoring financialinstitution. In chart 12, investors in the super senior, mezzanine, or equity tranches cantake tranche exposure to the referenced portfolio on either an unfunded or funded 12Synthic CDO with Funded and Unfunded TranchesPortfolioSupercreditSeniorMaswapsrketplaceTypically UnfundedSuper SeniorInvestorsMGTSingle-nameClass Acredit swapsFunded or UnfundedClass BMezzanine InvestorsClass CEquity(Owns AAATypically FundedAssets)Equity InvestorSource: JPMorgan.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 27Douglas Lucas (1-212) 834-5535Parties to a CDOAsset ManagerThe focus of a cash flow manager is often said to be to avoid defaults while the focus of amarket value manager is to achieve price appreciation. Certainly the market value structure,with its wider array of assets and easier trading rules is a more efficient vehicle to realizeprice appreciation. At the same time, the credit manager who can avoid defaults does notwant to rely on other parties agreeing with its credit assessment in order to realize value. Forthat manager, the cash flow structure is ideal since assets are not typically sold prior tomaturity. Yet it is obvious that the market value manager does not want to experiencedefaults and that the cash flow manager may wish to realize the benefit of price and equity tranche investors take care in reviewing the asset manager. Besidesexpertise in the CDOs underlying assets, the manager must understand the intricacies ofCDO trading rules and be able to comply with them. The manager may also need expertisein derivative instruments and interest rate or foreign exchange hedging. Some CDOinvestors prefer a small management company that will be focused on the CDO. Othersprefer a large manager that has available back-up personnel and clout in gaining access toallocations. Alarger firm might also have formal internal risk controls and audit argument about the best manager can take other twists as well. One investor mightspurn discussion of the size of the asset management firm as irrelevant, and stress that allthat really matters is the managers historical risk-adjusted performance. But an answer tothis argument is that managing a CDO is not like managing a normal portfolio because ofthe CDO structure and trading rating agency view of asset managers is ambivalent. As a policy and marketing issue,they have to base their CDO analysis on the ratings their organizations place on theunderlying collateral. They cannot give a manager a lot of credit for being able to improveupon rating agency credit assessment. However, ratings analysts are also aware that thereis great variability in the default probability of credits in the same rating category. Thenightmare of the CDO rating agency analyst is the manager who buys the most riskycredits within rating some cases, Moodys will adjust debt tranche target expected loss in view of theirassessment of the managers capabilities. The adjustments are more significant on thedownside than the upside. Fitch differentiates between managers via trading limits andother structural provisions. S&Padjusts its model recovery assumptions on the theory thatmanagers with demonstrated work out experience will reap higher recovery equity nor debt tranches want the asset manager to forget their interests. Thecompromise that is often reached is that the asset manager purchases a meaningful part ofthe CDOs equity tranche or subordinates a siginficant portion of its fee to debt and equitytranches. Debt tranche investors are satisfied that the manager has a first loss position inthe collateral while equity investors appreciate that the asset manager will share in equitytranche gains and can be argued that the debt tranche investors are getting the worst part of thisarrangement. The equity tranche holdersposition is analogous to owning a call on the
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 28Douglas Lucas (1-212) 834-5535value of the CDO portfolio struck at the par value of the debt tranches. The value of theCDO portfolio for a cash flow CDO is the after-default cash flow of the CDO CDO equity is deep in the money, equity holders are ambivalent about the volatilityof the CDOs after-default cash flow. (In the language of options, their delta is high andtheir vega is low.) Equity holders would appreciate higher CDO asset yields, but to havethem they would have to put up with higher default probabilities and potential losses. Aspotential gains go along with potential losses, prudence is a relevant suppose the intrinsic value of the equity tranche option has already been eroded bydefaults, such that equitys option is at the money or out of the money. In this case, thepotential change in the value of equitys option is one-sided and it craves , equity would like the CDO to purchase the most yieldy, credit risky portfolio:equity cant lose more than it already has, and the potential for upside is only possible if theCDO takes chances. (In the language of options, their delta is low and their vega is high.)This view of asset manager motivation suggests that debt holders should understand howCDO collateral coverage, quality, and concentration tests restrict trading activity if theCDO portfolio deteriorates. It also may argue for CDO managers who do not want theirCDOs to fail and affect their other businesses outside the InsurerSometimes a CDO structure incorporates bond insurance (financial guarantee insurance) onsenior tranches. Tranche holders then have two sources of payment: the CDO and, if theCDO fails, the bond insurer. Triple-A-rated bond insurers usually insure tranches thatwould have been rated single- or double-Aor higher without their guarantee. Typically,bond insurance is used with new asset classes or new CDO managers until investorsbecome familiar and more generous in their bids for unenhanced agencies appreciate the monitoring and structuring involvement of bond insurers intransactions. They will require a bond insurer to hold less capital to insure a CDO thanthey would require a CDO to hold internally. From the perspective of the CDO equitytranche, bond insurance makes sense if the reduction in senior tranche yield with bondinsurance is greater than the bond insurer -IssuerWhen the CDO is located offshore, a Delaware corporate co-issuer is often used. The co-issuer has a passive role in the overall CDO structure but is sufficient . connectionto qualify the CDO as a . corporate issuer under National Association of InsuranceCommissioners (NAIC) guidelines applicable to . insurance AgenciesS&Ppioneered market value CDO ratings in 1987 and cash flow ratings in 1988. By1990, however, Moodys dominated the rating of cash flow structures due to ratingstandards that more flexibly addressed a wider range of portfolio credit quality anddiversity. Beginning in 1996, Fitch began rating the second generation of market valueCDOs. Moodys and S&Pcame out with revised market value requirements in 1998 and1999, respectively, and became more active in that market.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 29Douglas Lucas (1-212) 834-5535Table 11Rating Agency Market Shares: By Numberof Rated CDOsMoody'sS&PFitch1987 - 200066%45%30%2000 only68%46%38%Source: JPMorgan. Swap ProviderCDOs sometimes enter into interest rate or currency options or swaps to match the cashflow of their assets to the requirements of their liabilities. For example, many CBOs issuefloating rate tranches backed by fixed rate bonds. To bridge the interest rate mismatch, theCBO might enter into a fixed-for-floating interest rate swap or purchase an interest ratecap. The CBO would pay a fixed interest rate on a notional amount to a counterparty inexchange for a floating interest rate on the same notional amount. In this example, thefixed coupons on its bonds would support the fixed rate payments the CBO makes to theswap counterparty. The floating rate the CBO receives from the counterparty would beused to make payments on its floating rate tranches. Acurrency swap or option might beused if CDO assets and liabilities are in different 13Interest Rate SwapCoupon oant eF iAxsesde tRsP ICDOSWAPRPO VIDERFloating Rate Payment Used toPay CDOs floating Rate ObligationsSource: JPMorgan. In these circumstances, the CDO, and by extension the CDO tranche holders, take on creditrisk to the swap or option provider. If the swap provider terminates or defaults, the CDOalso faces the risk to its liquidity of having to make a termination payment to the swapprovider. The CDO must also then find a replacement counterparty for the defaulted swapor cap. These risks are addressed by requiring the swap provider to be of high creditquality and writing other protective provisions into the derivative , Collateral Custodian and Servicerand Paying AgentUsually the same entity, the trustee is responsible for issuing the CDOs, maintaining andservicing the collateral, short-term cash reinvestment, payments (from the collateral and tothe tranches), and compliance testing. The various collateral coverage, quality, andconcentration tests makes this last task more complicated than a trustee role in a typicalasset backed securitization. Active trading also makes this role more difficult. Adherenceto the CDO waterfall when distributing payments to tranche holders is critical. The trusteeusually issues a monthly report detailing the status of the CDO portfolio and cashdistributions made by the CDO.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 30Douglas Lucas (1-212) 834-5535Underwriterand Placement AgentUsually a Wall Street securities firm that balances the differing objectives of trancheinvestors while satisfying the requirements of regulators and rating agencies andreconciling the advice of legal, tax, and accounting experts. The firm may adviseprospective managers, produce cash flow models and results, negotiate with ratingagencies, engage other professionals, market the tranches, monitor completed transactions,and produce relevant, timely, insightful, and helpful research.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 31Douglas Lucas (1-212) 834-55356Legal ConsiderationsBasic Transaction Structures and ICnD aO tyspical arbitrage transaction, the CDO (usually a Cayman Islandscompany) is newly established as a special purpose vehicle or SPV that is structured,as described further below, to be bankruptcy-remote. The CDO issues a nominal amountof common equity, which is owned by a charitable trust, and issues and offers to investorseconomic equity (which may be in the form of subordinated notes, but is more likely tobe in the form of preferred shares) and one or more tranches of fixed or floating rate notes. The CDOs securities are offered and sold pursuant to exemptions from, or in transactionsnot subject to, the registration requirements of the . Securities Act of 1933 (the 33Act). In most cases, the CDOs securities are offered only to . persons that arequalified institutional buyers under Rule 144Aof the 33 Act or to . persons inoffshore transactions in reliance on Regulation S (Reg S) of the 33 Act, although in sometransactions, the class of potential investors is sometimes expanded to include accreditedinvestors under Rule 501 of the 33 Act. The CDO will typically rely on the exemptionfrom registration as an investment company afforded by Section 3(c)(7) of the Company Act of 1940 (the 40 Act) and its . investors will be limited to qualified purchasers under the 40 CDO issues its notes pursuant to an indenture between a trustee, the CDO, and a .-domiciled co-issuer (if the CDO is established as an offshore vehicle). Under theindenture, the CDO grants a security interest to the trustee for the benefit of the CDOsnoteholders and other secured parties, including the trustee itself, the paying agent withrespect to the CDOs equity (which is usually the same financial institution that serves astrustee), the asset manager, the swap provider, and the bond insurer (if any). The indenturesets forth the waterfall provisions that govern the priority of payments to be made by theCDO to its secured parties and equity investors and also contains provisions relating to theperfection of the secured partiessecurity interest in the CDOs assets, restrictions on theCDOs investment activities, representations and covenants of the CDO, and remediesavailable to the trustee and noteholders in the event of the CDOs default. The CDO alsoenters into a number of other transaction documents, including a management agreementwith its asset manager and a collateral administration agreement with the trustee. The CDO uses the proceeds from the issuance of its securities to purchase assets in open-market transactions from one or more broker-dealers or other financial institutions on the datethe CDO first issues securities to investors (its closing) and during a post-closing ramp-up period. In many cases, the CDO purchases assets at closing from the securities firm that serves as initial purchaser or placement agent with respect to the offering of the CDOssecurities (which firm has typically acquired those assets at the direction of the CDOs assetmanager and warehoused them for a brief period in anticipation of the CDOs closing). Balance Sh. e Aet nCuDmObesr of balance sheet CDO transactions have utilized a two-tier transfer structure in which the sponsor bank or financial institution (in many cases, aNew York branch of a foreign bank) transfers loans held by it to a newly established SPV(usually a Delaware statutory business trust, corporation, or limited liability company)6Our thanks to Edward Mayfield for this analysis.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 32Douglas Lucas (1-212) 834-5535owned by the sponsor or one of its affiliates. The intermediate SPVtransfers the loansto the balance sheet CDO, which is also a newly established SPV(usually a Delawarestatutory business trust). Balance sheet transactions involving sponsors that are FDIC-insured banks have also utilized a one-tier transaction structure in which the sponsorbanks transfer loans directly to the issuing CDOs (however, because of positions recentlytaken by FASB, transfers of assets in one-tier structures may not be treated as sales foraccounting purposes, which would limit the continued utilization of one-tier structures byFDIC-insured banks). The loans may be assigned to the CDO so that it replaces the sponsor as lender of recordand has contractual privity with the loan obligors, but in most transactions, the sponsortransfers ownership interests or participations in the loans to the intermediate SPVwhileretaining bare legal title to the loans and privity with the loan obligors. The transfer of theparticipations from the sponsor to the intermediate SPVis made pursuant to a participationagreement and the transfer of the participations from the intermediate SPVto the CDO ismade pursuant to a sub-participation agreement. The CDO issues equity and debt and uses the issuance proceeds to purchase the loanparticipations from the intermediate SPV, which, in turn, uses the proceeds to purchase theparticipations from the sponsor. If the CDO is a Delaware business trust, it issues equity inthe form of trust certificates pursuant to a trust agreement and issues one or more tranchesof fixed or floating rate notes pursuant to an indenture. The CDO grants a security interestto the trustee under the indenture for the benefit of its noteholders and certain other securedparties, such as the trustee and any swap provider. The indenture contains provisionsrelated to perfection mechanics, priority of payments, representations and covenants, andremedies upon the CDOs default. The CDO also enters into a servicing agreement withthe sponsor or one of its affiliates, pursuant to which the sponsor agrees to act as servicerwith respect to the CDOs securities are offered to . persons that are qualified institutional buyerspursuant to Rule 144Aor to . persons in offshore transactions in reliance on Reg S. Bankruptcy-RemotenessIf bankruptcy proceedings (either voluntary or involuntary) were commenced with respectto a CDO under the . Bankruptcy Code, the CDOs noteholders, as secured creditors tothe CDO with a perfected security interest in the CDOs assets, should ultimately be ableto realize on the CDOs assets. However, provisions of the . Bankruptcy Code wouldcause the noteholders to experience delays in payment and, under certain circumstances,receive less than the full value of their collateral. For example, under the automatic stayprovisions of the . Bankruptcy Code, the filing of a bankruptcy petition with respect tothe CDO would automatically stay noteholders from proceeding against the CDOs assetsfor an indeterminate period of addition, if a CDO or its assets were to become the subject of the bankruptcy orinsolvency proceedings commenced with respect to any non-bankruptcy remote transferor ofthose assets either as a result of the substantive consolidation of the CDO and thetransferor or because the transfer of assets by the transferor is characterized as a transfer forcollateral purposes rather than as a true sale of those assets the CDOs noteholders
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 33Douglas Lucas (1-212) 834-5535could be exposed to potential delays in payment and loss in collateral value resulting fromthe transferors insolvency or bankruptcy. Such potential payment delays could occur even ifthe transferor were not eligible for relief under the . Bankruptcy Code and were insteadsubject to an alternative insolvency regime (generally, entities eligible for relief under . Bankruptcy Code include corporations, statutory business trusts, or limited liabilitycompanies that are domiciled, or that conduct a business or own property, in the ., but donot include banks or insurance companies). For example, . insolvency regimes applicableto banks typically either have automatic stay provisions comparable to that found in the Code or give banek.,g FivDeIrCs a, nind tchoen csaesrve aotof rasn (FDIC-insured bank, or the banking regulator of the state in which the bank is domiciled orhas a branch, in the case of a non-FDIC insured bank) the ability to obtain judicial stays toprohibit creditors from proceeding against the assets of insolvent minimize the potential for such payment delays and loss in collateral value, each CDOtransaction is structured, as described further below, so that the CDO is a bankruptcy-remote entity whose own bankruptcy risk is minimized and whose assets are isolated fromthe bankruptcy or insolvency risk of any non-bankruptcy remote transferor of those of CDOA BCanDkOrusp tbcayn risk is minimized by setting itup as an SPV, thereby limiting the universe of potential creditors with claims against theCDO, and by building into the CDO transaction structural impediments and disincentivesto those creditors commencing bankruptcy proceedings against the CDO. To limit the universe of an SPVs potential creditors, it is usually a newly establishedentity, with no operating history that could give rise to prior liabilities. The SPVs businesspurpose and activities are limited to only those necessary to effect the particular transactionfor which the , negs tiatbs lsisehceudri t(ies and purchasing andholding its assets), thereby reducing the likelihood of the SPVs incurring post-closingliabilities that are in addition or unrelated to those anticipated by rating agencies andinvestors. For example, restrictions on its corporate or trust powers may be set forth in theSPVs organizational documents, and the SPVmay be required to agree to correspondingcovenants in its indenture, as well as to covenants not to merge with another entity or issueadditional debt without obtaining, among other things, confirmations from the agenciesrating its notes that such actions will not result in a downgrade of their ratings. Impediments to an SPVs voluntary bankruptcy filing may take the form of requiring allthe members of the SPVs board of directors to approve any voluntary petition andrequiring the SPVto have at least one board member who is independent of the SPVsparent and who is charged with considering the interests of the SPVs rated notes in votingto approve a voluntary bankruptcy of impediments and disincentives with respect to involuntary filings are built intothe CDO transaction structure. The transaction is structured to impede the ability of holdersof the CDOs subordinated securities to file involuntary petitions against the CDO byrequiring the terms of the CDOs subordinated securities to provide that amounts becomedue in respect of such securities only to the extent that the CDO has sufficient funds to pay such amounts after paying amounts then due in respect of its senior securities. In addition,non-investor creditors such as the trustee or swap provider are required to covenant not topetition the CDO into bankruptcy until a year after all the CDOs notes have been repaid.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 34Douglas Lucas (1-212) 834-5535Finally, the CDO transaction is structured so that holders of rated notes have a first priorityperfected security interest in the CDOs assets to create a disincentive to the CDOs parentor the parents creditors, any other equity investors in the CDO, or any creditors of theCDO to file an involuntary petition against the CDO. Alegal opinion that the CDOsnoteholders have a first priority perfected security interest in the CDOs assets is typicallyrendered at From Transferor InTsroalnvsefnecrys oRfi sfkin an cTiraule a Sssaeltes. oftenhave attributes that make it difficult to distinguish whether they are transfers for collateralpurposes, made in connection with secured financings, or whether they are absolutetransfers, made in connection with true sales of those assets. The distinction is animportant one, since an asset that has been transferred for collateral purposes is part of the bankrupt or insolvent transferors estate and its transferee a secured creditor, subject to the risks of payment delays and losses in value described judicial authority offers definitive guidance on this issue for purposes of analyzing the sorts of complicated transfers that can be involved in CDO and other structuredtransactions. Some courts have given presumptive weight to whether the transferor andtransferee intended their transfer to be a true sale. Other courts have sought to identify the true nature of asset transfers and to determine whether the transfers bear greaterresemblance to sales or to secured loans by weighing their sale-like attributes against their loan-like attributes. In order to ascertain whether transferors of assets have trulytransferred the risks and rewards of ownership of those assets, as would be the case insales of those assets, or whether the transferors actually retained such risks and rewards, as would be the case in transfers for collateral purposes, these courts have examined suchfactors as whether the transferee had recourse back to the transferor in the event of theassets default, whether the transfer was irrevocable, whether the transferor continued toservice the asset and otherwise deal with the obligor under the asset, and whether thetransfer was characterized as a sale for accounting or tax a general matter, the terms of each transfer of an asset from a non-bankruptcy remoteentity to an SPVin a CDO transaction, whether it is the intermediate SPVin a two-tiertransaction or the CDO itself in a one-tier transaction, must constitute a true sale under theprinciples established in such case law. Depending upon the transaction, a true saleopinion or other legal comfort as to the nature of a transfer may or may not be required atclosing. For example, true sale issues typically do not arise, and opinion comfort is notrequired, in connection with an arbitrage CDOs purchase of loan assignments, bonds, and other securities in open-market transactions from broker-dealers or other financialinstitutions that are not affiliated with the CDO and that have held the assets only briefly inanticipation of their resale, since the indicia supporting characterization as a transfer forcollateral ,p .roesceosu rse back to the transferor upon the related obligorsdefault and revocability of the transfer are absent from such transactions. In contrast, transfers of loan participations can present particularly difficult true sale issuessince a non-bankruptcy remote transferor remains lender of record with respect to the loansand continues to service the loans after the transfer of the participations and the CDO hasno contractual privity with the loan obligors. Accordingly, in balance sheet transactionsinvolving a transferor eligible for relief under the . Bankruptcy Code or a non-FDICinsurede ,a .an kN (ew York branch of a foreign bank), a legal opinion is delivered
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 35Douglas Lucas (1-212) 834-5535at closing that provides legal comfort that the transfer of loan participations from thetransferor constitutes a true sale under applicable case law. In transactions involving anon-FDIC insured bank, appropriate regulatory comfort is also obtained from the statebanking regulator that it will treat the transfer of loan participations as a sale of the loansand will not treat the loans as property of the bank in the event of the banks , in balance sheet transactions involving FDIC-insured transferors, it has notgenerally been necessary to structure asset transfers from such transferors as true of statements by the FDIC that it would not seek to void an otherwise legallyenforceable and perfected security interest granted in assets transferred to an SPVby anFDIC-insured transferor, some securitization transactions involving an FDIC-insuredtransferor have been structured so that the transfer from the FDIC-insured transferorconstitutes a first priority perfected security interest in the transferred assets. Isolation From Transferor InsolvencSyu Rbisstka ntiv Seubstantive is an equitable doctrine under the . Bankruptcy Code by which abankruptcy court, in the exercise of its equitable powers, will consolidate separate, butrelated, ,t .iptaierse n(ts and subsidiaries) and their respective assets and liabilities sothat their combined assets and liabilities are treated as those of one, single entity and theentitiesrespective creditors become the creditors of the consolidated entity able to reachthose combined assets and liabilities. It is a remedy that is used sparingly to ensure theequitable treatment of all creditors of the consolidated entities in circumstances where theinterrelationships between members of a corporate group are so obscured they cannot bedisentangled. Some of the factors courts have cited to support decisions to substantivelyconsolidate related entities are (i) difficulty in segregating assets and liabilities of eachcompany, (ii) commingling of assets and business functions, (iii) existence of intercorporateguaranties on loans, and (iv) asset transfers without corporate formalities. While the remedyis an equitable doctrine under the Bankruptcy Code and a bank may not seek relief underthe Bankruptcy Code, it is possible for a receiver of an insolvent bank to jointly administer a substantively consolidated insolvency proceeding for a bank and its transactions, if structured as described above, do not typically present substantiveconsolidation issues. However, they can arise in balance sheet transactions. For example,in two-tier transactions, a true sale of assets from the non-bankruptcy remote transferor tothe intermediate SPVmay be insufficient to shield the assets from the insolvency risk of thetransferor if it wholly owns or owns a significant interest in the intermediate SPVand anoverly familiar relationship between the two would support their substantive consolidation,since the assets would never effectively be sold away from the transferor. If the second tiertransfer from the intermediate SPVto the CDO were structured as a perfected securityinterest rather than as a true sale then the CDOs noteholders would become creditors to theconsolidated entities. If the non-bankruptcy remote transferor were an FDIC-insured bank,the CDOs noteholders could obtain comfort from the FDIC statements referred to abovethat they would have the continued benefit of the CDOs assets as collateral; however, if thetransferor were not an FDIC-insured bank, the noteholders could experience delays inpayment and could be stayed from proceeding against the CDOs assets. To minimize the risk of substantive consolidation, SPVs in all structured transactions,including CDOs and intermediate SPVs, are required to abide by separatenesscovenants, whereby, among other things, they agree to maintain separate books, records,
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 36Douglas Lucas (1-212) 834-5535accounts, and financial statements from all other persons, to conduct business in their ownnames, to observe corporate formalities, to hold themselves out as separate entities, tomaintain arms-length relationships with their affiliates, and not to commingle assets withthose of other entities. In addition, a non-consolidation opinion and written comfort fromthe applicable state banking regulator may be required as a condition to closing in manybalance sheet Loan-Specific Legal Issues Set-oUffn. d er common-law principles and some state statutes, a borrower under a loan that has deposits with a transferor bank (or is otherwise owed any amounts by thetransferor) may be entitled, in the event of the transferors insolvency, to set off theamount of those deposits (or other amounts owed to the borrower) against the amount ofthe loan and thereby reduce its payments made under the loan. Set-off risk can arise inconnection with transfers by assignment as well as by participation. In addition, it is a risk for arbitrage CDOs that purchase loans as well as for balance sheet loan agreements contain explicit waivers of set-off rights by borrowers, and thesewaivers may provide sufficient comfort to rating agencies in deciding not to require a CDO maintain reserves to cover potential set-off risk. In some cases, rating agencies mayrequire an opinion of counsel as to the enforceability of such is some concern that in an insolvency of an FDIC-insured transferor, the FDICwould encourage borrowers, notwithstanding their express waivers of set-off rights, tooffset deposits against their loans and thereby cancel outstanding deposits in order toreduce the FDICs liability to repay depositors under the federal deposit insurance , reserves or credit enhancement may be necessary to cover set-off risk intransactions involving FDIC-insured transferors. Lender LIina years, a number of judicial decisions in the United States have upheld the right of borrowers to sue lenders or bondholders on the basis of variousevolving legal theories (collectively, termed lender liability). Generally, lender liabilityis founded upon the premise that an institutional lender or bondholder has violated a duty(whether implied or contractual) of good faith and fair dealing owed to the borrower orissuer or has assumed a degree of control over the borrower or issuer resulting in thecreation of a fiduciary duty owed to the borrower or issuer or its other creditors orshareholders. Although it would be a novel application of the lender liability theories, a CDO could be subjected to allegations of lender liability. In addition, under common-law principles that in some cases form the basis for lenderliability claims, if a lender or bondholder (a) intentionally takes an action that results in the under-capitalization of a borrower to the detriment of other creditors of such borrower,(b) engages in other inequitable conduct to the detriment of those creditors, (c) engages in fraud with respect to, or makes misrepresentations to, those creditors, or (d) uses itsinfluence as a stockholder to dominate or control a borrower to the detriment of othercreditors of such borrower, a court may elect to subordinate the claim of the offendinglender or bondholder to the claims of the disadvantaged creditor or creditors, a remedycalled equitable subordination.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 37Douglas Lucas (1-212) 834-55357Accounting ConsiderationsThe three interesting CDO accounting issues under . Generally Accepted AccountingPrinciples (GAAP) are: how should investors account for credit-impaired tranches, dosecurities issued by CDOs contain embedded derivatives which need to be bifurcated andmarked-to-market, and should the CDO be consolidated on any entitys balance sheet? We willdiscuss these issues in terms of . accounting standards although International AccountingStandards and . GAAPend up in much the same place on these issues as . GAAP. Thefollowing is intended to raise relevant issues rather than be definitive or forCredit-Impaired TranchesCDO tranches can be classified as held-to-maturity securities, available-for-sale securities,8or trading sMecaunryit do not use held-to-maturity accounting and those9that do tend to do so only for thAe ChDigOhe tsrta rnacthede tChDatO is as a trading security is recorded at fair value with changes in value recorded inthe Asset section of the balance sheet and the Trading Income (or its equivalent) section ofthe income statement. ACDO tranche that is classified as an available-for-sale security is recorded at fair value (., marked-to-market) with changes in value recorded in the Asset and Other10Comprehenssivecet iIonncso mofe the balance sheet. Accordingly, mark-to-market changesdo not affect the income statement unless the available-for-sale security suffers an other-than-temporary decline in value. Under EITF 99-20, an available-for-sale security needs tobe tested for other-than-temporary declines in value and if such a decline exists, then thesecurity must be written down. This other-than-temporary decline write down is recorded inthe income statement. As a result of applying EITF 99-20, you can end up with some part ofthe mark-to-market on an available-for-sale security still on the balance sheet in OtherComprehensive Income and the other-than-temporary decline mark-to-market in the incomestatement. EITF 99-20 also describes how interest income should be recognized on asset-backed securities. In summary, EITF 99-20 requires you to calculate an expected yield on thesecurity and book interest income based on that yield. If the estimated cash flows on thesecurity change, you need to decide (1) if you have an other-than-temporary decline write-down and (2) if you should prospectively adjust the yield you are using to book interestincome. The table that follows summarizes the provisions of EITF thanks to Marie Stewart for this is the GAAPthat describes how you classify securitiest ays held-to-maturity, available-for-sale or trading. Held-to-maturisecurities are recorded at amortized cost; available-for-sale securities and trading securities are recorded at fair requires the positive intent and ability to hold a to maturity before it can attain held-to-maturity accountingAdditionally, FAS140 states that securities that can be prepaid or settled in such a way that the holder might not recoversubstantially all of their investment can only be classified as trading or Comprehensive Income is a component of the Shareholders Equity section of the balance sheet.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 38Douglas Lucas (1-212) 834-5535Table 13Has there been a change in the timing or amount of estimated cash flows as measured by a change in thepresent value of the estimated future cash flows (using the most recent yield to recognize interest income)? IncreasedInterest IncomeIn rcerceoagsen itthioen y:ield prospectively (to the IRR of revisedestimate of cash flows discounted to the current amortized cost)Other-than-tempNoornaery decline:Stayed theI nsatemres t IncomeC orenctoingunei ttio na:pply the most recent yield to recognizeinterest incomeOther-than-tempNoornaery decline:Decreased Is the current fair value lower than the carrying value on the books?YesNoInterest IncomeC hreacnoggen Itnihttieorne:st IncomeD reeccroeagsneition:yield prospectively (tot hthee y cieulrdre pnrto mspaerckteivtelyyield used in the fair value determination)Other-than-tempNoornaery decline:Other-than-tempToersat rfyo rdecline:impairment and if it exists, writedown theinvestment to its fair value as a charge tocurrent earnings Source: Deloitte & Touche: Securitization Accounting Under FASB 140: The Standard Formerly Known as FASB 125. 1st edition,January DerivativesFAS 133 requires the separation of an embedded derivative from its host contract if all of the following criteria are met: (1) the economic characteristics and risks of the embeddedderivative instrument are not clearly and closely related to the economic characteristics andrisks of the host contract, (2) the hybrid instrument is not remeasured at fair value underGAAPwith changes in fair value reported in earnings as they occur (., the instrument is notbooked as a trading asset), and (3) a separate instrument with the same terms as the embeddedderivative instrument would meet the FAS 133 definition of a derivative instrument. The phrase clearly and closely related focuses on the question of whether the underlyingeconomic characteristics and risks of the embedded derivative are clearly and closelyrelated to the economic characteristics and risks of the host contract. In other words, arethe factors that cause the derivative to fluctuate in value clearly and closely related to thefeatures of the host contract? Aderivative that embodies the economic characteristics ofinterest . ,rLisIkB (OR coupon subject to a cap or a floor) that is embedded in adebt instwruomuledhn atn voet to be bifurcated, since the economic characteristics of thederivative (interest rate risk) and the host contract (interest rate risk) are the same. Aderivative that embodies economic chea..g,r aac rtertuisrtnics of a credit default swap (tied to credit losses in a specified portfolwioo)u tlhdat is embedded in a debt instrument have to be bifurcated, since the economic characteristics of the derivative (credit risk) andthe host contract (interest rate risk) differ. FAS 133 requires all derivatives to be on-balance sheet at fair value (., marked-to-market). There are detailed procedures for deciding if you have an embedded derivative andhow you mark it to market. An embedded derivative is generally ascribed a fair value ofzero at inception (., the day you bifurcate it from the host instrument). How you mark anembedded derivative to market after bifurcation is an interesting question. Some people usemarket spreads/prices; others model the cash flows of the CDO to arrive at a fair value.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 39Douglas Lucas (1-212) 834-5535Consolidation of the CDOUnder FAS 140, the transferor of assets to a CDO that is a Qualifying Special PurposeEntity (QSPE) does not have to consolidate the CDO on its balance sheet. (The transferormust still meet the other sales criteria of FAS 140 in order for the transfer of assetsrecognized as an accounting sale.) Only CDOs that are essentially brain dead canachieve the QSPE designation. To be a QSPE, the CDO must sell assets only in response to quantifiable credit deterioration of the assets (default, downgrade, decline in fair valueof a specified amount.) Furthermore, the CDO must dispose of the credit deterioratedassets in prescribed, mechanistic ways. Arbitrage CDOs generally will not be QSPEsbecause of the asset managers ability to actively trade the CDOs assets. Balance sheetCDOs are often structured as QSPEs so that the selling bank can retain the CDOs equitybut still get sale treatment for the assets and not have to consolidate the QSPE. Parties to a CDO other than the asset transferor cannot rely on the CDOs QSPEdesignation to avoid consolidation. The QSPE designation only insulates the transferor ofassets to the CDO from consolidation. The party that might be at risk for consolidation of anon-QSPE CDO is the transactions sponsor. Sponsor, unfortunately, is not well definedin the accounting literature. Some indications that a party might be a sponsor are whetherthey transferred assets to the CDO, are the asset manager, provide credit support, receivedbrokerage and structuring fees, own more that 50% of the CDOs equity, and even whether their name is on the CDO. Owning one of a CDOs debt tranches, by itself, is notan indication of being the CDOs sponsor. Unfortunately, accounting standards in this area are not clear and are not becoming clearer. Some indications that a CDO will not beconsolidated by the transferor or the sponsor are the activities of independent third parties, ., not someone who might be considered a sponsor. It is positive if suchindependent parties: own legal form equity equal to 3% or more of the fair value of assets, including anyderivatives to which the SPE is counterparty; own the majority of equity; have control of the CDO; have the risk and rewards of ownership of the standards are continually changing and being reinterpreted and accountantsoften have difficulty in understanding the pronouncements of the SEC and the FASB andapplying them to specific circumstances. Accordingly, you need to proceed with extremecaution when determining how you account for CDO tranches and who should consolidatea CDO.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 40Douglas Lucas (1-212) 834-553511Tax ConsiderationsCDO tax considerations can be divided into those that might affect CDO credit quality andthose that definitely do affect the taxation of equity tranche Credit QualityWith respect to CDO credit quality, three relevant tax considerations arise: Will the CDO be subject to . entity-level income tax? Will dividends and coupons on CDO investments be subject to . withholding tax whenthey are remitted to the CDO? Will the CDO be subject to local taxes and local withholding?With respect to entity-level . income tax, a .-domiciled CDO will organize itself asa partnership or a limited liability company to achieve flow-through tax -based CDOs are operated in such a way as to qualify for either a statutorytrading exemption from . taxation or so that they will not be considered to be engagedin a . trade or business. For example, they will be careful to purchase loans, not makeloans to . obligors. Other restrictions on the CDOs activities so as to avoid beingengaged in a . trade or business typically include: (1) no negotiation of loan terms; (2) cannot engaged in origination activities; (3) percentage limitations on the inclusionof revolvers and delayed draw-down loans; and (4) specific limitations if the portfoliomanager or an affiliate originate loans. The issue of . entity level income tax treatmentis addressed by counsels opinion at closing and disclosed in the offering opinions assume ongoing compliance with the CDOs organizational . withholding tax applied on payments to the CDO would be at a 30% rate, sincethe CDO entity is typically not resident in a tax treaty country. Such withholding taxwould be wasted since the CDO, as discussed below, is not subject to foreign income taxand there is no ability by the CDO entity to recover the withholding tax as a tax would greatly affect the ability of the CDO to pay its liabilities. Dependingupon the CDOs asset composition, there may also be . withholding tax . withholding tax treatment depends on the nature of CDO investments. The CDO isexpected to avoid debt investments that do not qualify for the portfolio interest exemptionand thus be subject to . withholding tax. Generally, for qualifying debt instrumentsunder the portfolio interest rule, there is no . withholding tax on interest paymentsprovided that appropriate documentation is given by the CDO to the paying agent of theCDO investment. ACDO may enter into credit default, interest rate or other swaps . counterparties. While swap payments received by the CDO will generally not besubject to . withholding tax, it is possible that withholding could apply in limited may also receive payments for consenting to amendments to credit agreements orindentures, and such payments may be subject to . withholding tax. CDO offeringmemorandums typically address . withholding tax issues and, if applicable, thanks to Andrew Chalnick and Lenny Zuckerman for this analysis.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 41Douglas Lucas (1-212) 834-5535Recently, the IRS, as part of its business plan for 2000, has opened a regulatory project toprovide guidance on the portfolio interest exemption for payments to tax haven is supposed that this public signal is meant to spark better disclosure on the part of localtax authorities with respect to the activities of . taxpayers in tax havens. The OECDhas similar concerns. Developments in this area will need to be monitored to see whatchanges may be required to new or existing tax and withholding issues are the subject of negotiation between the CDO and thelocal taxing authority. The CDO usually receives certification from the local authority thatit will have no or low taxes under current tax law and that changes in local tax law will notbe effective upon the CDO. The certification usually covers local tax withholding Tranche TreatmentThe tax treatment of . CDO equity tranche holders in an offshore vehicle depends onthe entitys tax classification and, if a corporate classification, whether it is a controlledforeign corporation, or a passive foreign investment company and if the latter, whetheror not the taxpayer has made a qualified electing fund election. For a domestic orforeign partnership or limited liability company CDO, the tax treatment of . equitytranche holders is on a flow-through basis. The relevant issues for . equity trancheholders relate to income timing and the characterization of income as either ordinary orcapital tranches should also determine whether they might experience phantom income, ortaxable income without corresponding cash flow distribution. This could happen when, forexample, CDO interests proceeds are used to pay down debt tranches or when gains fromtrading are reinvested in new CDO debt securities are generally subject to the regular federal income tax rulesgoverning conventional debt instruments. Under those rules, stated interest on senior notesis taxable as ordinary income as the interest is received or accrued, for cash and accrualmethod taxpayers, tax treatment of CDO mezzanine tranches may vary. In many circumstances it willnot be entirely clear whether such tranches should be treated as debt or equity for income tax consequences. As interest on such securities is typically subject todeferral, holders may, if the securities are treated as debt, experience phantom income, ortaxable income without corresponding cash flow distribution. If the securities areconsidered equity for . tax purposes, the treatment of the interest will vary dependingupon the CDOs tax classification and, if a corporate classification, whether the CDO is acontrolled foreign corporation or a passive foreign investment company. If the CDO is apassive foreign investment company it may not be possible for a holder of a mezzaninetranche to make a protective qualified electing fund election, which could have adverseconsequences to . holders of such memorandums will disclose relevant tax issues to tranche holders who shouldconsult their tax advisors on general issues and their particular tax situation.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 42Douglas Lucas (1-212) 834-5535Glossary and NotesAdvancIen r a tme:arket value CDO, the amount of tranche debt supportable by an assettype, expressed as a percent of the market value of the asset type. Varies according to thecharacteristics of the asset type and the desired rating of the tranche. Please see page pe epreiorido:d, after the reinvestment or revolving period, in which newcollateral purchases are not allowed and principal cash flow is used to pay down tranche CDO: whose purpose is to allow a money manager to expand assetsunder management and equity investors to achieve non-recourse leverage to CDOassets. There is no arbitrage in the classic sense of the word. Rather, equity holdershope to capture the difference between the after-default yield on the assets and thefinancing cost due debt rAehsospeuetrsi noagdre purchased over a before closrianmg ppa-neurdpi oad after closing. Arbitrage CDOs and repackagingsare exceptionbs atola tnhceep ussrhupeaoelst ec oufr aStieoen psage maPnaargtye rr:e s ponsible for trading CDO assets. See page shAeeCt DCOD Ow:hose purpose is to allow a commercial bank or other entityto reduce their balance sheet or free up economic or regulatory capital. An existingportfolio (or the risk of the portfolio) is transferred to the CDO and the transferorusually purchases CDOAr ebqituriatgy. .e S CeDeo mOpapgaere 5 Bond insAurna nexcete:rnal guarantee of debt tranche performance from a financialguarantor insurance company. See page flowA CDO: w here subordinated tranches are sized so that senior tranchescan be paid from after-default cash flow with a high degree of confidence. If portfolioquality deteriorates, asset cash flow may be redirected from subordinated tranches tosenior tranches. See page covCearsahg efl otewst sC:DO tests that divert cash flows from subordinatedtranches, prevent reinvestment in new CDO assets, and cause senior tranches to be paiddown. The two main collaotevrearl- colvlaerteargaenl itdze astthiseo anr ete tshte interest e Sraogmee teimstes a ratings based test is also used. See page quCaalsihty ftleoswts :C DO tests that restrict portfolio trading. Tests mayinclude objective measures of portfolio diversity, average rating, average life,prospective average recovery, and minimum weighted average coupon or spread. See page bon:d Aobsleigcautriotinz a(tCioBnO o)f corporate bonds. Refers to thespecial purp(oSsPeV v)e thhiactl eholds the asset portfolio and issues liabilities and alsoto the obligations the rSaeliez ethde d deebfti noibtiloigna otifo debt Aobsleicguartitoizna (tCioDn Oof) :corporate bonds, bank loans,ABS, RMBS, CMBS, or almost any nsopne-cioanlsumer obligation. Refers to the
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 43Douglas Lucas (1-212) 834-5535purpose (vSePhVic)l ethat holds the asset portfolio and issues liabilities and also to theobligations the the late 1980s, when high yield bonds were first securitized, two nomenclatures viedfor supremacy. The alliterative bonds-backed bonds had the advantage of beingdescriptive and similar to the names of other securitizations like mortgage-backedsecurities and asset-backed securities. In contrast, collateralized bond obligation isoff-target. It better describes a debt obligation secured by specific physical assets, like amortgage bond secured by land and buildings or an equipment trust certificate securedby high-yield bonds, or more pejoratively, junk bonds, carried a stigma. Meanwhile,collatermaloirztegodab gliegations (CMOs) enjoyed acceptance and esteem due to theirpristine credit quality and government agency affiliation. The CBO moniker borrowedthe respectability and popularity of CMOs and won out in usage over the arguablybetter BBBs.The CBO terminology also enabled a clever marketing analogy: a CMO divides 30years of first mortgage cash flows into maturity ranges that appeal to investors withdifferent time horizons; a CBO divides the credit risk of a pool of high yield bonds intodifferent classes that appeal to investors with different credit risk tolerances.Having settled on CBO for the securitization of high-yield bonds, it was natural forcollateralized loan obligation to be used for the securitization of commercial when bonds and loans were mixed into the same vehicle, collateralized debtobligation described the conglomeration. Now, having trounced the upstart andunfortunate moniker kitchen sink bonds, CDO is also the firmly entrenched namefor the securitization of emerging market corporates and sovereigns, and the middletranches of ABS, RMBS, and CMBS loanA obselicguartiitoizna t(iCoLn Oo)f: bank loans, usually commercialand industrial loasnpse. c Riael fpeursr pt(oS sPtehV ev) e hthicalte holds the assetportfolio and issues liabilities and also to the obligations the SPVissues. See thedefinitcionll aotfe ralized debt : tAiodnd trestsses the presence in the portfolio of a single issuer, loanparticipations, . obligors, triple-C credits, deferred interest instruments and thelike. See page defaAulcto snwtraapc:t where one party pays a fee and the other party has thecontingent obligation to make a payment if a referenced entity defaults. The structureincorporates flexibility with respect to the definition of default and the calculation of thedefault payment. See page derAivdaetirviveas:tive whose underlying is a credit event or credit measure suchas default, credit spread, or rating change of a referenced asset or impaired orD iemspigrnoavteido na susseetds: t o determine flexibility in selling andreinvesting sale proceeds.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 44Douglas Lucas (1-212) 834-5535Credit-linAkendo nteo twe:hose cash flow depends upon a credit event or credit measure ofa referenced entity or asset such as default, credit spread, or rating change. See page might purchase a credit-linked note issued, for example, by a commercial bankthat embeds the terms of a credit default swap. For each of the referenced loans thatdefault, the principal of the credit-linked note is reduced. The bank has shed credit riskbecause what it might lose from the default of the loan it makes up through thediminishment of its obligation to the CDO under the credit-linked note. The CDOreceives a coupon on the credit-linked note that compensates the CDO for the combinedcredit risk of the bank and the referenced loans. This was the method of Union Bank ofSwitzerlands Glacier xxSynthetic CLO with Credit Linked Note Initial Purchase of Credit Linked NoteICOMMERCIALCDOBANKInterest and Principal on Structured NoteReduced by Default Losses on ReferencedAssetsSource: traTnrcahnecsh:es ranking in seniority above the equity tranche. See page coTrrheela ptihoenn:o menon that companies tend to default together. The stateof the general economy or of specific industries affect companies and lead to correlateddefaults. See page proTbhaeb liilkiteyl:i h ood that an obligor or asset will default over a given timeperiod. See page sTevher liotys:s in the event default occurs. See page tpioronc:e ss of eliminating intermediaries between ultimate users ofcapital and ultimate providers of capital. It is brought about by better communication,transparency, and securitizationse . See definition of DiversityM socordey: s index of a portfolios diversity based on the insight that anumber of correlated credits will exhibit the same return variance as a smaller numberof uncorrelated credits. For example, ten credits in ten industries have a Moodysdiversity score of ten while ten credits in the same industry have a diversity score offour. Besides industry diversity categories, Moodys has geographical diversitycategories for emerging market obligors and asset categories for ABS and MBS market CABsOecsu (rEitiMzaCtiBoOn so)f: bonds or bank loans from obligorsdomiciled in emerging smpeacrkiaelt sp. u rRp(eoSfsePerV sv )te ohth itcahltee h olds
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 45Douglas Lucas (1-212) 834-5535the asset portfolio and issues liabilities and also to the obligations the SPVissues. Seethe definciotilolant eorfa lized debt trTahnec hmeo:st subordinate tranche, regardless of whether the instrument isstructured to look like equity or debt or issued in the legal form of eqity or referred to as junior subordinate notes, preference shares or income see page pay/sTlohwe sphaayr:i n g of principal repayment among tranches simultaneouslybut with a bias to senior tranches. Not used much now. See page or legaWl mhialetu trhiety e: x act amortization of CDOs is not known for cash flowCDOs because it depends on defaults and calls, the latest maturity date on theunderlying CDO assets provides this outside cUonvdeyr aSneccet:i o n 548 of the . Bankruptcy Code, a fraudulentconveyance can be found to occur if a transfer by a person of an interest in its property,made within one year of the commencement of a bankruptcy case with respect to suchperson, either (i) is made with an actual intent to hinder, defraud or delay such personscreditors or (ii) constitutes a constructive fraud on such persons creditors. Aconstructive fraud can be found to occur if the transferor receives less thanreasonably equivalent value in exchange for the transfer and was insolvent at the timeof (or became insolvent as a result of) such transfer, was engaged in a business forwhich its property remaining after the transfer constituted unreasonably small capital orintended to incur debts that would be beyond its ability to repay as they matured. Interest covOernaeg eo ft ethste: c ollateral coverage tests that diverts cash flows fromsubordinate tranches, prevents reinvestment in new CDO assets, and causes seniortranches to be paid down. Please see page :l i aLbeinlidtyer liability is a collective reference to various evolving legal theoriesused to uphold the right of borrowers to sue lenders under certain , lender liability is founded on the premise that an institutional lender hasviolated a duty (whether implied or contractual) of good faith and fair dealing owed tothe borrower or has assumed a degree of control over the borrower resulting in thecreation of a fiduciary duty owed to the borrower or its other creditors or shareholders. See page nri askss: e ts price risk that is not related to fluctuations in its theoretical orintrinsic value but rather the ability of the seller to get a fair price. See page valAueC CDDOO w:here the haircut market value of assets is compared totranche par and accrued interest. If there is not a superiority of the first quantity, theCDOs assets must be sold and tranches repaid in seniority until the prescribed ratio isachieved. See page worAth mteasrtk: e t value CDO test of the equity tranche value that, if breached,causes the CDO to sell its assets and retire debt tranches. See page 15.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 46Douglas Lucas (1-212) 834-5535Notional Tamheo uanmt:o u nt that interest rates or currency rates are multiplied by tocalculate the cash flow of a -market Atrna nasramctsi-olne:ngth non-recourse sale of financial assetsbetween unaffiliated entities in which the seller receives payment in full at the timeof the sale and takes such payments in the form of cash, rather than in the form ofthe buyers eCrDmO c:oined in this paper and not in use. ACDO created topurchase assets specifically originated for it. See page Fteosrt ao rc apsahr fvlaolwue C tDesOt:, one of the collateralcoverage tests that diverts cash flows from subordinated tranches, preventsreinvestment in new CDO assets, and causes senior tranches to be paid down. Seepage 23. For a market value CDO, the test that causes CDO assets to be sold toretire the senior-most tranche outstanding. See page sec:u rAitsye icnutreerde sptartys security interest in a financial asset isperfected once it has taken all the ,e .fpisli nregq uired under applicable law (a UCC financing statement or taking possession of the asset) that affords the securedparty maximum secured creditor protections in terms of being able to take the assetfrom or to the exclusion of third parties upon the debtors default. PrefereUnncdee: r Section 547 of the . Bankruptcy Code, a preference can befound to occur upon a transfer by a person of an interest in its property to a creditor,in respect of an antecedent debt owed by such person prior to the transfer, during therelevant preference period preceding the filing of a bankruptcy petition withrespect to the debtor, if at the time of the transfer, such person was insolvent and ifthe effect of the transfer was to improve the position of the creditor at the expense ofother similarly situated creditors. Under the . Bankruptcy Code, the preferenceperiod is one year prior to the date of the bankrupts petition filing if the creditor isan insider with respect to the bankrupt and otherwise 90 days prior the date of itspetition -proAtescttreudc tnuoritne:g and credit rating device to achieve a higherrating for an investment. Ahigh yield instrument, such as an equity CDO tranche, iscombined with a high credit quality zero coupon security, often a stripped Treasurybond. The rating agency limits their credit assessment solely to the cash flowsupported by the zero coupon bond and is silent to the upside potential contributedby the more risky asset. Generally this is done when regulatory or capitalrequirements restrict or penalize the purchase of the two assets in bTahnek riunptetcnyd:e d seniority of claimants in bankruptcy which canbe partially overthrown, especially in the ., by the bankruptcy judges powers ofequitable distribution and the negotiating power of subordinated investors. See page in ca:s h T fhloew c rteimditn pgrotection afforded senior tranches relative tosubordinated tranches in a cash flow CDO by the redirection of cash flows to pay
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 47Douglas Lucas (1-212) 834-5535down debt tranches via the operation of the waterfall and collateral coverage page of paymentTsh, eo rs chweadtuelref athllat: d etermines distribution of interestand principal proceeds to cash flowc oCllDaOte rtaralnches taking into account coverag. e S tees tpsage -rata disTthrieb udtiisotrni:b u tion of principal repayment to tranches page uepri:od after CDO closing in which assets are purchased. Associated witharbitrage rather than balance sheet CDOs. See page Tahmeo munatr:ket value of the asset after it defaults or the present value of allafter-default cash flowsSee page assTeht eo ra sosbelti goor ro: b ligor whose performance determines cashflows in a total return or credit default swap. See page or rIenv oa lcvainsgh pfleorwio dC:DO, the period in which principalproceeds can be reinvestecdo ilnla nterwa la csosaevrteser samoge elto .tnegst sas RepackaCgDinOgs-l:ike structures with one liability tranche and one asset are calledrepackagings. In such a structure, an interest rate swap or a currency rate swap changesthe cash flow characteristics of the asset into the cash flow characteristics of theliability. The swap might transform the currency of the underlying asset, or a fixed ratecoupon into floating, or even a zero coupon into a current pay coupon. This structure isemployed when, for perhaps regulatory or credit reasons, the investor cannot enter intothe transactions pnr:ocess and the result of pooling financial assets together and issuing liability and equity obligations backed by the pool of assets. The entity that issues theobligations and purchases the assets is generically called a special purpose vehicle(SPV) or Special Purpose Entity (SPE). The SPVis set up solely for the purpose of thesecuritization and might be a trust, limited liability company, partnership or acorporation. The obligations of the SPVare typically tranched into multiple classeswith different maturities and mortgages on residential property were the first asset class to be securitized,beginning with a Ginnie Mae sponsored transaction in 1970. Today, first mortgages arestill the most prevalent securitization. But since the mid-1980s almost every otherimaginable type of consumer debt has also been securitized: credit card, auto, boat,second mortgages, home equity lines, manufactured housing, RV, student loans, timeshare payments, and even property tax -consumer assets that have been securitized include: equipment leases, mortgageson commercial property, small business loans, franchise payments, loans for taxi-cabmedallions, and even the future royalty stream on record and CD airplay and sales,playfully called Bowie Bonds after the first recording artist to be so goes hdainsdin-itne-rhmaoenfd dci aowtmiiotmhn ethrcei al banks,
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 48Douglas Lucas (1-212) 834-5535finance companies, and other traditional holders of credit assets. Over the last twodecades, many of these institutions have gradually transformed themselves fromoriginators, sherovldicoeefr rscsr, eadnidt assets to originators, servicers, anddistribouft ocrsedit assets. The result is that the chain between ultimate borrower andultimate lender has shortened as these links have fallen success of CDOs, particularly of commercial loan-backed CDOs, is analogous tothe disintermediation of consumer principal payRdoewpany omr esnetq oufe nptriianlc pipaayl: t o tranches inorder of seniority. See page -: o fTfhe term set-off, when used in connection with a loan in respect of which alender has sold a participation interest, refers to the borrowers reduction, in connectionwith the lenders insolvency, of amounts payable under the loan to the lender byamounts owed by the lender to the borrower in respect of unrelated obligations (e..g, deposits of the borrower held by the lender). See page purpose vehicle (SPV) oSre sep deecfiainl iptiuornp ofse entity (SPE): nnoottee,: w hich, for example, embeds a total return or credit default swapand whose cash flows depend on some referenced asset or page c: o nSsuoblsidtaanttiiovne consolidation is the principle of law under which abankruptcy court, in the exercise of its equitable powers, will consolidate the assets andliabilities of separate, but related, entities so that their combined assets and liabilitieswill be treated as those of one, single entity. See page CDO oAr CLDOO otrh aCt BgOai:n s exposure to credit-risky assets viaderivative transactions rather than cash purchase of the assets. See page retuArnd sewriavpa:t i ve whose underlying is the total return of a referenced asset,., all coupons plus appreciation/depreciation. TrancShetd :in a senior or subordinate position relative to one another. See page : s aAletransfer of financial assets that, for purposes of . bankruptcy orinsolvency laws, constitutes a sale of such assets, rather than a transfer of the assets ascollateral in connection with a secured financing in which the transferor is the debtorand the transferee is the secured creditor. See page gp:urchase of assets before a CDO closes. See page or prio: r iTtyh eo fs cphaeydmuelne ttshat determines distribution of interest and principal proceeds to cash flow CDO tranches taking into account collateralcoverage tests. See page 20.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 49Douglas Lucas (1-212) 834-5535Rating Agency PublicationsCDO Rating Criteria for Cash Flow Collateralized Debt Obligations, November 4, Value CBO/CLO Rating Criteria, June 1, of CBOs/CLOs, December 8, Binomial Expansion Method Applied to CBO/CLO Analysis, December 13, Double Binomial Method and Its Application to a Special Case of CBO Structures,March 20, s Approach to Rating Market-Value CDOs, April 3, & CBO/CLO Criteria, Funds: Market Value Criteria and Overcollateralization Requirements, March StudiesFitchHigh Yield Default Rates 1980 2000, November 21, Secured Loan Recovery Study, February 29, Bank Loan Recovery Study, October 22, Default and Recovery Rates of Corporate Bond Issuers: 2000, February s Rating Migration and Credit Quality Correlations, 1920-1996, July &PRatings Performance 2000: Default, Transition, Recovery, and Spreads, January 2001.
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 50Douglas Lucas (1-212) 834-5535Asset Managers and Sellers since 1987ABN AMROBankgesellschaCfto BnneirnlignAeltusBanque ArjilConsecoAIGBanque IndosuCezredit AgricoleAIMCOBarclaysCredit LyonnaisAllianceBEACredit SuisseAllmericaBeacon HillCypress TreeAmerican ExpreBssear StearnsDavid L. Babson/Mass MutualAmerican GenerBaHlFDeerfieldAmerican MoneBy lack DiamondDelaware Investment ManagementBlackRockAdvisorsAngelo GordonBNPDeltecAntares Capital BConrpe, Smith &D BeaurtdscheANZBrinson PartnerDs,i BankCarillonDresdnerAsset AllocationC arlsonDuff & Phelps& ManagementCarlyleDWS Finanz-ServiceAtlantic AssetCaywoodEaton VanceAxaCDC Elliot and PageBahrain InternatCioennatlr eB PaanckificEnronBanca CommercCiaelreb eItraulsianaEquitableBanca di RomaCGAExport Import Bank Banco Bilbao ViCzhcanycaellorof KoreaArgentariaChartwellFalcon Asset Management Banco De CrediCtoh aseFederatedLocal de EspanCaIBCFinancial ManagementBank AustriaCIGNAAdvisorsBank of AmericCaitigroupFirst Dominion (CSFB)Bank of MontreaCllintonFirst ExectiveBank of Nova SCcootlioanialFirst Source FinancialBank of Tokyo-MCoitmsumboisnhwiealthF iBrsatn Uk nionBank Oneof AustraliaFisher, Francis, BankBostonConnecticut MuTtureael sL &ife Watts
New . Morgan Securities HandbookMay 29, 2001Global Structured Finance ResearchPage 51Douglas Lucas (1-212) 834-5535Asset Managers and(C Soenltlienruse sdi)nce 1987 FITGPMassMutualSummitFleming InvestmMenBtIASun CapitalForstmann-LefMerrill LynchSunAmericafFort WashingtonMetropolitan Rowe PriceFortressMFSTCWFountainMorley FundTennenbaumFranklinMuzinichTimesSquareFujiNatexis BanqueTsr aPionperu lWaiorersthamGen ReNew EnglandTransamericaGhentNicholas AppleTgraitoenGleacherNomuraTriumphGLXNorthwesternUBSGoldman SachsOak HillUnited Overseas BankGroupernent desO ctagonVan . HuffIndustries AgricolesGulf InternationOalv Berasnekas UnionWafraHarbourVPetersonWellingtoniewHarchPhoenixWells FargoHighlandPilgrimWestdeutsche LandesbankHSBCPIMCOZais GroupHypoVPPM AmericaereinsbankIBJPrincipalProspect StreetIDMProvidentIKB Deutsche IndustriebankPrudentialPutnamIncome PartnersINGRabobankRand Merchant BankIntermediate CapitalInternational FinRaonbcec CoorpINVESCORoyal Bank of ScotlandSakuraJ&WSeligmanJH WhitneySankaty (Bain)SantanderJohn HancockJordanSanwaSaudi International BankJPMorganKohlberg & CoSBCKBC BankScudder KemperKDPCM, LLCSenecaKidder, PeabodyShenkmanKorea Asset MaSnoacgieemtee GnteneraleLehman BrotherSstanfieldLexamStein Roe & FarnhamLibertyVSterlingiewLong TSrongerm Credit Bank of JapanStructured Credit PartnersMadison Park Structured Finance AdvisorsPreferred FundiSnugmitomoSource: Fitch, Moodys, S&P, JPMorgan.
New . Morgan Securities HandbookMay 25, 2001Global Structured Finance ResearchDouglas Lucas (1-212) Park AvenueNew York, . 10017Tel. (1-212) London Wall60 Victoria EmbankmentLondon EC2Y5AJLondon EC4Y0JPTel. (44 207) 777 1821 T el. (44 207) LTD.. One Exchange Square, 39A/Fkasaka Park BuildingCentral, Hong Kong2-20 Akasaka 5-chomeMinato-ku, Tokyo 107-6151, JapanTel. (852) 2841-4527Tel. (813) 5573-1185Additional information is available upon request. Information herein is believed to be reliable but JPMorgan does not warrant its completeness or accuracy. Opinions and estimatesconstitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The investments and strategies discussed here may not be suitablefor all investors; if you have any doubts you should consult your investment advisor. The investments discussed may fluctuate in price or value. Changes in rates of exchange mayhave an adverse effect on the value of investments. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. JPMorgan and/or itsaffiliates and employees may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or lenderto such issuer. JPMorgan may participate on a creditors committee relating to the restructuring of an issuer mentioned herein, and its employees may serve as directors of the '2001 . Morgan Chase & Co. All rights reserved. JPMorgan is the marketing name for . Morgan Chase & Co. and its subsidiaries and affiliates worldwide. . MorganSecurities Inc., and Chase Securities Inc., (CSI), are members NYSE and SIPC. Chase H&Q is a division of CSI. Morgan Guaranty Trust Company of New York and the ChaseManhattan Bank, are members FDIC. . Morgan Securities Asia Pte Ltd. (JPMSA) and Chase Manhattan Asia Ltd. are regulated by the Hong Kong Securities & Futures regulated by the Monetary Authority of Singapore and the Financial Services Agency in Japan. . Morgan Futures Inc. is a member of the NFA. Issued and approved fordistribution in the UK and the European Economic Area by . Morgan Securities Ltd., and Chase Manhattan International Limited and . Morgan plc, members of the London StockExchange and regulated by the Securities and Futures Authority. Issued and distributed in Australia by Chase Securities Australia Limited and . Morgan Australia Securities Limitedwhich accept responsibility for its contents and are regulated by the Australian Securities and Investments Commission. . Morgan Australia Pty Ltd. is a licensed investment adviserand futures broker member of the Sydney Futures Exchange. Clients should contact analysts at and execute transactions through a JPMorgan entity in their home jurisdiction unlessgoverning law permits Economic Area: Issued for distribution in the European Economic Area (the EEA ) by . Morgan Securities Ltd. and Chase Manhattan International Limited ( CMIL ), afirm regulated in the conduct of investment business in the United Kingdom by the Securities and Futures Authority Limited. This report has been issued, in the UK, only to personsof a kind described in Article 11(3) of the Financial Services Act 1986 (Investment Advertisements) (Exemptions) Order 1997 (as amended) and, in other EEAcountries, to personsregarded as professional investors (or equivalent) in their home jurisdiction. It is intended for use by the recipient only and may not be published, copied or distributed to any otherperson. Any EEApersons wanting further information on, or services in relation to, anything contained in this report should contact CMIL(telephone 44 171 777 4945). This reporthas been prepared by an entity which may have its own specific interest in relation to the issuer, the financial instruments or the transactions which are the subject matter of the contained herein may not be distributed to persons in the Netherlands. We do not make investments mentioned herein available to any EEApersons other than professionalor institutional investors. JPMorgan or an affiliate has an equity interest in the securities of the company. An affiliate of JPMorgan has a proprietary investment in a company. JPMorgan may be deemed to be an affiliate of the company. Aprospectus prepared by the company accompaniesthis report or has been previously delivered to you and is also available upon request to report should not be distributed to others orreplicated in any form without priorconsent of information is available upon request.
