Developments in Collateralized Debt Obligations New Products and Insights DOUGLAS J LUCAS LAURIE S GOODMAN FRANK J FABOZZI REBECCA J MANNING John Wiley & Sons, Inc ffirs.indd iii 4/9/07 9:04:32 AM ffirs.indd vi 4/9/07 9:04:33 AM Developments in Collateralized Debt Obligations ffirs.indd i 4/9/07 9:04:31 AM The Frank J Fabozzi Series Fixed Income Securities, Second Edition by Frank J Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L Grant and James A Abate Handbook of Global Fixed Income Calculations by Dragomir Krgin Managing a Corporate Bond Portfolio by Leland E Crabbe and Frank J Fabozzi Real Options and Option-Embedded Securities by William T Moore Capital Budgeting: Theory and Practice by Pamela P Peterson and Frank J Fabozzi The Exchange-Traded Funds Manual by Gary L Gastineau Professional Perspectives on Fixed Income Portfolio Management, Volume edited by Frank J Fabozzi Investing in Emerging Fixed Income Markets edited by Frank J Fabozzi and Efstathia Pilarinu Handbook of Alternative Assets by Mark J P Anson The Global Money Markets by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry The Handbook of Financial Instruments edited by Frank J Fabozzi Collateralized Debt Obligations: Structures and Analysis by Laurie S Goodman and Frank J Fabozzi Interest Rate, Term Structure, and Valuation Modeling edited by Frank J Fabozzi Investment Performance Measurement by Bruce J Feibel The Handbook of Equity Style Management edited by T Daniel Coggin and Frank J Fabozzi The Theory and Practice of Investment Management edited by Frank J Fabozzi and Harry M Markowitz Foundations of Economic Value Added: Second Edition by James L Grant Financial Management and Analysis: Second Edition by Frank J Fabozzi and Pamela P Peterson Measuring and Controlling Interest Rate and Credit Risk: Second Edition by Frank J Fabozzi, Steven V Mann, and Moorad Choudhry Professional Perspectives on Fixed Income Portfolio Management, Volume edited by Frank J 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Philippe Priaulet Analysis of Financial Statements, Second Edition by Pamela P Peterson and Frank J Fabozzi Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J Lucas, Laurie S Goodman, and Frank J Fabozzi Handbook of Alternative Assets, Second Edition by Mark J P Anson Introduction to Structured Finance by Frank J Fabozzi, Henry A Davis, and Moorad Choudhry Financial Econometrics by Svetlozar T Rachev, Stefan Mittnik, Frank J Fabozzi, Sergio M Focardi, and Teo Jasic ffirs.indd ii 4/9/07 9:04:32 AM Developments in Collateralized Debt Obligations New Products and Insights DOUGLAS J LUCAS LAURIE S GOODMAN FRANK J FABOZZI REBECCA J MANNING John Wiley & Sons, Inc ffirs.indd iii 4/9/07 9:04:32 AM Copyright © 2007 by John Wiley & Sons, Inc All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada Wiley Bicentennial Logo: Richard J Pacifico No part of this publication may be reproduced, stored in a 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disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com ISBN: 978-0-470-13554-9 Printed in the United States of America 10 ffirs.indd iv 4/9/07 9:04:33 AM DJL To my wife Elaine and my children Eric and Benjamin LSG To my husband Mark and my children Louis, Arthur, Benjamin, and Pamela FJF To my wife Donna and my children Karly, Patricia, and Francesco RJM To my parents Bob and Kathy and my husband Scott ffirs.indd v 4/9/07 9:04:33 AM ffirs.indd vi 4/9/07 9:04:33 AM Contents ‘ Preface About the Authors xi xv PART ONE Introduction CHAPTER Review of Collateralized Debt Obligations Understanding CDOs Cash Flow CDOs Synthetic Arbitrage CDOs Conclusion 10 28 37 CHAPTER Impact of CDOs on Collateral Markets 39 Collateralized Loan Obligations and the High-Yield Bank Loan Market Structured Finance CDOs and the Mezzanine Mortgage ABS Market Trust Preferred Securities CDOs and their Collateral Market Conclusion CHAPTER CDO Rating Experience CDO Rating Downgrade Data CDO and Tranche Rating Downgrade Frequency CDO Downgrade Patterns Why Downgrade Patterns? Downgrade Severity Extreme Rating Downgrades CDO “Defaults” and Near “Defaults” Summary 39 42 46 48 49 50 52 54 56 58 58 61 71 vii ftoc.indd i 4/9/07 9:07:06 AM viii CONTENTS PART TWO Developments in Synthetic CDOs CHAPTER ABS CDO Collateral Choices: Cash, ABCDS, and the ABX Growth of the Subprime Synthetic Market Importance of ABCDS to CDO Managers ABCDS The ABX Index Fundamental Contractual Differences—Single-Name ABCDS/ABX Index/Cash Supply/Demand Technicals What Keeps the Arbitrage From Going Away? Bottom Line—Buyers versus Sellers The Cash/ABCDS Basis and the CDO Arbitrage Single-Name ABCDS versus ABX in CDOs Summary CHAPTER Hybrid Assets in an ABS CDO Corporate CDS and ABCDS Advantages of Hybrid Assets in an ABS CDO Illustrative Hybrid ABS CDO Structure Cash Flow Challenges Conclusions CHAPTER Synthetic CDO Ratings Tests of Index Portfolios AAA Ratings and Expected Loss versus Default Probability Barbell Portfolios Summary CHAPTER Credit Default Swaps on CDOs CDO CDS Nomenclature CDO Credit Problems and their Consequences Alternative Interest Cap Options Miscellaneous Terms Cash CDO versus CDO CDS ftoc.indd ii 73 75 75 76 79 82 83 89 92 94 94 96 97 99 100 103 105 107 115 117 117 120 121 122 125 126 127 130 133 134 4/9/07 9:07:06 AM Collateral Overlap and Single-Name Exposure in CLO Portfolios 273 ordinate OC deltas have shrunk over the last year With respect to concentration risk across CLO portfolios and within a particular CLO portfolio, the smaller size of credits in CLOs has more than offset the prevalence of the same names across different CLOs ch13-CollateralOverlap.indd 17 2/26/07 2:42:06 PM ch13-CollateralOverlap.indd 18 2/26/07 2:42:06 PM Index AAA ratings, usage, 120–121 ABCDS See Asset-backed credit default swaps A/B/C structure See First lien mortgage ABSs See Asset-backed securities ABX basis, differences, 84e BBB- spreads, 89e buyers, sellers (contrast), 94 collateral choices, 75 contracts, 75 contrast See Home builder stock index market, macro-hedge funds (involvement), 96 PAUG contracts, 83 ABX.HE 06-2 BBB- index, 93e ABX.HE indices See Semiannual ABX.HE indices ABX index, 82–83 Accuracy ratio, 249 increase, Moody’s adjustments (impact), 248 Advance rate, AFC See Available funds cap After-default cash flow See Assets Alexander, Hadas, 200n, 229n American Capital Strategies, 180 Annual CDR, 226, 233 Annual collateral default rates See Commercial mortgage-backed securities; High-yield loans A-note/B-note (A/B) structure, 175–176 A-note holder, rights, 176 A-notes, classification, 206n Arbitrage See Hybrid ABS CDOs category, disappearance, reasons, 92–94 imperfection, 94 Arbitrage, impact, ARCap, 180 Asset-backed credit default swaps (ABCDS), 75, 79–82 amortization, performance, 113 collateral choice, 75 documentation, standardization, 99 importance See Collateralized debt obligations replacement See Cash ABS usage See Corporate ABCDSs Asset-backed securities (ABSs), CDS amortization, impact, 111e credit risk, specificity, 100 market basis relationship, 91e problems, 101 Asset-backed securities (ABSs) CDOs See Hybrid ABS CDOs collateral choices, 75 hybrid assets advantages, 103–105 usage, 99 percentage/rating distribution, 79e Asset managers (collateral managers), impact, Assets after-default cash flow, aggregate principal balance, 215n, 227n default, 26n liquidation, sellers, impact, Assumption sensitivity See Investment-grade CMBS CDOs; Mezzanine structured finance CDOs Attachment point See Tranches Auden, James B., 150n Available funds cap (AFC), 81 impact, 101 interest payment shortfall, 81 Average issuer-weighted cumulative defaults rates, alphanumeric rating, 18e Bach, Patricia, 190n Balance sheet category, impact, Bank credit quality, distinctions, 152 Bank holding company junior subordinated obligation, coupon/ maturity, 142 trust deconsolidation, 142n Bank/institutional loan share, 40e Bank interventions, records, 152 Bank preferred stock-backed CDOs, 50 Bankruptcy credit events, 35n remoteness, 275 Index.indd 2/26/07 2:43:01 PM 276 Bank statements, usage, 170 Bank TruPS CDO demand, 148 collateral default assumptions See Moody’s deferrals, 159–161 See also Trust-preferred securities CDOs Fitch recovery assumptions, 153e performance See Trust-preferred securities CDOs prepayments, 147–148 weighted average spreads, 147e Bank trust-preferred CDO issuance, 47e Barbell portfolios, 121–122 See also Extreme barbell portfolio; Modest barbell portfolio S&P/Moody’s ratings, contrast, 123e Basis mismatch, impact, 181 Binomial distribution, usage, 24 Binomial probability distribution, 17 scenarios, 22 B-notes holder, rights, 176 subordinate debt, 207 variation, 219 B-notes (junior participation), 206n defaults/losses, 196–197 structure See A-note/B-note structure Bond-backed CDO, 25e, 26e collateral yield, pursuit, 56 Bondholders, losses, 21–23 overstatement, 22 Bond-level analysis See Commercial mortgagebacked securities Bonds investors, call protection, 27 par value, 126n Brennan, James, 155n Bridge loans, classification, 206n Burke, Julie A., 150n Buyers designations, 126e sellers, contrast See ABX; Collateralized debt obligations Call protection See Bonds mechanisms, 174 Call provisions See Collateralized debt obligations variations, equity holders (benefit), 27–28 Call treatment, 87 Cantor, Richard, 18n, 194n, 198n, 200n, 229n, 245n, 247n–249n Capitalized PIK interest, interest, 129 Capital structure, 30 Capmark, 208 Cash ABCDS, addition, 95 Index.indd Sec3:2 INDEX basis, differences, 84e BBB- spreads, 89e bond, sale, 114 collateral choice, 75 diversion, impact, 16 issuance, 95 settlement, obtaining, 102n Cash/ABCDS basis, 94–96 Cash ABS amortization, impact, 113e bonds, ABCDS replacement, 99n investment, 110e Cash assets, CDO liability amortization (relationship), 112–114 Cash CDO, CDO CDS (contrast), 134–135 Cash flow CDOs, 10–28 challenges See Hybrid ABS CDOs credit structure, distribution, 11–12 function, 227 modeling, 186 protection, 4, volatility, 184 waterfall See Interest cash flow waterfall; Principal cash flow waterfall Cash interest shortfall, payment, 88 Cash mezzanine ABS CDO arbitrage, 95e Cash reserves, holdings, 170 CBOs See Collateralized bond obligations CDRs See Constant default rates CDSs See Credit default swaps Champlain CLO, exclusion, 267n Charter-owning CLOs, impact, 266 Clean-up call, 27 CMBSs See Commercial mortgage-backed securities C-note, junior note status, 175n Cohen Brothers, issuers, 164–166 Coissuer, Collateral See Trust-preferred securities assumptions, 153–154 See also Standard and Poor’s concentrations, assessment, 186 default assumptions See Fitch; Moody’s default rates See High-yield CMBS distribution See Commercial real estate CDO diversification, 17 haircuts, 149 historical annual default rates See Commercial mortgage-backed securities historical default rates See High-yield CLOs; Whole loan CREL CDOs historical rates See High-yield loan; Whole loan CRELs 2/26/07 2:43:01 PM Index Collateral (Cont.) investment considerations, 207 loss rates See Standard and Poor’s sensitivity matrices See High-yield loan; Whole loan CRELs pools, 227 portfolio, principal balance, 13 ratings distribution, 79 recovery rates, 219–220 risk differences, 231 risk level, inclusion, 208 types, diversification, 206 Collateralized bond obligations (CBOs), Collateralized debt obligations (CDOs) See Bond-backed CDO; Cash flow CDOs; Hybrid ABS CDOs; Single-tranche CDOs; Synthetic arbitrage CDOs arbitrage, 94–96 attributes, 3–8 buyers, sellers (contrast), 94 cash flow effect, 130 choices See Asset-backed securities collateral market, relationship See Trust-preferred securities Moody’s default/loss assumptions, example See Commercial real estate consolidation, FASB impact, 142n credit consequences, 127, 129–130 illustration, 127e credit problems, 128–130 illustration, 127e defaults, 61–71 downgraded tranches, percentage (CDO/ vintage ranking), 55e downgrade patterns, 54–56 impact See Collateral markets indenture, investors, 213 issuance, 103n See also New CDO issuance; Trust-preferred CDOs issuers, liability, 99n amortization, relationship See Cash assets; Credit default swaps managers, 112n ABCDS, importance, 76–79 marginal buyer, question, 86 mezzanine mortgage ABS market, relationship See Structured finance CDOs near defaults, 61–71 number, CDO/vintage ranking, 51e parties, 9–10 purchases See Residential B/C production purposes, 6–7 Index.indd Sec3:3 277 rating agency, 136–137 research, 245 ratings, public announcements, 52n reinvestment period, 112 required collateral loss rates See Standard and Poor’s review, single-name ABCDS/ABX contrast, 96 structural matrix, 8–9 illustration, 8e transactions call provisions, 26–28 interest rate swaps/caps, uses, 25–26 TruPS deferrals, usage, 158–161 understanding, 3–10 Collateralized debt obligations (CDOs) CDSs ABS CDS documentation, differences, 130n assignment, 136 contract, miscellaneous terms, 133–134 contrast See Cash CDO documents/calculations, 134 exiting, 135–136 interest rate caps, example, 132e nomenclature, 126–127 offsetting, 136 protection, sale, 136–137 termination, 135 usage, 125 Collateralized debt obligations (CDOs) rating downgrade data, 50–52 downgrade frequency, 52–54 expected loss permissible (Moody’s), 20–24 experience, 49 Collateralized debt obligations (CDOs) tranches cumulative percent, 54, 55e defaults, percentage, 64e events See Defaults ratings, migration, 60e ratings, type/original ranking See Worst current CDO tranche ratings Collateralized loan obligations (CLOs), 213 borrowers commonality, 260e–261e managers, ranking, 264e–265e ranking, 263e collateral overlap See U.S CLOs credits, 263–265 exposure, minimum, 259n high-yield bank loan market, relationship, 39–42 issuance/loan purchases See U.S CLO issuance/loan purchases; U.S CLOs market, fear, 254 portfolios collateral overlap, 257 single-name exposure, 257 2/26/07 2:43:02 PM 278 Collateralized loan obligations (Cont.) revolving senior tranche, usage, 267n single-name exposures, 263 structurers/managers/investors, concern, 254–255 term, coinage, tranche structure, 5e vintage, ranking, 258e Collateral managers See Asset managers Collateral markets CDOs, impact, 39 relationship See Trust-preferred securities CDOs Collateral overlap See Collateralized loan obligations assessment, 257 calculation methods, 259n increase, 257 managers, ranking, 262e percentage, 260e–261e potential, 241 reduction, 265 vintage, ranking, 262e Combo tranches, elimination, 61 Commercial and industrial (C&I) loans, 41 Commercial mortgage-backed securities (CMBSs), 17–182 annual collateral default rates, 225 assumed recovery rates, 219e, 220e bond-level analysis, 186 CDO collateral cumulative default rates, vintage ranking, 238e cumulative impairment rates, 200 deals categories, 182e types, 181–182 default rates, 200–202 evaluation, 183–186 extension risk, 180 historical performance, 197–203 interest shortfalls, 181 investors, 214 large loans, Moody’s hypertranching, 218e loss severity, 202–203 curve, 217e prepayment risk, 180 sequential pay structure, 180 structure, 179e subordination levels, 198e transactions, 222n upgrades/downgrades, 198–199 usage See Portfolios Commercial mortgage-backed securities (CMBSs) loan collateral See Loss severity annual default rates, 225e cumulative collateral default rates, 226e Index.indd Sec3:4 INDEX default rates, 239n defaults, property type/default year (ranking), 193e Fitch default/loss curves, 216e loss severity matrix, property type ranking, 195e marginal default rates, vintage (ranking), 191e recent default history, 190–194 Commercial mortgage-backed securities (CMBSs) tranches, 198 default/impairment, 200 interest shortfalls, impact, 180–181 performance/upgrade activity, 212 rating transition matrix, 199e Commercial mortgage loans fixed rate characteristic, 173 performance, 197 Commercial mortgage REIT, 155 Commercial real estate (CRE) CRE-related securities, quality, 215 finance, evolution, 169 loan performance, 187–190 primer, 169 Commercial real estate (CRE) CDO See Issued CRE CDOs characteristics, 211e collateral default/recovery estimates, 237e distribution, 208 historical/required loss rates, 237e Moody’s default/loss assumptions, example, 197e credit analysis, 214–215 definition, 205–207 global usage, 209 investors characteristics, 212e impact, 212–214 market trends, 207–209 performance, 211–212 rating, 215–220 relative value, 234–241 methodology, 221 spreads, basis points, 235e subordination levels, 235e tranches, number, 222n types, 210–211 usage, 205 Commercial real estate loans (CRELs), 178 average default curve, loan amount (ranking), 189e collateral default rate volatility/default rates, 240e cumulative defaults, underestimation, 240 default curve variability, vintage ranking, 189e defaults/losses, 187 2/26/07 2:43:02 PM Index Commercial real estate loans (Cont.) demand, 171 evaluation, 183–186 historical performance, 186–197 investors, 211 recovery rates See Standard and Poor’s volatility, underestimation, 240 Commercial real estate loans (CRELs) CDOs collateral cumulative default rates, vintage (ranking), 239e high-yield CLOs, contrast See Whole loan CREL CDOs Condo loans, 178 Constant default rates (CDRs) See Annual CDR conversion, 224 Construction loans, 178 Continue-to-defer rates, 161 Contractual differences, 83–89 impact See Relative spreads Co-op conversion loans, 178 Corporate ABCDSs, usage, 100–103 Corporate CDSs, usage, 100–103 Corporate credit problem, clarity, 101 Corporate credit risk, generality, 100 Corporate loans, Coupon step-ups, 27 Covenant package, components, 183 Coverage tests, 13–16 usage, 12 CRE See Commercial real estate Credit analysis See Commercial real estate CDO Credit default swaps (CDSs) See Asset-backed credit default swaps amortization, impact See Asset-backed securities basis, differences, 84e CDO liability amortization, relationship, 109–112 contrast See Cash CDO initial cash flows, 126e premium, 104n stepup, 87 upfront exchange, 134 withholding, 131 protection payments, 107–109 reserve fund, usage, 108e super-senior tranche, usage, 109e settlement, 31 termination/assignation/offsetting, 114 trading, 114–115 usage See Collateralized debt obligations CDSs; Corporate CDSs Credit default swaps (CDSs) indices, 34e portfolios, S&P/Moody’s ratings (contrast), 118e standard tranches, 28, 33–37 Index.indd Sec3:5 279 illustration, 36e Credit enhancement comparison, 235–236 increase, 237 Credit events definition, 80 frequency, initial LTV, 197e occurrence, 31 Credit outlook status, usage, 245 Credit protection buyer/seller, 126 source, 56 Credit quality, measurement, 120 Credit ratings, 16–26 Credit risk exposure, 103 Credit structures, usage See Market value credit structure Credit tenant leases (CTLs) classification, 206n result, 182 Credit unsecured rating, consideration, 246 CRELs See Commercial real estate loans CTLs See Credit tenant leases Cumulative collateral default rates See Commercial mortgage-backed securities; Highyield loan collateral Cumulative default rates, 192n See also Idealized cumulative default rate; Issuerweighted cumulative default rates blended averages, 231 Cumulative downgrade frequency, calculation, 52 Cumulative impairment rates, cohort/rating ranking, 201e Cumulative rating notch change, 59e CUSIP identification, 80 CWCapital, 180 Dealers, loss incurrence, 32n Debt service coverage ratio (DSCR), 184 Fitch opinion, 216 usage, 214 Debt thickness, 216n Defaults See Collateralized debt obligations CDO tranche events, 133 curve, variability, 189 percentage See Collateralized debt obligations prediction power, improvement See Rating default prediction power probability, 120 contrast See Expected loss equivalence, 249e indications, 215 rate equivalents, alternatives, 250–251 Defeasance, impact, 174 Deferral rates, 161 2/26/07 2:43:02 PM 280 Delta excess See Overcollateralization hedging, 32 Dent, Pamela, 184n Detachment point See Tranches Discounted payoff, 196 Discount/premium reference obligations, initial cash exchange, 81 Distressed loans, Distressed ratings downgrade, 80, 88–89 Distressed tranches, 272 Diversification See Collateral amount, definition, 24 benefits, 23e Fitch TruPS regions, 158e importance, 22–23 See also Trust-preferred securities CDOs increase, 213 Diversity expected losses, relationship, 23e score, 17 Dollar-weighted scores, 19 Dow Jones CDX.NA.IG, 35 Downgrades See Extreme rating downgrades calculation, 52 criticism See U.S downgrades history, 214 patterns See Collateralized debt obligations usage, reasons, 56–58 severity, 58 Drevon, Frederic, 198n DSCR See Debt service coverage ratio Due diligence, usage, 209 Emery, Kenneth, 224n Engineering reports, usage, 170 Environmental reports, usage, 170 Equity cash flows, 31 Equity holders, benefit See Call provisions Equity REITs, 183 See also Real estate Equity tranches, 272 Erturk, Erkan, 202n Esaki, Howard, 187n, 226n study, 192n See also Life insurance company holdings Escrow accounts, usage, 170 European high-yield bond market, funding source, 56 European static synthetic arbitrage CDOs percentage, 65 performance, 56 Excess overcollateralization See Overcollateralization deltas, 267 See also Senior tranche excess OC deltas; Subordinate tranche excess OC deltas Index.indd Sec3:6 INDEX Expected loss See Investment-grade CDO deal default probability, contrast, 120–121 relationship See Diversity Extension risk See Commercial mortgagebacked securities increase See Interest-only loan Extension risk, impact, 173–174 Extreme barbell portfolio, 121 Extreme rating downgrades, 58–61 Fabozzi, Frank J., 3n, 11n, 43n, 104n Failure to Pay, credit event, 35n Failure to Pay Interest, credit event (absence), 128n Financial Accounting Standards Board (FASB), impact See Collateralized debt obligations Financial assets, ownership, Financial guarantors, impact, 10 Financial institutions, Fitch 30-year default assumptions, 151e First-lien commercial mortgage loans, 173–176 First lien mortgage, A/B/C structure, 175n Fitch collateral default assumptions, 150–155 default/loss curves See Commercial mortgage-backed securities loan collateral ratings See I-preferred term securities IV recovery assumptions See Bank TruPS; Insurance TruPS required collateral defaults, 152 thirty-year default assumptions See Financial institutions; Insurance companies TruPS regions See Diversification Fitch-rated TruPS CDOs, insurance assets (performance), 164e Five-year default rates rating outlook status, 248e ratings, rankings, 248e UBS stratification, 251e Fixed caps, 131–133 applicable stipulation, 81 term, usage, 82 arrangement, 87–88 Fixed Rate Payer, term (usage), 126 Floating amount events, 103, 129 definition, 80 Floating Rate Payer, term (usage), 126 Foreclosure, 196 Full-capital structure CDOs, 28, 33 Full-capital structure synthetic arbitrage CDOs, 28–32 Funded positions, value, 85e Funding, requirements, 84–86 Fund of funds-backed CDOs, 50 2/26/07 2:43:03 PM Index Generally accepted accounting principles (GAAP), 142n treatment, change, 143n Generic bid side numbers, difference, 92n GIC See Guaranteed investment contract Gillis, Thomas, 202n Goldman, Masumi, 187n, 226n Goodman, Laurie S., 3n, 11n, 43n, 104n Gordon, Sally, 196n, 240n Guaranteed investment contract (GIC), 107 Guarantors, impact See Financial guarantors Hamilton, David T., 18n, 194n, 245n, 247n–249n Harris, Gus, 198n, 200n, 229n Herfindahl score, 215 calculation, 215n, 227n High-grade collateral, purchase, 43 High-yield bank loan market, relationship See Collateralized loan obligations High-yield bond CDOs, problem, 26n High-yield bonds, 25 defaults, 26n High-yield CLOs collateral historical default rates, 224e contrast See Whole loan CREL CDOs recovery rates, 224e success, 57 High-yield CMBS (HY CMBS) collateral default rate volatility/loss rates, 239e cumulative impairment rates, 238n High-yield loan (HYL), 25 annual collateral default rates, 225 collateral loss rate sensitivity matrices, 233e High-yield loan (HYL) collateral annual default rates, 225e cumulative collateral default rates, 226e historical rates, 224e portfolio, 223 Historical bank interventions, 150–153 Historical data, improvement, 252 Historical defaults, 17–20 rates, usage, 245–246 usage, 236 Historical insurance impairments, 154–155 Home builder stock index, ABX (contrast), 91e Home equity issuance (2006 ratings), 78e Home price appreciation (HPA) environment, 90 Homogenous five-year historical default-rate categories, formation, 251 Homogenous one-year historical default-rate categories, 250 Homogenous portfolios, 121 S&P/Moody’s ratings, contrast, 123e Index.indd Sec3:7 281 HPA See Home price appreciation Hu, Jian, 198n, 200n, 229n Hybrid, term (reference), 99 Hybrid ABS CDOs arbitrage, 95e cash flow challenges, 107–115 structure, illustration, 105–106 flowchart, 106e Hybrid assets, usage See Asset-backed securities CDOs Hybrid CDO cash liabilities, 113 underwriting, 105 Hybrid REITs, 183 HYL See High-yield loan Hypertranching, 217–218 See also Property example, 218e methodology, 218 iBoxx, 33 I/C See Interest coverage Idealized cumulative default rate, 19 IG CDO See Investment-grade CDO IG CMBS CDOs See Investment-grade CMBS CDOs Impairment Moody’s definition, 229n rates, calculation, 154 Implied writedown attempts, 135 double counting, 129 usage, 128n Index portfolios, tests, 117–120 Index roll dates, 82 Initial cash exchange, 88 Institutional loans, purchase, 39–40 Institutional minus Pro Rata All-In Spreads, 41e Insurance assets, performance See Fitch-rated TruPS CDOs Insurance companies collateral, range, 145–146 Fitch thirty-year default assumptions, 156e impairment rates (1977-2005), 155e Insurance company preferred stock-backed CDOs, 50 Insurance company surplus notes, maturity, 144 Insurance holding company debt, structure, 143 Insurance impairments See Historical insurance impairments Insurance TruPS deferrals, 161 See also Trust-preferred securities CDOs Fitch recovery assumptions, 153e Insured debt, usage, 10 Insured tranches, elimination, 61 Insurers, impact See Monoline bond insurers 2/26/07 2:43:03 PM 282 Interest caps, alternative options, 130–133 Interest cash flow waterfall, 12e Interest coverage (I/C) ratio, 14 test, 14–15 trigger, 14–15 cash flow mechanism, 253 Interest deferral, impact, 102 Interest-only loan, extension risk (increase), 174 Interest payment interruption, 102 Interest payment shortfall See Available funds cap Interest rate caps, 26e example See Collateralized debt obligations uses See Collateralized debt obligations Interest rate swaps, 25e counterparty, one-time payment, 26n uses See Collateralized debt obligations Interest shortfalls cap, inapplicability, 130 coverage, absence, 181 impact See Commercial mortgage-backed securities tranches Interindustry default correlation, modeling, 252 International Swaps and Derivatives Association (ISDA), 76, 80 documentation, definitions, 127 publication (1999), 80 INTEX, usage, 159n, 259 Investment bankers, impact, 9–10 Investment-grade CDO (IG CDO) deal, expected loss, 22e Investment-grade CMBS CDOs (IG CMBS CDOs) assumption sensitivity, 233–234 data, absence (question), 231–232 loss rates, 229–230 mezzanine structured finance CDOs, contrast, 228–234 Investment-grade CMBS (IG CMBS) lifetime cumulative default rates, vintage ranking, 231e tranches, 210 Investment-grade CMBS (IG CMBS) collateral CREL collateral, comparison, 238–239 cumulative default rates, vintage (ranking), 239e default rate volatility/loss rates, 239e, 240e historical default/recovery rates, 230e historical/required loss rates, 230e loss rate sensitivity matrices, 234e Investment-grade (IG) bonds, 25 Investment-grade (IG) collateral, 11 Investment-grade (IG) indices, 35–36 I-preferred term securities IV, Fitch/Moody’s ratings, 154e Index.indd Sec3:8 INDEX ISDA See International Swaps and Derivatives Association Issued CRE CDOs, 206e Issuer-weighted cumulative default rates, 18e J.E Roberts, 180 Junior participation See B-notes Kay, Larry, 184n, 185n, 192n, 194n Keisman, David, 194n Kizer, Leslie, 196n, 240n Leahy, Jim, 153n, 155n Liabilities ownership, 4–6 structure, 24–25 LIBOR See London Interbank Offered Rate Life insurance company holdings, Esaki study, 192n Lifetime cumulative default rates, loan amount ranking, 187e Lifetime default rates See Loans Lifetime downgrades number, reduction, 65 rate, calculation, 63 LNR Partners, 180 Loan-level analysis, 184–186 Loans characteristics, 192n collateral See Loss severity historical annual default rates See Commercial mortgage-backed securities defaults, event, 216n lifetime default rates, 188 origination, 170–172 ratings See Moody’s spreads, impact, 41 underwriting, 170–171 Loan SF-backed CDOs, performance, 49 Loan-to-value (LTV) ratio, 172, 185 usage, 214 Lockbox provisions, usage, 170 Lockouts, impact, 174 London Interbank Offered Rate (LIBOR), CDO payment, 112n earnings, 110 flatness, 133 index, 130–131 level, impact, 25 spikes, 26 Long-short strategies, 125 Long-term securities, subordination, 141 Loss distribution tests, 24 Loss rate, stress, 239 Loss severity See Commercial mortgage-backed securities 2/26/07 2:43:03 PM 283 Index Loss severity (Cont.) CMBS loan collateral, 194–195 matrix, property type (ranking) See Commercial mortgage-backed securities Low-diversity SF-backed CDOs advantage, 57 performance, 49 LTV See Loan-to-value Lucas, Douglas L., 3n, 11n, 43n, 104n Mack, Phillip, 153n MacNeill, Mary, 190n Macroeconomic hedge funds, 76 Macro-hedge funds betting limitations, 90 involvement See ABX protection purchases, 89 Make-whole provision, 27 Managed CDOs, contrast See Static CDOs Management restrictions See Noteholders Manufactured housing (MH) collateral, 212 Marginal default rates, vintage ranking See Commercial mortgage-backed securities loan collateral Market value CDOs, 13n downgrading, absence, 57 credit structure, usage, 7–8 protection, 4, Mark-to-market process, uncertainties, 134 Master servicers, appointment, 171–172 Maturity extension, credit event, 80n Mezzanine ABS CDOs arbitrage See Cash mezzanine ABS CDO arbitrage; Hybrid ABS CDO arbtrage protection, sales, 89 residential B&C collateral, 79 Mezzanine lender protection, 177–178 rights, 177 Mezzanine loans, 176–178 defaults/losses, 196–197 subordinate debt, 207 variation, 219 Mezzanine structured finance CDOs (SF CDOs), 228 assumption sensitivity, 233–234 contrast See Investment-grade CMBS CDOs data, absence (question), 231–232 loss rates, 229–230 purchases See Residential B/C production S&P BBB CDO required collateral loss rates, 229e spreads, 228 illustration, 229e Index.indd Sec3:9 subordination levels, 228 illustration, 229e Mezzanine structured finance (SF) collateral historical default/recovery rates, 230e historical/required loss rates, 230e loss rate sensitivity matrices, 234e Mezzanine structured finance (SF) lifetime cumulative default rates, vintage ranking, 231e MH See Manufactured housing Modest barbell portfolio, 121 Modified-Modified Restructuring, credit event, 35n Modified Restructuring, credit event, 35n Modu, Emmanuel, 154n Monoline bond insurers, impact, 10 Moody’s bank TruPS collateral default assumptions, 153–154 collateral default assumption, 155–157 default/loss assumptions (example) See Commercial real estate CDO findings, importance, 252 hypertranching See Commercial mortgagebacked securities loan ratings, increase, 254–255 ratings See I-preferred term securities IV contrast See Credit default swaps indices REIT fundamental analysis, adjustment, 157 study (2004), advice, 247–249 WARF, 19e Mortgage loan, sponsor default, 175 Mortgage REITs, 183 Mortgage-related assets, concentration, 158 Moss, James E., 150n, 158n, 159n Multifamily properties, sensitivity, 194 Near defaults See Collateralized debt obligations Net cash flow (NCF), usage, 216n New CDO issuance, 147–148 Non-Agency issuance, percentage, 76 Nonperforming loans, Non-PIKing performing tranche, principal payment, 62 Nonrecourse CRE loans, 171 North American indices, 35n NorthStar Realty Finance, 208 Noteholders, management restrictions (safety nets), 13–16 Notional amount, term (usage), 126 Obias, Paulo, 184n O/C See Overcollateralization 2/26/07 2:43:03 PM 284 Offshore incorporation, usefulness, One-year default rates rating outlook status, 247e ratings, ranking, 247e UBS stratification, 250e Origination category, impact, Ou, Sharon, 18n, 194n Overcollateralization (O/C) delta, excess, 266–272 excess, 266–272 deltas See Senior excess OC deltas; Subordinate excess OC deltas ratio, 13 tests, 13–14 basis, 13n trigger, 14 cash flow mechanism, 253 Overlap See Collateral overlap Pari passu tranches, elimination, 61 Partial calls, 27 Par trade, term (usage), 82 Par value test, 13–14 Pass-through entities, qualification, 182–183 Pay as you go (PAUG) contract, 83 settlements, 127–128 occurrence, 107 Pay As You Go (PAUG) settlement, codification, 99 Pay as you go (PAUG) template, 79–80 inclusion, 81 removal, 80n usage, 76 PayGo ABCDS, 104n Pay-in-kind (PIK) bond, 128n feature, 15, 128n occurrence, 15–16 PIKing, effectiveness, 15–16 Payment failure, 80 Philipp, Tad, 184n Phillip, Tad, 198n Physical settlement impact, 127 nonallowance, 83 PIK See Pay-in-kind Portfolios CMBSs, usage, 99n diversity, 24 rating distributions, 122e Premium reference obligations, initial cash exchange See Discount/premium reference obligations Index.indd Sec3:10 INDEX Premium squeeze to zero, 131–133 term, usage, 82 Prepayment penalties, 27 penalty points, impact, 174 risk impact, 173–174 issue, 185 Principal cash flow waterfall, 13e Principal-protected tranches, elimination, 61 Principal writedown, impact, 102 Property appraisals, usage, 170 capital structure, 173e, 196 hypertranching, 217 type, importance, 192 value, 216n derivation, 184 Property-level analysis, 184 Property-level loans, 172–178 Property-type diversification, securitization benefit, 179 Pro rata amortization phase, 111 Pro rata loans, 40 security firm/finance company purchases, 41n Protection buyer, responsibility, 134 Protection payments See Credit default swaps implicit loss, 106 Protection premium, counterparty adjustment, 103 Protection seller compensation, 135 payment, 102n receipt, payment, 133e Quality tests, 16 Ramkhelawan, Gregory, 184n, 185n, 192n, 194n Rating agencies, 10, 136 assumptions See Trust-preferred securities CDOs calculations, 186 methodologies, changes, 252–255 rankings See Five-year default rates; Oneyear default rates transition matrix, 58, 61 Rating default prediction power (improvement), rating watches/outlooks, usage, 245–252 Rating outlooks status See Five-year default rates; Oneyear default rates UBS stratification, 250e, 251e usage, 245–246 2/26/07 2:43:04 PM Index Rating watches quality, consideration, 251–252 UBS stratification, 250e, 251e usage, 245–246 Real estate assets, equity REIT ownership/operation, 143 loans, operating companies, 208n recession (2001-2003), 192 Real estate insurance trust (REIT) balance sheet, 213 collateral, 163 credit quality, 155–157 direct loans, 208n eligibility, 213n issuer, 141 Moody’s default probability assumption See Unrated equity REITs; Unrated mortgage REITs qualification, 213n secured debt, 157 securities, 182–183 TruPS, 150 CDO, 221 Recovery rates, 20 See also Commercial mortgagebacked securities; High-yield CLOs; Standard and Poor’s impact, 233 usage, 236 stresses See Whole loan CREL CDOs Reference Entity, term (usage), 126 Reference Obligation, term (usage), 126 Reference portfolios, usage, 117 Refinancing risk, 174 Refinancings, cash out, 79 REIT See Real estate insurance trust Relative credit quality, distinguishing, 246–249 Relative loss severity, property type indicator, 194 Relative spreads, contractual differences (impact), 83 Relative value methodology See Commercial real estate CDO Rent rolls, usage, 170 Repurchase rate (repo rate), 84 Resecuritized Real Estate Mortgage Investment Conduit (ReREMIC), 209, 214 Reserve fund, usage See Credit default swaps Residential B/C issuance, tranche ranking, 44e Residential B/C production, mezzanine SF CDO purchases, 44e Residential B/C rating, 79e Residential B/C securities, BBB spreads, 46e Residential mortgage-backed securities Index.indd Sec3:11 285 (RMBSs), 4, 42–43 RMBS/HEL collateral, 232 tranches, 202 Restructuring, 196 Revolving senior tranche, usage See Collateralized loan obligations R.H Donnelley, risk, 265 Risk-adjusted ROE, 84 RMBSs See Residential mortgage-backed securities Roy, Debjani, 200n, 229n Rubock, Dan, 184n Russian debt crisis (1998), 209 Safety nets See Noteholders Sale-leaseback transactions, impact, 182 Scenario default rates (SDRs), 223 See also Whole loan CREL CDOs Schiavetta, John, 150n Scholz, Detlef, 200n, 229n Second lien mortgage, usage, 172 Senior AAA tranches, Senior excess OC deltas, 267–272 Senior/junior AAA notes, usage, 10 Senior participations (whole loans), 206n Senior tranche excess OC deltas, 268e–269e Sensitivity matrices, usage, 234 SF See Structured finance SF CDOs See Mezzanine structured finance CDOs; Structured finance CDOs Short mortgage credit positions, creation, 100 Short-term bank financing, Short-term debt, usage, 10 Silverman, Marion, 150n, 158n, 159n Single-asset event risk, 227 Single-name ABCDS, 76, 78 ABX contrast See Collateralized debt obligations ABX index/cash, contractual differences, 83–89 sellers, 91 trades, 94 Single-name CDS book, imbalance, 32 market, bid/ask spread, 92 Single-name risk, 265–266 Single-tranche CDOs, 28, 32–33 terms/economics, 32n Site inspections, requirement, 170 Small and medium enterprise (SME) loans, Snyderman, Mark, 187n Special servicers, appointment, 171–172, 179 Sponsor foreclosure/default, 177 Spreads See Investment-grade CMBS CDOs; Mezzanine structured finance CDOs; Whole loan CREL CDOs 2/26/07 2:43:04 PM 286 Spreads (Cont.) basis points See Commercial real estate CDO comparison, 221 differential, 84 Stabilized capitalization rate, application, 216 Standard and Poor’s (S&P) AAA synthetic CDO ratings CDX NA IG portfolio, 121e BBB CDO required collateral loss rates, 223e BBB CRE CDO required collateral loss rates, 236e BBB required loss rates See High-yield loan; Whole loan CRELs collateral assumptions, 120, 252–254 CREL recovery rates, 219e LCD, usage, 224 loss rates, requirement, 230 ratings, contrast See Credit default swaps indices Standard deviation measurement, usage, 239 Static CDOs, managed CDOs (contrast), 30 Stavropoulos, Peter, 202n Stress factor, 19–20 Structured finance CDOs (SF CDOs) bid, mezzanine Residential B&C tranches (dependence), 45 mezzanine mortgage ABS market, relationship, 42–46 Structured finance securities (SF securities) estimated ultimate recovery rates, 202e impact, 229 realized losses, 202e Structured finance (SF) five-year rating transition matrices, 232e Structurers, impact, 9–10 Subordinated notes, coverage, 272 Subordinate excess OC delta, 267–272 Subordinate tranches, PIK-ability, 15 Subordination impact, 56n levels See Commercial real estate CDO; Investment-grade CMBS CDOs; Mezzanine structured finance CDOs; Whole loan CREL CDOs comparison, 221 usage, 235 Subprime market, growth, 77e Subprime mortgage deals, subordinate tranches (protection purchase), 90 Subprime mortgage issuance, growth, 45e Subprime mortgage securitizations, mezzanine tranches (SF CDO bid), 45 Subprime residential mortgage loans, collateral (level), 43n Index.indd Sec3:12 INDEX Subprime synthetic market, growth, 75–76 Super-senior counterparties, funding, 104–105 Super-senior credit protection, 115 Super-senior swap counterparties, responsibility, 105 Super-senior tranche, 99n funding, 112 issuance cost, 104 usage, 110 See Credit default swaps Supply/demand technicals, 89–92 Synthetic arbitrage CDOs, 28–37 arbitrage levels, 31–32 Synthetic asset option, addition, Synthetic balance sheet CDO performance problems, 56n Synthetic CDOs problems, 56n ratings, 117 spectrum, 29e Synthetic market, volumes (increase), 79 Synthetic positions, value, 85e Synthetic spread, requirement, 86 Tenant credit quality, usage, 170 Thin debt tranche, 216n Thomas, Russ, 158n, 159n Thompson, Eric, 184n, 185n, 192n, 194n Tier capital applicability, Federal Reserve (impact) See Trust-preferred securities Trac-X, 33 Tranches See Distressed tranches; Equity tranches attachment point, 35 detachment point, 35 downgraded number See Aaa CDO tranches number, CDO/vintage ranking, 51e percentage, 120 protection, 265–266 ratings See Collateralized debt obligations tranches downgrade frequency, 52–54 upgrade, 214 usage, TruPS See Trust-preferred securities Trustee-reported data, INTEX reliance, 259 Trustees fees, 30 impact, 10 reports, usage, 159n Trust-preferred-backed CDOs, growth, 46 Trust-preferred CDOs, 141 issuance, 47e Trust-preferred securities (TruPS), 141–143 deferrals See Bank TruPS; Insurance TruPS usage See Collateralized debt obligations 2/26/07 2:43:05 PM 287 Index issuers/issues, 163–166 obligation, 159 regions See Diversification tax deduction, 142n Tier capital applicability, Federal Reserve (impact), 143n Federal Reserve recognition, 142–143 unsecured obligations, 6n Trust-preferred securities (TruPS) CDOs assets, 144 bank TruPS deferral, 160e performance, 162e collateral market, relationship, 46–47 type, percentage, 146e type combinations, 146e diversification, importance, 157–158 insurance assets, performance See Fitchrated TruPS CDOs insurance TruPS, deferral, 163e issuance, 144–147 statistics, 144n issuance, collateral type (ranking), 145e issuers, mid-2006 ranking, 165e liabilities, 149 number/average size, vintage ranking, 145e OC tests, 148 performance, 161–163 rating agencies, assumptions, 150–161 structure, 148–150 Trust-preferred spreads, 47e Trusts FASB impact See Collateralized debt obligations unconsolidation, 143n Tung, Julie, 198n, 200n, 229n Underwriting practices, 185 process, passage, 159 Unfunded super senior, 108–110 addition, trades, assumption, 95–96 Unrated equity REITs, Moody’s default probability assumptions, 157e Unrated mortgage REITs, Moody’s default probability assumptions, 157e Unsecured rating, UBS stratification, 250e, 251e U.S arbitrage cash flow CDOs, backing, 63 U.S bank C&I loan holdings/recessions, 42e U.S CLOs collateral overlap, 258–265 issuance/loan purchases, 40e U.S downgrades, criticism, 253 Index.indd Sec3:13 Vama, Praveen, 18n Variable cap, 131 Varma, Praveen, 194n Volatility, underestimation, 226 See also Commercial real estate loans Voting rights/control, 134 Vrchota, Robert, 190n WARF See Weighted average rating factor Waterfall, 11 See also Interest cash flow waterfall; Principal cash flow waterfall Weighted average FICO score, level, 82 Weighted average rating factor (WARF), 17–19 See also Moody’s comparison, 119 level, 210, 222 score, 20 Weighted average spread (WAS), 147 See also Bank TruPS Weill, Nicholas, 198n, 200n, 229n Whole loan CREL CDOs (WL CREL CDOs) collateral historical default rates, 224e credit enhancement, 225–228 data, absence (question), 225–228 diversity, differences, 227 high-yield CLOs (HY CLOs), contrast, 221–228 historical results, 223–225 recovery rates, 224e stresses, 223 risk concentration, 228 scenario default rates, 223 spreads, 222 illustration, 222e subordination levels, 222 illustration, 222e tranche, survival, 223 Whole loan CRELs collateral historical rates, 224e collateral loss rate sensitivity matrices, 233e S&P BBB required loss rates, 224e Whole loans See Senior participations Worst current CDO tranche ratings, type/original ranking, 62e Writedowns, 80 likelihood, 88 timing, 31 Yield maintenance, impact, 174 Zennario, Jane, 194n 2/26/07 2:43:05 PM ... 9:04:32 AM Developments in Collateralized Debt Obligations New Products and Insights DOUGLAS J LUCAS LAURIE S GOODMAN FRANK J FABOZZI REBECCA J MANNING John Wiley & Sons, Inc ffirs.indd iii 4/9/07... ffirs.indd iv 4/9/07 9:04:33 AM DJL To my wife Elaine and my children Eric and Benjamin LSG To my husband Mark and my children Louis, Arthur, Benjamin, and Pamela FJF To my wife Donna and my... evelopments in Collateralized Debt Obligations: New Products and Insights is being published less than one year after the publication of the second edition of Collateralized Debt Obligations: