Structured finance and collateralized debt obligations new developments in cash and synthetic securitization

Structured Finance and Collateralized Debt Obligations Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com Structured Finance and Collateralized Debt Obligations New Developments in Cash and Synthetic Securitization Second Edition JANET M TAVAKOLI John Wiley & Sons, Inc Copyright C 2008 by Janet M Tavakoli All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada Originally published as Collateralized Debt Obligations and Structured Finance No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 646-8400, fax (978) 646-8600, or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically 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 Library of Congress Cataloging-in-Publication Data: Tavakoli, Janet M [Collateralized debt obligations and structured finance] Structured finance and collateralized debt obligations : new developments in cash and synthetic securitization / Janet M Tavakoli — 2nd ed p cm — (Wiley finance series) Originally published in 2003 under title: Collateralized debt obligations and structured finance Includes bibliographical references and index ISBN 978-0-470-28894-8 (cloth) Asset-backed financing—United States Mortgage-backed securities—United States I Title HG4028.A84T38 2008 332.63 2044—dc22 2008008483 Printed in the United States of America 10 Contents Preface xiii Acronym Key xix CHAPTER Securitization Terminology Simplified Cash CDO The CDO Arbitrage CHAPTER Structured Finance and Special Purpose Entities SPCs and Historical Abuse SPEs and SPVs Documentation Setup Costs Example of a Multiple Issuance Entity Cayman-Domiciled SPEs Repackagings to Satisfy Investor Demand Credit-Linked Notes and Funding Costs Structured Floaters Principal-Protected Notes Loan Repackagings Liquidity Mismatched Maturities Unwind Triggers Linked to Derivatives Transactions DAX-Linked Note with Triggers Ratings Master Trusts Owner Trusts Grantor Trusts Real Estate Mortgage Investment Conduits Multiseller and Single-Seller Conduits 10 16 18 19 19 22 24 25 27 27 28 29 29 30 32 34 34 35 36 36 37 v vi CONTENTS Domestically Domiciled Corporations Bankruptcy-Remote? Enron, JPMorgan Chase, and Sureties CHAPTER Credit Derivatives and Total Rate of Return Swaps Risk to Portfolio Value Credit Derivatives and Credit Default Swaps Negotiated Language Basis Risk: Persistent CDS Language Issues Physical Settlement and Cash Settlement Negotiations Digital, Binary, Zero-One, All-or-Nothing, or Fixed Recovery Cash Settlement Initial Value × (Par − Market Value) Normalized Price Method—Alternate Termination Payment Hedge Costs in Cash and Synthetic CDOs Deliverables: CDOs and the Cheapest-to-Deliver Option Convertible Bonds and Asset Swaps Negative Basis Trades Default and Recovery Rate The Default Protection Seller: Counterparty Credit and Correlation Default Language for Sovereign Debt Default Language for Nonsovereign Debt: Controversy and CDOs CDS Pricing Issues Synthetic CDOs Total Rate of Return Swaps (Total Return Swaps) Pricing TRORS on Levered CDO Tranches TRORS versus Repos Equity TRORS: Corporate Loans Disguised as Capital Injections Information Asymmetry and Moral Hazard CDS versus TRORS Pay-as-You-Go Indexes 39 40 43 45 45 47 49 49 50 52 53 54 55 55 56 62 62 65 65 66 69 70 72 74 75 76 78 78 79 81 CHAPTER CDOs and the Global Capital Markets 83 Evolution of the CDO Market 84 Contents CHAPTER Risk and Valuation Issues The Portfolio Diversification Myth Modern Portfolio Theory: Bane of CDOs Abnormal Is Normal Mark-to-Market Hazard Cash Flow Hazard Global Derivatives Risk Loans and Leveraged Loans The Leverage Paradox New Structured Finance Deals Fraud Hedge Funds: A New Investor Class Tavakoli’s Law, Hedge Funds, and the Great Unwind Brain Damage Theory Dead Man’s Curve and Leveraged Funds Margin of Safety versus One-Sided Illiquid Leveraged Bets CHAPTER Early CDO Technology True Sale Hybrid and Synthetic Structures Credit Enhancement Monoline and Multiline Insurance CDO Classification Market Value CDOs Cash Flow CDOs The Origins of U.S Securitization Collateralized Mortgage Obligations CHAPTER Early Warning Commercial Financial Services Rating Agencies’ Failed Models Anatomy of a Flawed Process Terminology Early Red Flags CFS Gets Creative Selling Out the Future Ignoring an Audit Report Lessons to Be Learned Fallout from CFS’s Bankruptcy vii 91 91 92 96 98 99 100 101 103 104 104 107 110 112 113 114 117 117 119 119 121 124 124 126 135 143 143 144 145 147 149 149 150 151 153 viii CONTENTS CHAPTER Subprime and Alt-A Mortgages: Collateral Damage Truthiness in Lending and Borrowing The Predators Fall Classic Ponzi Scheme Portfolio Risk The Risk Managers’ Dilemma How to Create a Securitization Disaster Models versus Common Sense Lack of Appropriate Due Diligence and/or Disclosure Investors and Ratings Hedge Funds and ABX Indexes: Alpha Bets A Good Year (for Some) BSAM’s Hedge Funds Undone by Leverage Bear Stearns’ Hedge Fund Lenders Bailout Disclosure: Investor Fallout from the Mortgage Debacle “The First Thing We Do, Let’s Kill All the Lawyers” Market Fallout from the Mortgage Debacle Redlining and Red Ink CHAPTER Cash versus Synthetic Arbitrage CDOs Comparison of Managed Arbitrage CDO Features: Cash versus Synthetic Deals The Arranger and the Manager Mandate Agreement Deal Assembly CDS Language for the Synthetic CDO Selecting the Portfolio and Impact on Rating Rating Criteria and Restrictions Substitution and Reinvestment Criteria Warehousing Assets Pricing and Closing Ramping Up the Portfolio Reinvestment Period Noncall Period Pay-Down Period Weighted Average Life and Expected Final Maturity Early Termination Legal Final Maturity Tranching and the Synthetic Arbitrage Advantage Waterfalls for Cash versus Synthetic Arbitrage CDOs 155 158 160 162 164 164 165 167 172 173 174 177 181 184 186 188 190 191 193 193 195 196 197 197 198 199 207 207 208 208 209 209 210 210 210 211 211 212 Contents Payment-in-Kind Tranches Psychic Ratings: Rating Agency Treatment of PIK Tranches The Super Senior Advantage CDS versus Cash Asset Spreads Hedging the CDO Portfolio Cash Flows Settlement in Event of Default or Credit Event Documentation Cash versus Synthetic Arbitrage CDO Equity Cash Flows Sample Cash Flows Summary of Cash Arbitrage CDOs versus Synthetic Arbitrage CDOs CHAPTER 10 CDO Equity Structures Accruing Errors Probability of Receipt The Best and Worst Equity Investments The Best Equity Earns All Residuals Equity Investor Injects Cash as Overcollateralization Rated Equity Earns Stated Coupon Appropriate to Rating Rated Equity: Static Deal Equity Investor Earns a Stated Coupon on the Remaining Equity Investment Moral Hazard and Conflict of Interest Leveraging the Best: Unfunded Equity Investments— Ultimate Leverage Actively Traded and Limited Substitution Synthetic Arbitrage CDOs Interest Subparticipations: When Equity Isn’t First Loss Participation Notes Capped Participation Notes Combination Notes Investor Motivation Principal-Protected Structures First- (and nth-) to-Default Basket Swaps First-to-Default Notes The Smartest Equity Investment: Protection Money CHAPTER 11 CDO Managers Best Practices The Valued Few ix 218 218 219 220 226 233 236 236 237 246 247 250 253 254 256 257 259 260 262 268 270 273 273 276 278 278 279 280 282 290 290 291 292 293 x CONTENTS CHAPTER 12 Balance-Sheet CLOs and CDOs True Sale (Fully Funded): Delinked Structure Linked Nonsynthetic Structures Linked Black-Box CLN CDOs Synthetic Structure with SPE Partially Synthetic Linked CDOs Fully Synthetic CDOs Small to Medium-Size Enterprises—Europe SMEs: United States versus Europe Secured Loan Trusts Bank Regulatory Capital and Basel II CHAPTER 13 Super Senior Sophistry Cash Flow Magic Trick Rating Agencies—Moody’s Tranching The AAA Disappearing Act Rating Agencies and Ratings Shopping Triple-A Basket with Percent First-Loss Tranche Super Senior Attachment Point Super Senior Pricing Super Seniors or Senile Seniors? Where Are the Regulators? Junior Super Seniors Super Senior Investors Negative Basis Trades Leveraged Super Seniors and Constant Proportion Portfolio Insurance Final Thoughts on Super Seniors CHAPTER 14 Synthetics and Mark-to-Market Issues Synthetic Cash Windfall Synthetic Equity Portfolio Swaps Bespoke Tranches: Single-Tranche CDOs Short Mezzanine and Long Equity Banks’ Invisible Hedge Funds Extraordinary Popular Delusions and the Madness of Correlation 295 295 299 301 304 307 308 310 315 318 321 331 333 334 337 338 340 341 342 343 345 346 347 348 349 350 353 353 354 356 357 359 365 365 Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization, Second Edition by Janet M Tavakoli Copyright © 2008 Janet M Tavakoli Index Absolute value, 284 ABX.HE Index, 81 ABX index, 161, 176–177, 360 ACA Capital, 416, 422 ACA Financial Guaranty Corp., 419, 423–424 Accounting: improprieties, principles, 41, 44 rules, 1, 3, standards, 431–432 Accredited investor, 394 Acquisitions, 28 Actively traded synthetic arbitrage CDOs, 273 Adams Square Funding, 415 Add-on factors, 322, 324 Adelphia, 353 Adjustable-rate mortgages (ARMs), 80, 187, 191–192, 420–422 Administrator, SPEs, 22 Affilate, qualifying, 49 Aggressive trading, 99 AIG Financial Products Corp., 417 All-or-nothing payout, 52–53 Alpha, 174–177 Alt-A loans, 81, 92, 420, 425 Amaranth Advisors, 112–113 Ambac Assurance Corp., 418–419, 424 American credit spread option, 60 Amortization, 35, 227, 237, 296, 316 Arbitrage: CBOs, 84 CDOs, 5–6, 54, 69, 71, 84, 88–89, 123, 125–126, 193–195, 200, 207, 308, 331 characteristics of, 1, 3, 49, 74–75, 85–86, 327, 331, 334, 347–348, 370 CLOs, 295 Arbitrageurs, 5, 59, 62 Arrangers, functions of, 4–6, 27, 55–56, 86, 99–100, 117, 127, 171, 197–199, 208, 234, 240, 255, 262, 293, 306, 354, 361–363, 367, 408 Arthur Andersen, 148 Asset: classes, conventional, 121 management, 39, 293 non-investment-grade, 287–289 risk, 3, 313 warehousing, 207–208 Asset-backed CDOs, 87, 173 Asset-backed commercial paper (ABCP), 37–38, 412–413, 427 Asset-backed securities (ABS), 2, 8, 41, 49, 69, 72, 79, 147, 160, 201, 245, 328–329, 415 Assured Guaranty Corp (AGC), 418 Audits, 148, 150–151, 406, 431–432 Auto loans, 45 Automatic stay, Available funds cap (AFC), 79–80, 170 Backed bonds, Backwardation, 253 Balance-sheet transactions, 1, 3, 9, 72, 88, 101, 104, 118, 125, 207, 232, 297, 304–306, 332, 356, 374 Banco Ambrosiano, 11–15 Bank Austria Creditanstalt (BaCa), 313 Bank for International Settlements (BIS), 25, 100–101, 127, 274, 299, 305–306, 316, 321–322, 350–351, 406 Bank of America, 427 Bank regulatory capital, 321–328 Bankruptcy, 3, 8, 33, 40–43, 49, 68, 197, 211, 430–431 Barclays Capital, 417 439 440 Barrier option, 58 Bartmann, William R., 144–145, 147, 149, 153–154 Base-case: default scenario, 237–238, 243 rate, 131 Basel Capital Accord (Basel I), 321 Basel II, 280, 321–330, 350, 416, 429 Basis: characteristics of, 226 positive, 62 risk, 49–50, 56, 79 Basket swaps, 89 BBB tranche, 369, 374 Beacon Hill fund, 98 Bear Stearns Asset Management (BSAM): functions of, 173–174, 178 hedge fund lenders bailout, 184–186 hedge funds undone by leverage, 181–184 Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage Fund, 111–112, 181–185 Beneficiary, SPEs, 10 Berkshire Hathaway, Assurance, 425 Bernanke, Ben, 420 Best practice CDO managers (BPMs), 292–294 Beta market, 225 Bid/offer spread, 362–363 Bid side of market, 224, 227 Bilateral contracts, Bilateral loans, 67, 296 Binary payout, 52–53 BISTRO (Broad Index Secured Trust Offering), 304, 331, 346 Black-box CLN CDOs, 301–304 Bonds: accrual, 137 corporate indexes, 81 coupons, 128, 130, 169 duration of, 61, 129, 133–134 equivalent yield (BEY), 128–129, 227, 248–249 historical perspectives, 84 par floating-rate, 51 proxy, 54 ratings, INDEX subprime mortgage and, 46–47 types of, 28, 36, 39, 44–46, 56–61, 64, 66, 72, 75, 84, 86, 100, 120, 122, 125, 170, 218, 222, 226–227, 245, 280–282, 408, 425 Borrowed money, 3, 56 See also Loans Brain damage theory, 112–113 British Bankers’ Association (BBA), 83 British sterling, 32, 127, 230–231 Broad Index Secured Trust Offerings (BISTROs) See BISTRO Broker-dealers, 115 Buffett, Warren, 115 Bush, President George W., 430 Buy-and-hold portfolios, 62, 237 Buyer: credit default protection, 52–54, 56 credit default swap (CDS), 47–48 credit protection, 66, 70 Calamos, John, Sr., 407–408 Calculation agent, 234 Callable par asset swap, 59 Call options, 59–60, 127, 129 Canadian Imperial Bank of Commerce (CIBC), 419 Capital: arbitrage, 1, investment, 39 markets, 23, 38, 97, 104, 109, 292–293, 346 pricing, 342 regulatory, 331 See also Bank regulatory capital structure, 89 Capital gains/losses, CapMAC Holdings Inc., 425–426 Cash against goods (CAGs) transactions, 375 Cash arbitrage CDO, 194, 201, 209–210, 212–213, 220, 236–237, 245–246, 337 Cash CDOs, 99–100, 126 Cash flow, 7, 23–24, 34, 36–37, 39, 42, 72, 117, 139, 226–233, 237–248, 253–254, 258–259, 262 Cash market, 49 Cash settlement, 50–53, 233–235 CAST deals, 313 Cayman Islands, SPEs, 20, 22–24 Index CDO managers: best practices, 292–293 functions of, 291 high-performance CDOs, 293–294 Central banks, 161 Certificate holder, 145, 318 Chase Secured Loan Trust (CSLT), 256 Cheapest-to-deliver option, 56 Cialdini, Robert, 105–106 CIFG, 425–426 Cifuentes, Arturo, 406 Clawbacks, 42, 59, 119 Clean-up call, 210 Closing, 208, 294 Collateral, 5, 25–26, 43, 72, 178, 205, 211, 373–374, 404 Collateralized bond obligations (CBOs), 2, 28, 70–71, 84–85, 130, 304–307, 403 Collateralized debt obligations (CDOs): arbitrage, see Arbitrage, CDOs balance-sheet deals, 123, 332 basic structure, classification of, 121–124 defined, deliverables, 55–56 documentation, 41 economics of, equity structures, 247–289 global capital markets, historical perspectives, 83–89 hedges, 78–79, 226–233, 368 indexes, 81 investment-grade, 360, 370 leveraged, 115 managers, see CDO managers market size, 86–88 maturity of, 207 multisector, 88, 373–374 pay-as-you-go (PAUG) template, 79–80 risk management, 87 simplified cash, 4–5 special purpose entities (SPEs), see Special purpose entities (SPEs) synthetic, 321, 327–328, 333, 335, 361, 369, 370 technology and, 117–142 termination payments, 52–54 Collateralized fund obligations (CFOs), 2, 403–404 441 Collateralized loan obligations (CLOs): arbitrage, 334 characteristics of, 28, 35, 69, 84–85, 87, 118, 122, 124 synthetic, 304–307, 318 true sale, 295–297, 299, 307 Collateralized mortgage obligations (CMOs), 36, 123, 126, 135–142 Combination notes (CNs), 278–279 Commercial banks, 6, 24 Commercial Financial Services: audit report, 150–151 bankruptcy, fallout of, 153–154, 406 case illustration, 149–150 flawed process, 144–145 global market, 152 lessons learned, 151–152 list of warnings, 152–153 rating agencies’ failed models, 143–144 red flags, 147–148, 152 terminology, 145–147 Commercial mortgage-backed securitized (CMBS), 2, 79 Commercial paper (CP), 21, 37–38, 330 Committee on Uniform Securities Identification Procedures (CUSIP) number, 27, 201, 280 Commodity Futures Trading Commission (CFTC), 107 Commodity market, 103, 252 Common stock, 56–57 Computer software programs: CDO management, 293 portfolio management, 197 Conditional probabilities, 114 Conduits: multiseller, 37–39 real estate mortgage investment (REMICs), 36–37, 80, 136 single-seller, 37–39 Confidentiality, 30, 48, 302 Conflict of interest, 268–270 Conseco, 66–69 Constant annual default rate (CADR), 240, 242–244, 264, 266 Constant proportion debt obligations (CPDOs), 1, 382–384 Constant proportion portfolio insurance (CPPI), 350, 384 442 Constellation CDOs, 413–415 Contract negotiations, 48 Controlled amortization, 35 Conversion numbers, 59 Conversion price, 57 Convexity, 61, 128–129, 133–134 Conveyances, 8, 41 CORE deal, 313 Corporate-backed CDOs, 370 Corporate credit CDOs, 87 Corporate malfeasance, 432–433 Corporations, domestically domiciled, 39–40 Correlation: coefficients, 132 credit default swaps, 65 models, 367–368 smile, 364 trading, 364–367 Counterparties: collateralized debt obligations, 74 credit default swap (CDS), 48, 65–66, 68 credit risk, 324 implications for, 234, 305 risk, 322, 326 secured loan trusts, 320 SPEs, 21–22 total rate of return swaps, 51, 75 Country risk, 204–205 Countrywide, bailout, 426–427 Coupon: bond market, see Bonds, zero-coupon fixed, 249, 255 floating, 249 floating-rate, 296–297 payments, 229 Covariance, 132 Coverage tests, 215, 245 Credit card receivables, 34–35, 104, 148–149, 177 Credit default protection, 366, 371, 374 Credit default risk, 76 Credit default swaps (CDS): cash asset spreads vs., 220–226 characteristics of, 29, 47–49, 53–70, 83, 85, 236, 361 defined, global derivatives risk, 100–101 indexes, 88 note structure, 310 INDEX single-name, 366, 370 TRORs compared with, 78–79 Credit derivative product companies (CDPCs), 402–403 Credit derivatives: characteristics of, 21–22, 83, 86, 117, 119–120, 176, 193, 322 default, 62–63 defined, development of, 321 recovery rate, 62–65 risk and portfolio value, 45–47 stand-alone, 370 types of, 47–49 Credit enhancement, 3, 38–39, 119–120, 161, 387, 406, 422 Credit events, 25, 49–50, 52, 69, 79–80, 197, 233–236 Credit funds: credit derivative product companies (CDPCs), 402–403 hedge, 397–399 hedge funds and collateralized fund obligations, 403–404 IO and PO tranches, 399 limited purpose finance corporations (LPFCs), 399–401 structured investment vehicles, 401–402 Credit-linked notes (CLNs), 25–27 Credit protection, 48, 50–53 Credit quality, 34, 70 Credit rating, 33, 41, 65, 85, 199, 408–412 Credit risk, 2, 6, 22, 28, 39–40, 49, 60, 69–70, 72, 96, 99, 107, 117, 127, 132, 311, 313, 334, 354 CreditSights, 366 Credit spread option (CSO), 59–60 Credit spreads, 45–47, 76, 87, 228, 257, 354–355 Credit Suisse: Alternative Capital (CSAC), 415 Securities (CSS), 415 Creditworthiness, 68, 127 Credit wrap, 34, 119–120, 388 Criminal penalties, 431 Cross-border transactions, 51 Cumulative probability, 286 Currency/currencies: hedges, 55 implications of, 228 Index overlays, 232 risk, 46 SPEs and, 24–25 swaps, 30 Deadbeat, Dead man’s curve trade, 113–114 Dealer, functions of, 50, 56, 226–227 Debentures, 8, 56 Debt, types of, 8, 23, 45, 65–69, 120, 122, 124, 168, 174, 179, 182, 206 Debt-for-tax structure, 8, 36 Debt service coverage ratio (DSCR), 378 Deep-in-the-money options, 57 Default: correlations, 366 impact of, 233–236, 316 probability, 63–64, 115, 367 rate, 45, 420 risk, 49, 63 swap, 322 see also Credit default swaps (CDSs) Delinked structures, 304–305 Deliverables, 50, 54, 198 Delta hedge ratio, 87, 360, 362, 367–368 Delta P, 128 Derivatives, see Credit derivatives characteristics of, first-order, 61 SPEs and, 22 trading strategies, generally, 180 triggers linked to, 30–31, 49–50 Deutsche Bank, 313 Digital payout, 52–53 Dilution effect, 59 DIMAT Inc., 144, 151, 154 Diminished financial obligation, 66 Director, charitable trust, 22 Disclosure, significance of, 151–152, 172–173, 186–188, 318 Discount rates, 127–128 Distressed exchange, 66 Distressed rating, 80 Diversification, importance of, 38, 91–92, 198 Dividends, 59 Documentation: arbitrage CDOs, 236 bankruptcy process, 42 443 cash arbitrage CDO, 209 CDOs, 41 credit default swaps, 70 credit-lined notes, 26 importance of, 294 Euro medium-term notes (EMTNs), 25 medium-term notes (MTNs), 25 owner trusts, 36 small to medium-size enterprises, 313 SPEs/SPVs, 18–19, 21–22 true sale structures, 297 Dow Jones CDX North America Investment Grade Index, 382 Downgrades, 171, 270, 304, 417–418, 423 Drexel, 84 Drop, 251 Due diligence, 76, 105, 107, 151–152, 164, 172–173, 195, 377, 417 Dynamically hedged risk, Dynamic hedging, 135 Dynamic trigger, 31–32 Economies of scale, 243–245 Efficient market: characteristics of, 346 hypothesis, theory, 59–60 Embezzlement, Emerging markets, 21, 33, 207, 379–382 Enron, 11, 42–44, 61, 86, 97, 104–105, 120, 153, 179, 198, 273, 353 Equity, see Equity investments cash flow, cash vs synthetic arbitrage CDO, 236–237 CDO, 104, 176 characteristics of, 23 defined, 4–5 income, 320 investors, 236 management, 108 ownership, 21 risk, 86 synthetic, 354–356 tranche, 362 transactions, 75 Equity investments overcollateralization of, 257–259 residuals, 256–257 types of, 10, 254–256 Errors, CDO equity structure, 250–253 444 Euribor, 72, 204, 232, 276–277, 279 Euro/eurodollar market, 32, 197, 205, 207, 221–222, 229–231, 315 Euro Medium-Term Notes (EMTNs), 17, 19–20, 22–25, 27–30, 34, 277 European Central Bank (ECB), 328 European market, 240, 243 European MBSs, 34 Event risk, 273 Everquest, 182–182 Excess reserve, 383 Excess spread, 121, 161 Failure to pay (FTP) principal/interest, 80, 197 Fair value, 221–222 Fannie Mae, 127, 160, 427 Federal Home Loan Mortgage Corporation (FHLMC), 126–127, 135, 426 Federal National Mortgage Association (FNMA), 126–127, 135, 426 Federal Reserve, 42, 173, 322, 331, 406 Fees, types of, 6, 98, 110, 115, 117, 182, 188, 240, 272, 291, 294, 391 Financial Accounting Standard Board (FASB), 20–21 Financial asset securitization investment trusts (FASITs), 7, 37 Financial Guaranty Insurance Corporation (FGIC), 418–419, 424, 426 Financial Security Assurance Inc (FSA), 418 Financial Services Authority (FSA), 110, 418, 424 Financial statement, as information resource, 431 See also Balance-sheet transactions; Profit and loss (P&L) statement First-loss transactions, 336–338, 353–354 First-to-default swaps, 284–288 Fitch ratings, 204, 257, 259, 307, 333, 377–378, 382, 406, 416, 422, 426 Fixed cap, 80 Fixed recovery settlement, 53 Flat price, 252 Flaw of averages, 110–111 Floaters, 27, 224 Floating amount event, 79–80 Floating rate: implications of, 27, 80 liabilities, 316 INDEX MBS, 127 payments, 72 Forced conversion, 57 Foreclosure, 179, 181, 416 Foreign depository laws, 21–22 Foreign exchange rates, 230 Forward contracts, 252–253 Forward flat price, 251 Forward rate, 221–222 Franklin National Bank, 11 Fraud, 96, 104–107, 135, 148, 179, 186, 188–189, 192, 273, 297, 378, 393, 431 Fraudulent conveyances, 41 Freddie Mac, 126, 160, 427 Full price 252 Fully synthetic CDOs, 308, 310 Fundamental analysis, 63 Future flows, 2, 374–379 Future value, 221 Futures: analysis, 221 contracts, 113–114, 222 Galena Street Fund, 185 Game theory, 16 Gap margin, 32 Gaussian distribution, 95 Generally accepted accounting principles (GAAP), 41, 44, 431–432 Geometric Brownian Motion (GBM), 384 German Pfandbriefe market, 123 German Stock Exchange (DAX), notes with triggers, 3234 ă Gesellschaft mit beschrankter Haftung (GmbH) securitization, 39–40 Ginnie Mae, 126 Glacier CLN CDO black box, 302–304 Glacier Finance Ltd., 53 Glass-Steagall Act restriction, 76 Global Crossing, 97, 104 Global market, 3, 15, 89, 328 Global risk, 101, 120 Government National Mortgage Association (GNMA), 126–128, 131–133, 135 Grantor trusts, 316–317 Greenspan, Alan, 165 Guaranteed Loan Pools Certificates (GLPCs), 315–316 445 Index Guarantees, 119 Guarantors, 422–423, 425–426 Guaranty book, 416 Haircut, 124 Hard bullet, 35 Hard currency, 34 Hedge fund of funds, 122 Hedge funds: ABX indexes, 174–177 borrowing from, 77 CDOs, 365 characteristics of, 9, 24, 49, 98–99, 178, 181–184, 271, 365 collateral, 110 future directions for, 430 leveraged, 173 speculation, Hedge ratio, 87, 130–131, 133, 371 Hedges: cost of, 55, 228, 232 types of, 21, 37 Highly leveraged transactions (HLTs), 256, 318 High-yield obligations, 21 Hollywood funding, 386–388 Housing and Urban Development (HUD), 127 HSBC Holdings, 417 Hybrid ARMs, 192 IBM, 224–225 Illiquidity, 3, 111, 173–174, 237 Income tax, corporate, 18 Indexes, characteristics of, 81 Information asymmetry, 78 Information resources: indexes, 81 rating agencies, see Rating agencies web sites, 43 Initial public offerings (IPOs), 182–183 Insurance companies: monoline, 119–121, 305, 334, 343, 353, 388, 415–416 multiline, 119–121, 384–386, 388 portfolios, 24, 89, 421 Insurance Companies Act of 1982, 48 Interest: floating, 80 impact of, rates, 30, 124, 127–130, 141–142, 232, 237 shortfalls, 79–80 subparticipation (ISP), 273–276, 304, 306–307, 358–359 Interest coverage (I/C) tests, 256 Interest-only loans, 192 Interest rate swap, 51 Internal rate of return (IRR), 219, 237–238, 240, 243, 245, 248, 258–259, 266, 280–282, 354–356 Internal Revenue Code, 36 International banking, 15 International Monetary Fund (IMF), 328, 380 International Monetary Market (IMM), 222 International Swap and Derivatives Association (ISDA): functions of, 19, 21, 25, 49–50, 66–67, 100–101 future directions for, 430 on mortgage loans, 179 pay-as-you-go (PAUG) template, 79–80 physical settlement, 234 In-the-money options, 57 Inverse floater formula, 137 Investment banks, 6, 9, 49, 24, 38, 99, 132, 153, 178, 185, 187, 248–249, 292–293, 388–389, 407 Investment grade, 32 Issuer, functions of 274 Jargon, 371 JPMorgan, 120, 304 JPMorgan Chase, 42–44, 101 Junior tranche, Junk economics, 367–368, 406 Junk portfolio, 270 Junk rating, 99 Keynes, John Maynard, 253 Kmart, 353 Knock-in unwinds, 32 Kreditanstalt fur ă Wiederaufbau (KfW), 311, 313 Landesbank Kiel (LB Kiel), 307–308 Law of probabilities, 139 Lawyers, functions of, 188–189, 294 Leases, 23, 121–122 446 Letter of credit (LOC) transactions, 42, 119, 375 Leverage, 25, 89, 103–104, 107–110, 115, 124, 270–272, 408 Leveraged transactions, 1, 102, 25, 28–29 LIBOR See London Interbank Offer Rate (LIBOR) Liens, 40–41, 122 Life settlements, 391–394 Limited partners/partnerships, 39 Limited purpose finance corporations (LPFCs), 399–401 Limited recourse, 22 Limited substitution synthetic arbitrage CDOs, 273 Linear regression, 132 Lipper awards, 407 Liquidation, 31–32, 112, 209, 280 Liquidity, 29, 38, 45–46, 70, 119, 208, 391 Loans: Alt-A, 81, 92, 420, 425 assignable, 23 bilateral, 67, 296 commercial and industrial (C&I), 296–298 conventional, 121 credit default protection, 66–67 credit risk, 40, 49 floating-rate, 315 fraudulent, 84 hedging, 66 high-yield, 122, 125 interest-only, 192 leveraged, 28 mortgage, see Mortgage loans multilateral, 296 nonperforming, 122, 145–146 repackaging, 28–29 resolved, 150 secured, 63–64 secured trusts, 318–321 subprime, 45–46, 178–179, 415, 419–421, 423 Lockout period, 59–60, 296 London Interbank Offered Rate (LIBOR), 25–26, 70, 72, 74, 76–77, 80, 137, 192, 223–224, 227–229, 240, 249, 279, 297, 316, 340, 347, 382 Long Term Capital Management (LTCM), 101, 108–109, 111–112, 184–185 INDEX Loss(es): allocation, 254–255 capital, first, see First-loss transactions types of, 415 unexpected, 95–96 Make-whole provisions, 59 Malpractice, 188 Managed cash arbitrage CDOs, 194, 211–212, 214, 256, 310 Managed CDOs, 126 Managed deals, 171 Managed synthetic arbitrage CDO, 194–195, 211–212, 215, 217, 219, 237, 243, 261–262, 305 Management agreements, 21 Mandate agreement, 196 Margin requirements, 186 Mark-to-market (MTM), 5, 29, 31–34, 75, 98–99, 178, 196, 228, 230–231, 321, 324, 342, 344–345, 347– 348, 351, 353–371, 383, 418 Market manipulation, 179–180 Market risk, 46, 72, 322–323, 326 Market value, 55, 75–76, 98, 123–124, 324 Marquee deals, 104 Master agreement, 21 Matching credit default protection, 324–325 Maturity: in bond market, 61, 245 credit default swaps, 62 date, 35, 59 expected final, 210 MBIA Inc., 416, 418–419, 424–425 Medium-term notes (MTNs), 29, 301–302 Merchant banks, 24 Mergers and acquisitions (M&As), 49, 385 Merton, Robert, 109 Mezzanine tranche: characteristics of, 86–87, 355–356, 360–364, 366, 371 delta, 368 short, 364 TTORS pricing, 75 MILA, 168 Minimax theorem, 16 Mismatched maturity transactions, 29–30 Modern portfolio theory, 92–96 Moment of the joint distribution, 132 Index Money market, basis point, 249 Monte Carlo: distribution models, 97 methods, 290 simulation, 367 Moody’s ratings, 53, 59, 64–65, 67–68, 87–88, 198–202, 204–207, 237, 257, 259–260, 302, 307, 333–341, 354, 366, 382, 403, 406, 408, 416–419, 422–423, 426 Moral hazard, 6, 78, 99–100, 185, 268–270, 371, 415, 426–427 Moratorium, credit default swap, 68 Mortgage-backed CDOs, 83, 345, 370 Mortgage-backed securities (MBS), 72, 74, 104, 121–123, 126, 138, 174, 245 Mortgage loans: Alt-A, 155, 181, 191 ARMs, see Adjustable-rate mortgages (ARMs) default on, 190–191 fixed-rate, 192 piggyback, 186 prime, 158, 169, 171 restructuring, 416 subprime, 45–46, 155, 158–160, 164–165, 179–181, 191–192, 405 types of, 123 Multicurrency portfolios, 46, 232 Multiholder obligations, 67 Multilateral loans, 296 Multiline insurance products, 384–386, 388 Multiple issuance entities (MIEs), 19–22, 26 Multisector CDOs, 88, 373–374 Mutual funds, 24 National Association of Insurance Commissioners (NAIC), 280, 318 National Recognized Statistical Rating Organization (NRSRO), 405, 407, 426 National Westminster Bank, Repeat Offering Securitization Entity Funding No (R.O.S.E.) CDO, 299–301 Nationally Recognized Statistical Rating Agencies (NRSROs), 172, 416–417 Negative basis trades, 62, 348–349 Negative carry, 252 Net asset value (NAV), 109 447 Net equity cash flows, 266 Net WAC, 79 Neumann, John von, 16 Neuroeconomics, 112–113 No cap, 80 No cross-default, 21 No-loss scenario, 242 Noncall period, 209–210 Non-credit-default derivatives, 30–31 Non-investment-grade first-loss risk, 40 Nonperforming loans, 122, 145–146 Nonrecourse financing, Normal distribution, 95–96 Noteholders, 145, 318 Notes: collateral loan, 301–304 combination (CNs), 278–279 credit-linked (CLNs), 25–28, 55, 310 DAX-linked with triggers, 32–34 Euro medium-term (EMTNs), 17, 19–20, 22–25, 27–30, 34, 277 first-loss, 260 first-to-default, 290 floating-rate (FRN), 27, 50, 225 medium-term, 25, 29, 301–302 participation (PN), 276–278 principal-protected (PPN), 28–29, 282 Notional portfolio, 87, 212, 324, 366, 370 Novations, 49 Obligor, functions of, 296, 304 Off-balance-sheet transactions, 7–9, 48, 83, 295–296, 330, 417, 431 Offer side of market, 224 On-balance-sheet asset, 325 144A See Rule 144A Option pricing model, 109 Options, 30, 57–60, 127–129, 366 Ordinary course of business, 42 Organization for Economic Cooperation and Development (OECD), 17, 305, 321, 325, 343, 358–359, 388 Original issue discount (OID), 399 Out-of-the-money options, 57 Over-the-counter (OTC) market, 83 Overcollateralization, 37, 75, 119, 124, 146, 161, 170, 215, 257–259, 321, 345 Overhedge, 52 Ownership issues, 14–15, 49 OwnIt, 177–178 448 Parapet, 182–183 Pari passu position, 22 Parity, conversion, 57 Partially synthetic CDOs, 307–308 Participation notes (PN), 276–278 Partnerships, 36 Par value, 33, 52, 57 Pass-through structures, 7–8, 23, 35–36, 135, 386 Pay-as-you-go (PAUG), 79–81 Pay-down period, 210 Payer, total rate of return, 72 Pay-in-kind (PIKing) shortfalls, 79 Paying agents, 22 Payoff profile, 60, 254 Payout period, 35 See also Termination payout Pay-through structures, Pension funds, 24, 173 Performing assets, 146 Petroleum-related forward contracts, 253 Physical settlement, 50–52, 80 Piggyback mortgages, 186 Planned amortization classes (PACs), 138 Poison pill takeover defenses, Ponzi scheme, 162–163, 168, 391, 393 Portfolio: diversification, 39, 85, 100, 120 diversity score, 208 management, components of, 39, 196 risk, 164 selection, 198–199 Predator lending, 160–162 See also Loans, subprime Preferential payments, 42 Preferred stock, 4, 56 Premium: conversion, 57–58 credit default swap, 52, 65 credit spread options, 60 percent of conversion, 57 Prepayment: principal, 212 rate, 138–141, 316 Present value, 37, 61 Pricing, influential factors, 38, 74–75, 109, 208, 342–343 Prime broker, 74, 107, 110, 111, 155, 185–186 Prime rate, 316 INDEX Principal-protected Schuldschein (PPS), 259, 266, 282 Principal-protected structures 280–282 Private equity, 28, 49, 122 Private placement, 76, 98, 164, 182, 188 Probability factor, 226 Probability theory, 114 Profitability, 104 Profit and loss (P&L) statements, 5–6 PROMISE SME CDO, 311–314 Prospectuses, 121, 183, 187–188, 415 Protected call option, 59 Protection money, 290 Prudential, 1–2 Public Company Accounting Oversight Board (PCAOB), 432 Public policy, 44 Put options, 60 Qualified institutional buyers (QIBs), 20 Qualifying special purpose entities (QSPEs), 10, 20–21 Quarterly money market (QMM), 249 Radian Asset Assurance, Inc., 418 Ramp-up period, 208, 294 Rating agencies, functions of, 38, 45, 61, 63, 67, 87, 152–153, 168, 171–172, 191, 195, 197, 200–201, 218– 219, 257, 260, 288, 293–294, 306, 332, 334–337, 351, 368, 405–407, 415–417, 422, 429 RBG metals, 97, 106 Real estate investment trusts (REITs), 136, 161 Real estate mortgage investment conduits (REMICs), Receivables, 8–9, 23, 121–122 See also Credit card receivables; Trade receivables Recovery defined, 145 rate, 53, 63, 179, 240, 266 types of, 420–422 values, 50, 52, 207, 236–237, 243, 284, 302 Redemptions, 212 Redlining, 191–192 Reference: collateral, 88 entity obligations, 49, 56 obligors, 63–64 449 Index Refinancing, 192 Reg S, 297 Regional banks, 24 Regulatory bodies, 321 Reinsurance, 34, 272 Reinvestment: CDOs, 70–71 impact of, 35, 126, 207, 232–233, 245, 248 period, 209, 215–216 risk, 137 Renewal cost, 38 Repackaging, 19–20, 24–31, 59, 259, 280, 310, 347 Repo rate, 75–76 Representations, 41 Repricing risk, 38 Repudiation, credit default swap, 68 Repurchase agreement, 75 Reserve accounts, 119, 121, 212, 216 Reserves, significance of, 6, 107 Residential mortgage-backed securities (RMBS), 2, 35–36, 79–80, 169–171, 176, 182–183, 360, 419 Residual equity cash flows, 242, 255–256, 258 Residual interest, 36 Residual returns, 10 Residual risk, 5–6 Residual tranche, Resolution Trust Corporation (RTC), 34 Restructuring, 49, 66, 68–69, 197, 240 Return distribution, credit vs market, 95 Return on capital, 327 Revenue growth, 104 Revolving period, 35 Revolving term securitization, 35 Right-way-around swaps, 33–34 Ring fencing, 21 Risk: disclosures, 76 diversification, 102 first-loss, first-to-default, 290 management strategies, see Risk management premium, 45 profile, 142 reduction, transfer, 9, 171, 328 Risk-free assets, 54 Risk-free rate, 60–61 Risk management: cash flow hazard, 99–100 CDOs, correlation trading, 367–368 credit derivatives, 45–46 fraud and, 104–107 global derivatives risk, 100–101 hedge funds, 107–110 leverage, 103–104 loans, 101–104 mark-to-market hazard, 98–99 normal distribution and, 96–98 modern portfolio theory, 92–96 portfolio diversification, 91–92, 100 subprime mortgages, 164–165 Tavakoli’s Law, 110–112 Rule 144A, 20, 24, 164, 297 Sarbanes-Oxley Act of 2002, 430–431, 433 Savings banks, 24 SBA International program, 316–317 Scenario analysis, 135 Scholes, Myron, 109 Secondary market, 6, 29 Secondary paper, 32 Securities Act: of 1933, Regulation D, 394 of 1934, 430 Securities and Exchange Commission (SEC), 98, 173, 381–383, 391–392, 405, 429–432 Securitization: defined, 1–2 disasters, 165–166 terminology, 1–6 U.S., origins of, 126–135 Security Capital Assurance (XL Capital Assurance Inc.), 418, 423, 426 Seller: conduit requirements, 37–38 credit default protection, 52–54, 56 credit default swap (CDS), 47–48 credit protection, 66 default protection, 65 Senior tranches: junior, 346–347 super, see Super senior tranches Sensitivity analysis, 237–238, 244, 246 450 Sequential-pay CMO, 136–137 Settlement: characteristics of, 49–50 credit event, 233–236 date, 252 default and, 233–236 negotiations, 50–52 PAUG, 80 physical, 234 types of, 50–52 Shell corporations, 10, 14 Sigma, 412 Simplified cash CDO, 4–5 Single-name CDS, 366 Single-tranche, characteristics of, 169 Single-tranche CDOs (STCDOs), 86–87, 100, 354–355, 357–359, 361–363, 365, 367 Sinking funds, 245 Size of transaction, 32 Small to medium-size enterprises (SMEs): CDOs, 310–315 Europe, 310–315 United States vs Europe, 315–318 Societe Generale (SocGen), 417 Society for Worldwide Interbank Financial Telecommunications (SWIFT), 375 Soft bullet, 35 Soft currency, 33–34 Soft default, 66 Sold assets, defined, 145–146 Sovereign assets, 33–34 Sovereign risk, 51, 63 Special purpose corporations (SPCs), Special purchase entities (SPEs): bankruptcy-remote, 40–43, 88 cash flows, 240–241 Cayman-domiciled, 22–24 classification of, conduits, 36–39 credit-linked notes (CLNs), 25–28, 55 deal assembly, 197 defaults, 21 defined, 2–3, derivative transactions, 30–32 documentation, 18–19, 21–22 domestically domiciled corporations, 39–40 double structure, INDEX equity investments, 237 examples of, funding costs, 25–27 historical abuse, 10–16 liquidity, 29 maturity requirements, 29–30 multiple issuance entities (MIEs), 19–22, 26 off-balance-sheet, 9, 41 offshore, 40 principal-protected notes, 27–28 qualifying (QSPE), 10 ratings, 34 repackaging, 19–20, 24–31, 310 setting up, 16–17, 19 simplified cash CDOs, 4–5 structured floaters, 27 synthetic structures with, 304–307 taxation, 17–18 transactions using, 15–16 trusts, 34–36 unwind triggers, 30–34 Special purpose acquisition companies (SPACs), 394–395 Special purpose corporations (SPCs), 3, 20, 136, 316–317 Special purpose vehicles (SPVs): bankruptcy-remote, 124 characteristics of, 3, 16–18, 117, 240 documentation, 18–19 equity cash flows, 260 interest subparticipation (ISP), 306 loans, see Collateral loan obligations (CLOs) multi-issuance, 279 notes, 302 Specific risk, 322–323 Speculators, 253 Sponsor: bank, 29, 299–301, 313, 320 CDO equity structures, 274 conduit, 38 Spot price, 252–253 Spread convexity, 367, 370 Spreadsheet applications, 243 Standard & Poor’s (S&P) 500, 180, 390–391, 408, 419 Standard & Poor’s (S&P) ratings, 333–335, 337–339, 349, 356, 364, 406, 416, 422–423, 426 Index Standard deviation, 92, 96, 131 Static CDOs: characteristics of, 126 synthetic arbitrage, 260–264, 305 Static deals, 171, 260 Static pool securitizations, 146 Static triggers, 32–33 Step-up coupons, 59 Stress tests, 243, 423 Stripped convertibles, 59–61 Structured finance, benefits of, Structured instrument vehicles (SIVs), 293–294, 400, 416–417 Subordination, 161, 406 Subprime loans, 45–46, 155, 158–160, 164–165, 171, 179–181, 191–192, 405 Subsidiaries, 8, 41, 136, 272 Substitution clauses, 34 Successor, in mergers, 49 Super senior CDOs, 417 Super senior tranches: AAA tranche, 332–334, 336–340, 343–345 attachment point, 332–333, 341–342 cash flow magic trick, 333–334 characteristics of, 89, 117–118, 211, 219–220, 332–333, 353 first-loss, AAA basket with percent, 340–341 historical perspectives, 331–332 investors in, 347–348 junior, 346–347 leveraged, constant proportion portfolio insurance, 349–350 negative basis trades, 348–349 pricing, 342–343 rating agencies, 332, 334–337, 351 regulation of, 345–346, 350–351 risks, 331–332 Supply and demand, 62, 70, 74, 257 Sureties, 44, 120 Surveillance, 292, 294 Swaps: asset, 56–61, 220–227 basket, 283, 284–288 counterparty, 22 credit default (CDS), see Credit default swaps (CDSs) cross-currency, 51, 53, 55, 231 451 currency, 30, 228, 232 dual-currency, 230 global credit default, 83 interest rate, 220–226, 320 first-to-default, 284–288 interest rate, 222, 297 portfolio, 264, 356–357 right-way-around, 33–34 second-to-default, 288 strike price, 316 total rate of return, see Total rate of return swaps (TRORS) total return (TRS), 2, 29, 85 wrong-way-around, 34 Swiss Bank Corporation (SBC), 53, 301–304 Syndication, risk diversification, 102 Synthetic CDOs arbitrage, 226, 236–237, 239, 246, 273 characteristics of, 20, 25, 55–56, 70–72, 86–87, 123, 125–126, 193–195, 197, 211–212, 220, 311 managed arbitrage, 206 static arbitrage, 71, 309, 336 Synthetic CLOs, 304–307 Synthetic credit structures, Synthetic financing, 115 Synthetic securitization, 1–2, Synthetic state portfolios, 272 Synthetics, 85 TABX, 81 Tail risk, 96 Taxation issues, 3, 8, 17, 36, 41, 320 Tax evasion, 16–17, 44 Tax laws, Team players, defined, 345 10–K reports, 430–431 10–Q reports, 430–431 Termination, early, 210–211 Termination payouts: cash settlements, 52–53 hedge costs, 55 initial value x (par - market value), 53–54 normalized price method, 54–55 Time horizon, 128 Total rate of return swaps (TRORS): CDS compared with, 78–79 characteristics of, 2–3, 50, 72–74, 318, 320–321 equity, 76–77 452 Total rate of return swaps (Continued ) information asymmetry, 78 investors in, 73 maturity of, 76 pricing, on levered CDO tranches, 74–75 repo rate, 75–76 Total return swap (TRS), 2, 29, 85 Toxic convertibles, 77 Trade receivables, 53 Trading, defined, Trading book, 5–6, 48, 77, 86–87, 140, 324, 359–361, 366, 371 Trading book arbitrage CDO, 356 Trading desk, 5–6 Trading positions, risks, 323 Tranches: call for, 209–210 CBOs, 138 CDOs, 4–6, 51 CMOs, 136–137 commercial paper, 330 credit-linked notes, 25–26 distressed, 183 equity, 27–28, 85, 183, 211–212, 245, 248 first-loss, 182, 257, 260, 276, 318 fixed-coupon, 137 floating-rate, 136–137, 139, 232 interest-only, 138–139 interest subparticipation, 274–276 investment-grade, 173 mezzanine, 88–89, 186 144A, 28 payment-in-kind (PIK), 218, 245 principal-only, 139 single-A, 99 SPEs/SPVs, 19, 21–22 super senior, see Super senior tranches subparticipation, 297, 306 survival rate, 266 synthetic, 287 triple-A, 219, 354, 409 volatile, 140 Z, 137–138 Tranching, 35, 120–121 Transformers, 388–390 Transition matrix, 45 Transparency, 14, 115, 355 Travelers, 128–130 Treasury securities, 54, 251 INDEX Trigger events, 124, 210–211, 215, 236, 321, 350, 416 Triple-A tranches (AAA): basket with percent first-loss, 340–342 characteristics of, 332–335, 354, 409 default, 344 first-loss, 337–338 mezzanine, 417 rating agencies, 332, 334–337, 341, 351 perceptions of, 338–340, 343–345 subordination of, 340 True sale at law, 8–9, 20, 41 True sale structures, 117–118, 328, 295–299, 307 Trust: account, 121 certificates, 316 grantor, 36 master, 34–35 owner, 35–36 real estate investment (REITs), 136, 161 secured loan (SLTs), 318–321 Trustee, functions of, 22, 28–29, 294 Underlying assets, 24, 28, 31, 33–34, 48 Underwriting standards, 422–423 Union Bank of Switzerland (UBS), 53, 302, 433 United Capital Asset Management LLC, 185 United Kingdom: British Banker’s Association (BBA), 83 British sterling, 32, 127, 230–231 credit default swap (CDS), 48 LIBOR, 25–26, 70, 72, 74, 76–77, 80, 137, 192, 223–224, 227–229, 240, 249, 279, 297, 316, 340, 347, 382 U.S Dollar (USD), 228, 230 U.S Treasuries See Treasuries U.S Treasury price patterns, 127–128, 133 Unprotected call, 59 Unwind/unwinding: characteristics of, 110, 112, 240, 416–417 hedge cost, 228 triggers, 31, 423 US Technologies, Inc (UST), 432 Valuation date, 234 Value-added tax (VAT), 17–18 Value-at-risk (VaR), 97, 322, 324–325, 327 Variable cap, 80 453 Index Variable interest entity (VIE), 10 Variance, 93–94, 131 Vatican Bank, 11–14 Vernick, Mitchell, 149–151 Volatility, impact of, 47, 53, 56, 59, 63, 70, 92–95, 111, 129, 201, 225–226 Voting rights, 76 Warehouse management, 294 Warrants, 41, 56, 59 Wash trades, Waterfalls, 212–217, 256, 260, 262, 264, 274 Weighted average coupon (WAC), 169–170 Weighted average life, 210 Weighted average maturity (WAM), 137–138 Weighted average rating factor (WARF), 201, 207, 226 Whistleblowers, 431 Windfall, synthetic cash, 353–354 Withholding tax, 18 Workouts: components of, 66, 233 periods, 64 WorldCom, 86, 97, 104–105, 353 Worst-case tranching, 339 Write-downs, 87, 212, 216, 278, 418, 433 XL Financial Assistance Ltd., 418–419 Yen/dollar arbitrage, 141 Yield: bond, 129 curve, inverted, 251 Zero-coupon bonds, 28, 56, 59, 64, 222, 280 Zero-one payout, 52–53 Zero positive carry, 251 Zero tax, 17–18 ... Data: Tavakoli, Janet M [Collateralized debt obligations and structured finance] Structured finance and collateralized debt obligations : new developments in cash and synthetic securitization / Janet... Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization, Second Edition by Janet M Tavakoli Copyright © 2008 Janet M Tavakoli CHAPTER Structured. .. Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization, Second Edition by Janet M Tavakoli Copyright © 2008 Janet M Tavakoli CHAPTER Securitization