Fixed Income Research

Collateralized Debt Obligations: Market, Structure, and Value

June 1998

Sunita Ganapati MBS and ABS Research 212-526-7965

Alex Reyfman Quantitative Research 212-526-7253

CONTENTS EXECUTIVE SUMMARY ...................................................................................................................................................... 3 I. CDOsMARKET EVOLUTION AND STRUCTURAL CHARACTERISTICS .............................................................. 5 BANK CLOs .................................................................................................................................................................. 7 TRADITIONAL CDOs ................................................................................................................................................... 9 ILLUSTRATIVE TRANSACTIONS ...................................................................................................... ....................... 10 RATING AGENCY METHODOLOGY ......................................................................................................................... CREDIT ANALYSIS OF THE UNDERLYING PORTFOLIO ....................................................................................... STRUCTURAL AND CASH FLOW ISSUES ................................................................................................ .............. OTHER RATING CONSIDERATIONS ....................................................................................................................... ILLUSTRATIVE TRANSACTIONS ...................................................................................................... ....................... 13 13 17 18 20

II.

III.

CDOs AND DIVERSIFICATION OF CREDIT RISK ................................................................................................... 21 BOX: MOODYS DIVERSITY SCORE ...................................................................................................................... 25 ASSESSING VALUE IN CDOs .................................................................................................................................. 26 VALUATION CONSIDERATIONS WITHIN THE CDO MARKET ............................................................................... 26 RELATIVE VALUE OF CDOs VERSUS COMPARABLE SECURITIES .................................................................... 31 CONCLUSION ............................................................................................................................................................ 36

IV.

Acknowledgements: Jase Auby, Jawahar Chirimar, Jared Epstein, John Fernando, Lisa James, Ravi Mattu, Andy Sparks, Beth Starr, Prashant Vankudre
Publications: M. Parker, D. Marion, A. DiTizio, C. Triggiani, B. Davenport, J. Doyle
This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. 1998 Lehman Brothers Inc. All rights reserved. Member SIPC.

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EXECUTIVE SUMMARY
Collateralized debt obligations (CDOs) are structured fixed income securities with cash flows linked to the performance of debt instruments. The underlying collateral backing a CDO consists of one or more types of debt, including bank loans, high yield bonds, emerging market corporate and sovereign debt, and subordinated securities from structured transactions. Issues with primarily loan collateral are known as CLOs and those with bond collateral are known as CBOs. CDOs are issued by commercial banks, insurance companies, and money managers. The motivations for issuing CDOs are varied. Commercial banks securitize their high quality, low yielding commercial and industrial loans to gain regulatory capital relief and manage their credit exposure. Traditional issuersinsurance companies and money managersuse CDOs to leverage high yield assets, lock in term funding, and earn incremental fee income. Typically, these issuers acquire the collateral specifically for the purpose of securitization. Similar to other asset-backed securities (ABS), CDOs consist of several tranches, with the senior tranches having coupon and principal payment priority over the mezzanine and equity tranches. The primary risk of CDOs is the incidence of default in the underlying collateral. The risk of the collateral portfolio depends on its average collateral quality and the extent of its diversification. Diversification reduces the variability of losses of a collateral pool and lowers the risk of the senior tranches. CDOs merit consideration as an emerging asset class that currently offers value versus comparably rated asset-backed securities for the following reasons: Senior and mezzanine tranches of CDOs currently incorporate a new asset class premium and trade at wider spreads than comparably rated, structurally similar securities. Over time as the market grows and liquidity increases, this premium is likely to narrow. The commercial bank CLO sector is likely to become as large and liquid as the credit card market. With increased sponsorship from floating rate ABS investors, the spread differential of benchmark CLOs over credit card ABS is likely to narrow. Japanese bank CLOs command a significant premium over benchmark CLOs due to investor concerns about collateral and servicing quality. For transactions backed by syndicated loans to U.S/European corporations (the majority so far), the spread premium is largely unjustified and these securities represent value.

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AAA/Aaa rated tranches of traditional CDOs with high yield/emerging market collateral trade at wider spreads than bank CLOs due to lower liquidity and uncertainty about their default behavior. For investors willing to forego some liquidity, these securities offer significant value. The conservative credit enhancement levels for senior tranches required by the rating agencies compensate for uncertainty about default behavior. Equity tranches of traditional CDOs offer investors an efficient way of making long-term, leveraged investments in high yielding assets. These tranches outperform unleveraged investments in the collateral even in default scenarios twice as high as the most recent default experience (during the economic expansion since 1992).

In Section I of this report we describe the evolution of the CDO market, the structural characteristics of CDOs, and some illustrative CDOs. Section II explains the rating agencies methodology for assessing the risk of these securities. Section III discusses the importance of measuring collateral diversification in evaluating CDOs. Section IV explores value within the CDO market and relative value opportunities.

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I. CDOsMARKET EVOLUTION AND STRUCTURAL CHARACTERISTICS

Since the late 1980s, insurance companies and money managers have used CDOs to finance leveraged investments in fixed income securities. Until recently, issuance was intermittent and opportunistic. But over the last two years, the market has witnessed tremendous growth (see Figure 1) led by commercial banks seeking regulatory capital relief and money managers seeking to increase assets under management. CDOs are increasingly viewed as an ongoing capital markets instrument, and the CDO market will likely continue to grow. Commercial banks use CLOs to securitize their commercial and industrial loan books. CLOs enable banks to gain capital relief from rules requiring 100% risk capital weighting on corporate debt assets. Traditional CDOs issued by money managers and insurance companies are leveraged vehicles backed by lower quality, high yielding securities. While the rating process for both types of CDOs is similar, issuer motivations, collateral characteristics, and structural features are distinct. Additionally, like-rated classes of each type of CDO trade at different spreads. Figure 2 depicts a typical CDO structure. CDOs are issued from a special purpose vehicle (SPV) and consist of several senior/subordinate tranches of securities with varying levels of credit risk. The tranches and the collateral can pay either fixed or floating rates; most transactions to date pay a

Figure 1.
$ billion
50

Issuance Estimates and Projections

45 40 Traditional CDOs Commercial Bank CLOs 30 30 19 20

20

10

7 0

8 5

0 1988-1995 (E) 1996 (E) 1997 (E) 1998 (P)

*Includes issuance in the ABS CP market; E = estimates, P = projections. Sources: Moodys and Lehman Brothers.

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Figure 2.

Typical CDO Structure

Reports Asset Manager Trustee

Aaa Aa2 Aaa & Aa2 Floating Rate Notes

Underlying Underlying Securities Securities (Bonds and/or Loans)

Underlying Securities CDO

Special Special Purpose Vehicle Purpose Entity (SPV)

Issued Securities
Baa3 B3 Baa3 & B3 Fixed/Floating Rate Notes

Cash

Cash

NR NR Notes/Equity

Hedge Provider (Triple A rated) AAA

floating rate to CDO investors. Interest rate basis and currency risks between the collateral and the CDO tranches are generally hedged through swap agreements with a AAA counterparty. The most subordinated tranche is the equity class, and it is the first tranche to absorb losses in the underlying pool. If losses exceed the amount of the equity tranche, additional losses are passed on to the mezzanine tranches and then the senior tranches. The equity tranche receives the excess spread, i.e., the difference between the interest received on the collateral and the interest paid to bondholders of senior tranches net of losses. The investor base for CDOs has expanded significantly over the last few years. The senior and mezzanine tranches appeal to asset-backed and

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investment grade corporate bond investors such as money managers, insurance companies, banks, and conduits. Subordinated tranches are sold to equity investors such as insurance companies and high net worth individuals. Issuers generally retain a portion of the equity in order to align their economic incentives with those of investors. BANK CLOs Since 1997, Japanese, European, and U.S. banks have led the surge in bank CLO issuance. Regulatory capital relief is the common reason for issuing these securities, but individual issuer motivations have varied. Capital deficient Japanese banks have issued CLOs to meet BIS capital targets. Capital rich U.S. and European banks use CLOs to optimize return on equity (ROE) ratios and manage credit exposure. By transferring some of the credit risk of their borrowers, banks use CLOs to maintain flexibility in client relationships without undue loan portfolio concentration. Bank CLO transactions are often structured as master trusts similar to credit card ABS. The master trust structure is well suited to these transactions since most of the underlying assets, like assets of credit card ABS, are revolving lines of credit. The structure also allows for easy addition of loans to the trust and ongoing issuance of new securities. The master trust is a bankruptcy remote SPV that owns the collateral or the rights to the cash flow of the collateral or securities linked to the performance of collateral credits. The method of transferring collateral to the SPV determines whether a bank CLO transaction can receive ratings that are independent of the originating bank (i.e., whether true sale treatment is achieved). There are three broad ways to transfer credit risk from the originating banks books to the SPVloan assignment, loan participation, and credit-linked notes. Figure 3 summarizes the various methods of loan transfer. Loan assignment transfers loan ownership to the SPV, which

Figure 3.

Summary of CDO Structures

Secured Participation Participation with first priority security interest Originating bank No NationsBank Commercial Loan Master Trust Credit-Linked Note Unsecured corporate obligation Originating bank Yes SBC Glacier Finance, Ltd.

Assignment Legal Structure Assignment (True sale)

Participation Participation

Lender of Record Ratings Linkage Example Transactions

Securitization entity No Balanced High Yield Fund (BHF)

Originating bank Yes ROSE Funding (NatWest)

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becomes the lender of record. This form of loan transfer always accomplishes true sale and independent ratings for the CLO. Loan assignment is common in traditional bank CDOs with noninvestment grade bank loan collateral. In a loan participation, the originating bank continues to be the lender of record although the economic interest in the loan is sold to the SPV. Only a secured loan participation (one that has a first priority security interest in the underlying loan or the right to the loan cash flows) generally results in a true sale. The third type of credit risk transfer is accomplished through credit-linked notes. These notes are unsecured debt obligations of the issuing bank that are linked to the performance of a specific obligor. If the underlying obligor defaults, losses are passed through to the trust. In the event of the issuers bankruptcy, investors in the CDO become unsecured creditors of the issuing bank, not the underlying credits. Such transactions do not achieve true sale. Transactions backed by creditlinked notes are typically issued by highly rated banks (generally AA-/Aa3 or better). Since true sale is not achieved in all structures, bank CLOs fall into two categoriesdelinked and linked CLOs. Structures with loan assignment or secured loan participations are generally delinked from the rating of the originating institution since they achieve true sale. Linked CLOs have either credit-linked note structures or loan participations that do not achieve true sale. Investors in linked transactions are exposed not only to the risk of collateral deterioration but also to the issuers downgrade or default. The choice of structure depends primarily on the issuers motivations, the country-specific laws on participations and assignments, and the banks loan agreements. Assignments are less common in the case of commercial bank CLOs since such a loan transfer may require that the obligor be notified, which could weaken lender-borrower relationships. Credit enhancement for senior bank CLO tranches is achieved primarily through subordination. Subordination levels for the most senior class have been in the 8%-15% range depending on the average quality of the collateral, its diversification, and the average life of the securities issued (see Section II, Rating Agency Methodology). Unlike a traditional CDO, excess spread in a bank CLO is minimal because the underlying assets are mostly investment grade quality and carry low yields. Additional credit protection may be achieved through cash reserves and early amortization triggers. These triggers are designed to accelerate payments to investors in the event of credit quality deterioration and issuer insolvency. Credit quality is controlled through collateral guidelines such as minimum diversity score, maximum weighted average rating score, maximum weighted average maturity of collateral, and obligor and industry concentration limits (see Figure 4). If these guidelines are not maintained

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Figure 4.

Collateral Guidelines for Example Bank CLOs

SBC Glacier 610 (Baa3) 40 8% 2%*** 51 months NationsBank 1145 (Ba1/Ba2) 70 5% 3% 42 months

Maximum weighted average rating* Minimum diversity score** Industry concentration limits Obligor concentration limits Maximum weighted average maturity

*Weighted average rating score is used by the rating agencies to measure the average credit quality of the underlying assets. See Section II, Rating Agency Methodology. ** Diversity score is a statistic used by Moodys to measure the diversity of a portfolio across industries and regions (for emerging market debt). See Section III on CDOs and Diversification of Credit Risk. *** Declines for each rating category down to 0.25% for B2 rated obligors.

or corrected within a defined time period (typically three months), early amortization is triggered. TRADITIONAL CDOs Insurance companies and money managers issue CDOs to leverage their high yield portfolios. Since these securities can consist of both bonds and loans, we refer to them more generally as collateralized debt obligations (CDOs). CDOs are usually created to exploit differences in credit spreads between investment grade and high yielding fixed income securities, and are sometimes called arbitrage CDOs. For money managers, CDOs create stable fee income, increase assets under management, and lock in funding for a 3- to 7-year term. Traditional CDOs have either cash flow or market value structures. With cash flow CDOs, principal on tranches is repaid using cash generated from repayments on the underlying loans. The primary risk in cash flow CDOs is default risk of the underlying collateral; market value of the collateral is not a direct concern. In market value CDOs, investors are repaid principal from the sale of underlying collateral. The collateral is therefore marked to market periodically. Cash flow CDOs are more commonly issued than market value CDOs. A traditional CDO is issued by an SPV that purchases the underlying assets. Assets can consist of high yield debt, emerging market sovereign/corporate debt, and/or subordinated tranches of structured securities. A specified period (ramp-up window) after the CDO is issued allows the asset manager to build the collateral portfolio gradually. This window is necessary to minimize the risk of adversely affecting the market by requiring the purchase of a large volume of assets at the time of issuance. Cash flow CDOs have a 3- to 5-year reinvestment period. During this time, excess cash flows from the collateral are reinvested in additional collateral rather than distributed to investors. The asset manager may trade a fixed

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percentage (10%-15% per annum) of the pool, providing active portfolio management for equity investors. Selling credit-impaired assets is permitted at all times. After the reinvestment period, cash flows from the collateral are passed through to investors. Cash flows to investors are also subject to call provisions (see below). Unlike the manager of a cash flow CDO, the manager of a market value CDO has the flexibility to reinvest cash flows and trade the collateral portfolio at any time as long as the collateral guidelines are maintained. Since repayment is based on cash flows from the sale of underlying collateral, these structures are not pass-through entities and have bullet/controlled amortization principal repayment. After the reinvestment period, traditional CDOs are usually callable at par by the holder of the equity tranche or the asset manager. Callability provides equity holders the flexibility to redeploy their investments when the CDO vehicle begins to lose leverage as senior tranches are paid down or if the collateral has performed well. Credit enhancement for CDOs is achieved primarily through subordination and excess spread. (Section II discusses how subordination is determined based on collateral quality and diversification.) The sequential-pay structures lead to growth of the relative amounts of subordination once the senior bonds begin to amortize. Excess spread in these transactions is subordinated and is in the 5%-7% range. Excess spread is substantial since the underlying collateral is noninvestment grade, high yielding securities and the CDO tranches are investment grade, lower yielding securities. CDO structures amortize early in the event of collateral credit quality deterioration as defined by collateral guidelines or ratio tests. Collateral guidelines include limits on weighted average rating, diversification, maturity, par value, and rating distribution. Overcollateralization and interest coverage ratio tests protect the structure from collateral deterioration. The overcollateralization test requires that a minimum ratio of par amount of performing collateral to par amount of senior notes be maintained. If this ratio falls below the minimum level, cash flows are diverted from the interest payments to the subordinated notes and to equity to pay down the principal of the senior classes until the ratio is brought into compliance. Similarly, the minimum ratio of interest on collateral to interest on senior notes is mandated. ILLUSTRATIVE TRANSACTIONS To illustrate differences in CDO structures we examine several actual transactions. Figure 5 describes the structure of three bank CLOs and two traditional CDOs. Each of the bank CLOs represents a different type

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Figure 5.

Structural Features and Credit Enhancements for Bank CLOs and Traditional CDOs
Bank CLOs NationsBank SBC Glacier Commercial Loan Finance Secured participation Credit-linked notes No $4.26 bill. (2 series) AAA/Aaa 3- and 5-yr Yes AA+/Aa1 5- and 7-yr 8.25% Baa2, Ba2, B3 5-yr Add/call credit-linked notes Bullet Yes 3(a)2 Yes SBC NatWests ROSE Participation Yes AA/Aa2 0.75- and 5-yr 4% A, BBB NA Static pool* Traditional CDOs Balanced HY Fund (BHF) Amvestors Assignment Assignment No $360 mill. Aaa and Aa2 5.6 yrs 22.5% Aa2, Baa3 3-yr 20% trading flexibility Amortizing 3-yr noncall 144A Yes BHF Bank Aktiengesellschaft No $204 mill. Aa3 7.9 yrs 22% Baa3, B3, Caa 5-yr 15% trading flexibility Amortizing 5-yr noncall 144A/Reg S 25% of issue Salomon Brothers Asset Mgmt.

Type of Structure Ratings Linkage Transaction Size Senior Class Rating Average Life

$1.74 bill. (2 series) $2 bill.

Subordination for most Senior Tranches 7.5%/9% Other Rated Tranches Revolving/ Reinvest. Period Collateral Substitution A2/A, BBB 3-yr Ability to add; sell only credit impaired assets Bullet No 144A 25% of issue NationsBank

Principal Repayment Callability Securities Act ERISA eligibility Servicer (Bank CLOs)/ Asset Mgr. (CDOs)

Amortizing No 144A/Reg S Yes NatWest

* Only with rating agency permission during first 18 months.

of structure. NationsBanks and SBCs transactions have revolving master trusts, and NatWests transaction has a static pool. Subordination levels for static pool transactions are not as high as those for revolving master trusts. NationsBank achieved ratings delinkage and AAA/Aaa ratings for senior classes through a secured participation structure. NationsBanks bullet repayment and delinked ratings resulted in a structure similar to credit card ABS. SBCs Glacier transaction also has a bullet repayment, but because of linked ratings it differs from credit card structures. NatWests ROSE transaction has a less common principal amortizing structure. Although currently the bank CLO market is structurally varied, it is converging to a master trust, delinked bullet repayment structure with 3- and 5-year maturity similar to the NationsBank transaction. The two traditional CDOs in Figure 5 are the Balanced High Yield Fund (BHF) and Amvestors. Although the BHF transaction is backed by loans and managed by a bank, its structure is similar to traditional high yield CDOs. Traditional CDOs are structurally more homogeneous than bank CLOs, but the collateral differs among transactions. Both CDO examples have assignment structures with amortizing principal repayments. The asset manager

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has the flexibility to trade a fixed percentage of the assets. CDO transactions generally have a 3- to 5-year reinvestment and noncall period. Senior tranches can be AAA/Aaa or AA/Aa. For a discussion of valuation differences between various CDOs, see Section IV.

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II. RATING AGENCY METHODOLOGY

In analyzing CDO transactions, rating agencies are primarily concerned that all CDO tranches have risk characteristics consistent with their rating. The riskiness of a particular tranche is controlled by its credit enhancement. In this section we discuss the rating agencies procedures for determining credit enhancement levels. Although their approaches are broadly similar, each agency has its own methodology. In general, the Moodys approach is more quantitative and transparent than that of S&P, Fitch IBCA, and Duff & Phelps. Our discussion focuses on cash flow CDOs, which constitute the majority of the market. Analysis of market value transactions differs from cash flow transactions, and we address some of these differences later in the section. The analysis of CDO tranches can be divided into two main steps (see Figure 6). The first establishes a loss distribution for the collateral. Collateral losses are a function of the credit quality of the underlying debt and the extent of its diversification. Second, collateral losses are used in a cash flow model to determine the required credit protection level for the CDO tranche. Credit protection is determined primarily by the subordination level and secondarily by early amortization triggers, collateral and excess spread ratio tests, collateral guidelines, and portfolio trading restrictions. The agencies determine the level of tranche credit protection so that the expected loss of a rated tranche matches a target expected loss corresponding to the desired rating class. For example, Moodys requires that a Aaa CDO tranche with a 6-year maturity have an expected loss of 0.002%, the historical Aaa loss rate. CREDIT ANALYSIS OF THE UNDERLYING PORTFOLIO In determining the adequacy of credit enhancement levels for CDO tranches, the rating agencies first assess the credit quality of the underlying pool. Pool credit quality depends on the ratings of the underlying debt and the extent of its diversification across industries and obligors. The agencies start with a nonhomogeneous portfolio of securities and arrive at summary measures of the credit quality. Differences in collateral typessenior or subordinated bonds, loans, or other fixed income securitiesare accounted for by differences in default rate, recovery assumptions, and average life.
Weighted Average Credit Rating of Collateral

The weighted average rating of the collateral is the single rating that best summarizes the portfolios credit risk. It is computed using the ratings of the individual obligations in the portfolio. The rating of each obligation is matched to a numerical weighting factor, which reflects the historical default rates of the corresponding rating class. Figure 7 shows the mapping from rating classes to weighting factors used by Moodys. The historical default rates, and therefore weighting factors, increase faster than

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Figure 6.

CDO Rating Process Summary

Collateral Wgt Avg Credit Rating

Collateral Diversity Score

Default Rate

Desired Issued Securities Rating

Collateral Recovery Rate

Apply Default and Recovery to Collateral Cash Flow

Run Collateral Cash Flow through Deal Structure

Determine Credit Enhancement Levels

Figure 7.
Factors

Rating Factors for Computing Weighted Average Credit Rating

Default Rates (%)

7000 6000 5000 4000 3000 2000 1000 0 Aaa Aa2 A2 Baa2 Ba2 B2 Caa2 Historical One-year Default Probabilities* Moodys Factors

21 18 15 12 9 6 3 0

Source: Moodys Investors Service, Historical Default Rates of Corporate Bond Issuers, 1920-97.

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proportionally as ratings fall. The portfolios weighted average rating is found by multiplying the rating factor of each obligation by its portfolio percentage value and adding the results. This produces a numerical score for the portfolio, which is matched to a letter rating using the inverse of the same mapping scale. The portfolios weighted average rating is used to attribute the same default probability to each loan in the collateral. For example, if the weighted average rating of the collateral is Ba, then the default probability on each independent loan obligation is assumed to be the historical average default probability of Ba rated debt (e.g., 15% for 8-year maturity bonds from Moodys default study). Unrated obligations in the underlying portfolio are assigned ratings based on one of the following approaches. The agency can impute ratings from other rated obligations of the obligor or from a rated parent. In the absence of public ratings, the agencies may either issue shadow ratings based on three years of financial data of the obligor or assign a rating of CCC to the obligor. Another approach, commonly used in evaluating pools backed by bank loans, involves correlating the lenders internal rating scale with the rating agencys scale. Under this methodology the rating agencies evaluate the internal rating process of the lending institution and compare the banks internal rating with their own for obligors rated by both. Agencies also review the banks historical default and recovery rates for obligors within each rating category. Rating agencies may use statistical regression analysis to establish a ratings matrix through which the banks internal rating can be mapped to the external rating. The mapping is generally conservative. For example, if an internal rating score maps to both AA and A for different borrowers, the agencies will generally use A as the mapped rating. After establishing the base-case collateral default probability, the rating agencies adjust it to reflect the rating being sought for the tranche. Rating agencies make conservative default assumptions in rating senior CDO tranches of transactions backed by high yield securities. Default probabilities are multiplied by stress factors to obtain stress case1 default assumptions for each CDO tranche (see Figure 8). For example, S&P assumes default probabilities 2.5 times higher than historical defaults for rating a AAA/Aaa CDO tranche. Figure 9 compares the AAA/Aaa stress case default assumptions used by Fitch with historical 10-year cumulative corporate default rates. Fitchs default assumption is 67.2% for rating a CDO tranche AAA/Aaa with an underlying pool that has a weighted average rating of B. This rate is conservative in comparison to historical defaults for B rated bonds. The rate is twice the default rate of Edward Altmans2 studies and 1.5 times that of Moodys studies.
1 Stress cases are extreme default assumptions that rating agencies make to determine the amount of credit enhancement required for a desired rating of a CDO tranche. 2 Corporate Bond and Commercial Loan Portfolio Analysis, September 1996.

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Figure 8.

S&Ps Stress Case Default Levels

Desired CDO Rating AAA AAA AA A BBB BB S&P Default Stress Levels 2.50x 2.50x 2.00x 1.50x 1.25x 1.00x

Figure 9.

Comparison of Fitch 10-year Cumulative Default Assumptions with Historical Default Rates, in %
Default Assumptions for a AAA Rated CDO Tranche 1.3 1.3 2.3 5.0 14.0 54.3 67.2 Historical 10-year Default Rates Probability of Default Altmans* Moodys Bond Study Study Ratings (1971-1994) (1970-1997) AAA AAA AA A BBB BB B 0.08 0.08 1.30 0.98 3.66 15.21 35.91 0.82 0.82 1.07 1.65 4.53 20.88 43.85

Weighted Average Rating of Underlying Collateral AAA AAA AA A BBB BB B

*See footnote 2, page 15 above.

Diversification

In addition to the weighted average rating, the other important consideration for assessing the credit risk of the collateral portfolio is diversification. Diversification across industries improves credit quality since defaults of companies within an industry tend to be positively correlated. The more diversified a pool of obligations across industries, the less the required credit enhancement for a specific rating. Rating agencies measure diversification differently. Moodys adopts an explicit mathematical formula and computes a diversity score. (Section III, CDOs and the Diversification of Credit Risk discusses the impact of diversification on credit risk and explains Moodys Diversity Score and the binomial expansion method.) For a given level of credit enhancement, the higher the diversity score, the lower the expected losses on the most senior CDO tranche. Although the other agencies do not use an explicit diversity score to assign probabilities to collateral losses, they assume higher default risk on less diversified pools. For example, S&P requires higher levels of credit enhancement for industry concentrations greater than 8% (4% for Fitch, 5% for DCR), and obligor concentrations over 12% (10% for Fitch, 3% for DCR). For emerging markets collateral, rating agencies also specify regional concentration limits. While diversification in general is viewed positively, Fitch penalizes diversification beyond the managers expertise in specific industries or asset types.

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Recovery Rates

Recovery rates on defaulted debt determine the severity of defaults on cash flows. Recovery rates along with default probabilities determine the loss rates of the underlying collateral. The agencies base their recovery assumptions on the historical performance of corporate debt. Senior secured bank loans are assumed to have the highest recovery rates followed by senior secured bonds, and subordinated debt has the lowest recoveries (see Figure 10). STRUCTURAL AND CASH FLOW ISSUES After establishing the credit quality, diversification, and recovery rates of the pool to determine the distribution of collateral losses, the rating agencies use a cash flow model of the transaction to simulate the effect of default and recovery scenarios on the tranches. At this stage of the rating process the impact of cash flow provisions such as excess spread, reserve accounts, and early amortization triggers is evaluated. The average life of the collateral also affects the cumulative defaults that the structure is subjected to. Thus shorter average life debt will be subject to lower default stress tests than comparably rated, longer maturity corporate debt. The collateral portfolio credit analysis provides the base-case default probability and recovery assumptions for the simulations. To measure the robustness of the CDO structure, the agencies vary default and recovery timing assumptions in combination with different interest rate scenarios.
Early Amortization

Rating agencies set minimum collateral guidelines or overcollateralization tests that the collateral pool must meet. Failure to adhere to these guidelines results in the unwinding of the transactionan early amortization event. These guidelines are incorporated in the cash flow model while evaluating the risk of the CDO tranches. The stronger the guidelines, the lower the expected losses on senior tranches.
Figure 10. Recovery Assumptions and Historical Recovery Rates, in %
Historical Recoveries from Moodys Default Studies Average Std. Dev. 71 21 71 22 56 24 51 26 33 22

U.S. Debt Senior Secured Bank Loans Senior Secured Bank Loans Senior Secured Bonds Senior Unsecured Debt Subordinated Debt Emerging Market Sovereign Sovereign Corporate

Recovery Assumptions Moodys S&P Fitch DCR 50 50-60 60 60 50 50-60 60 60 50 40-55 60 50 30 25-50 45 40 15-20 15-28 25 30 S&P 25 25 15

Moodys Min. (25% of Par, 30% Market Value) Min. (25% of Par, 30% Market Value) Min. (10% of Par, 15% Market Value)

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Average Life and Type of Collateral

Bank CLOs are usually backed by revolving loans with 4- to 5-year final maturity, while traditional CDOs are backed by term debt with 7- to 10-year maturity. The shorter average life of the bank CLO collateral leads to lower required subordination than traditional CDOs. In the event of an early amortization, a senior investor in a bank CLO is repaid sooner than a senior investor in a traditional CDO. This is because draws on revolving lines of credit that make up bank CLO collateral are repaid on an ongoing basis and new draws are not sold into the master trust if an early amortization has been triggered. By contrast, term debt backing traditional CDOs is repaid only at maturity. CDO investors would need to wait until sufficient cash flows were generated by the collateral to be repaid fully.
Timing of Defaults

For the base case cash flow model, scenario defaults are generally assumed to be front-loaded. This is a conservative assumption since early defaults have a greater impact on cash flows than late ones. For example, Moodys and DCR assume 50% of defaults occur in the first year and the balance is equally spread over the next five years. Fitch assumes that 58% of defaults occur in the first two years and the balance over the next three years. For stress scenarios, the agencies change the default timing assumptions. For example, Moodys runs five scenarios where 50% of defaults occur in one of years two through six and the balance occur equally in each of the other five years. In each of the default scenarios, Moodys analyzes cash flows for five different interest rate scenarios (presumed to be a range spanning +/-2 standard deviations from the current yield curve).
Timing of Recoveries

Recovery timing assumptions also affect the timing of cash flows of the collateral. The type of collateral determines the recovery time. For example, the market for distressed domestic bonds is fairly liquid and these recoveries are assumed to take place immediately. By contrast, loans are less liquid and a longer workout period is assumed. Cash flow model simulations produce expected losses for all the CDO tranches. Credit enhancement levels (including subordination and early amortization triggers) are adjusted until the expected loss of each tranche matches the target value. Figure 11 shows the targets used by Moodys. The structure may be adjusted further to account for risks not quantified by the cash flow model. OTHER RATING CONSIDERATIONS
Prefunding Risk

Traditional CDO managers usually purchase at least some of the collateral in the market following issuance. The rating agencies take into account the

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Figure 11.

Moodys Target Expected Loss

Desired Rating for CDO Tranche Aaa Aa2 A2 Baa2 Ba2 B2
*For a 6-year maturity.

Target Expected Loss* (%) 0.002 0.049 0.320 1.080 5.370 12.450

credit and price sensitivity of the collateral to be purchased and impose restrictions on minimum diversity score or industry and obligor concentrations, weighted average coupon, and minimum weighted average ratings for the pool. The agencies also account for possible negative carry in the event that there is a lag in purchasing assets and the cash earns interest at lower rates than the coupon on the CDO tranches.
Considerations for Market Value Transactions

The approach for assessing risk in market value transactions is different from cash flow transactions. Price volatility of underlying assets determines the credit risk of market value CDOs. The prices of the underlying loans/bonds are assumed to reflect credit risk and hence no explicit credit rating process is undertaken. Instead, rating agencies assess the volatility of returns for each asset type and determine an advance rate. An advance rate, like an overcollateralization rate, is the amount of debt that can be issued against a certain type of asset as collateral. The advance rate is determined for each asset in the pool separately. It is computed based on the mean and standard deviation of prices of the asset for a given period. The advance rate reflects the liquidity of the asset, its sensitivity to interest rates, and its credit quality. For example, advance rates on high grade corporate bonds/loans are significantly higher than advance rates on high yield or emerging market debt, i.e., the better the credit quality, the higher the potential leverage. Stress scenarios for these transactions are based on significant market declines and interest rate changes.
Quality of the Asset Manager/Lending Institution

The quality of the manager or lending institution is critical to evaluating CDO transactions with trading flexibility. The manager chooses and manages the collateral pool. Rating agencies evaluate the managers experience, objectives, and capabilities.
Ongoing Credit Controls and Monitoring

The rating agencies impose restrictions on minimum diversity score, weighted average coupon, and minimum weighted average ratings on a cash flow CDO manager/bank (for master trust CLOs). A market value manager,

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however, has more discretion to trade the portfolio. In both cases, trading for credit-driven events (i.e., downgrades) is permitted. ILLUSTRATIVE TRANSACTIONS We discuss some rating considerations for two CDO transactions. First is the NationsBank CLO, which has set the standard for bank CLOs. Second is the Balanced High Yield Fund (BHF), an example of a traditional high yield CDO structure. Figure 12 summarizes the rating information and resulting subordination for the tranches. The subordination of the Aaa class of NationsBank is less than 10% while the subordination of the BHF Aaa and Aa2 classes is more than 22%. This difference can be attributed to several differences between the transactions. First, the NationsBank collateral is of higher quality. The Moodys historical average Ba1 3-year default rate is 4.4%, while the B2 8-year historical default rate is 47.5%. Rating agencies impose more stringent stress requirements for the Aaa classes of transactions backed by lower rated collateral. Second, the NationsBank portfolio is much larger and better diversified. The diversity score of BHF is half that of NationsBank. Finally, the average life of the collateral used in the BHF managed CDO is longer than that of the CLO issued by NationsBank.

Figure 12.

Collateral Guidelines and Enhancement Levels for Illustrative CDOs

NationsBank* 1145 (Ba1-Ba2) 70 3.5 years Aaa 3 and 5 years 7.5% and 9% BHF 2650 (B1-B2) 35 8.38 years Aaa and Aa2 5.6 years 22.5%

Weighted average rating Moodys Diversity Score Weighted average life of collateral A class (most senior) rating A class (most senior) maturity A class (most senior) subordination

*Within each rating class there are two series, distinguished by average life.

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III. CDOs AND DIVERSIFICATION OF CREDIT RISK

For a CDO, the level of diversification of the collateral portfolio is a major determinant of risk. A portfolio consisting of a few bonds is needlessly risky, but by combining many bonds together the default risk of individual bonds is diversified and the risk per dollar invested is reduced. Because bonds in one industry tend to default when that industry is contracting or during economywide recessions, defaults in a portfolio are often correlated.3 This section discusses the effect of diversification on the risk of CDOs and the impact of default correlation on diversification.
CDOs with Independent Defaults

Senior CDO tranches are protected from collateral losses up to the subordination level of the transaction. The first several defaults are absorbed by the equity and mezzanine tranches. However, a high number of defaults in the collateral portfolio may cause the senior tranche of a CDO to experience losses. An example will illustrate how diversification decreases the risk of large dollar losses in the portfolio and protects the senior tranche. In a sample CDO structure, the underlying bond portfolio consists of 20 similar zero coupon bonds with independent defaults. Each bond has a default probability of 15% and a recovery rate of 50%. The 15% default rate approximates an 8-year cumulative historical default rate on Ba collateral. The size of the senior tranche is 80% of the collateral. Subordination protects the cash flows to the senior tranche if the collateral portfolio loss is less than 20%. The mezzanine tranche is 15% of the collateral, while the equity is 5%.4 The possible default scenarios in the example portfolio include 0 defaults, 1 default, 2 defaults, and so on to 20 defaults. The binomial distribution gives the probability of each default scenario.5 Using these probabilities and the assumed subordination level, we calculate the expected loss of the senior tranche and its standard deviation. The expected loss of the senior tranche for this CDO structure is 0.005% and the standard deviation of losses is 0.15%. The expected losses on the mezzanine and equity tranches are 20.2% and 89.3%, respectively, and the standard deviations are 22.1% and 24.8%. Increasing the number of bonds in the portfolio decreases the expected senior tranche loss by decreasing the standard deviation of collateral losses. To keep the investment dollar amount constant, the par amount of each bond declines as the number of bonds in the portfolio increases. Figure 13 shows
Formally, two bonds have correlated defaults if Prob {bond 1 defaults & bond 2 defaults} > Prob {bond 1 defaults} Prob {bond 2 defaults} . 4 The examples omit some features of real transactions, such as excess spread and early amortization triggers. 5 The distribution of a random variable (in this case the number of defaults in a portfolio) associates all the possible outcomes with corresponding probabilities.
3

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Figure 13.
Probability

Sensitivity of Collateral Loss Distribution to Number of Independent Bonds

0.10 20 bonds 40 bonds 60 bonds

0.08

0.06

0.04

0.02

0.00 0 5 10 15 20 25 30 35 40 45 50
Collateral Loss Value (%)

the probability distribution of collateral losses for portfolios containing 20, 40, and 60 bonds. Increasing the number of bonds does not affect the average collateral loss but decreases its standard deviation. The size of the CDO tranches remains at 80%, 15%, and 5% of the collateral for all cases. Figure 14 shows the effect of increasing the number of bonds on the expected losses and the standard deviation of losses for the collateral and the three CDO tranches. As the number of bonds increases, expected portfolio losses remain the same while the standard deviation of portfolio losses falls. With many bonds the probability of large collateral losses is low. Since the senior tranche experiences losses only in high default scenarios, the expected senior tranche loss is essentially zero when the collateral portfolio contains many bonds. The expected losses of the mezzanine tranche decrease as well. However, expected losses on the equity tranche increase as the number of bonds is increased. Intuitively, this occurs because the probability of at least one bond defaulting increases as the number of bonds increases. Another way to analyze the trade-off between the number of bonds in the portfolio and the subordination level in CDOs is to match target expected senior and mezzanine tranche losses. Figure 15 shows the required subordination level for the senior and mezzanine tranches when the target expected losses are 0.002% and 1.5%, respectively. These are the approximate expected loss targets determined by Moodys for the Aaa and Baa ratings. The equity tranche is the remainder of the portfolio after the senior and mezzanine tranches are determined. Increasing the number of bonds

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Figure 14.
No. of Bonds in Portfolio 20 40 60

Diversification and Tranche Losses

Expected Portfolio Losses 7.5% 7.5 7.5 Stand. Dev. of Portfolio Expected Losses (%) Losses Sr. Tranche Mezzanine Equity 3.99 0.005 20.2 89.3 2.82 0.000 18.3 95.2 2.30 0.000 17.6 97.4 Sr. Tranche Losses 0.15 0.01 0.00 Standard Deviation Mezzanine Equity Tranche Losses Losses 22.1 24.8 16.6 13.9 14.0 9.2

Expected tranche losses are computed by weighting the tranche loss (for a given portfolio loss) by the corresponding probability and adding. Standard deviations are the square roots of the probability-weighted squared deviations of tranche losses from their mean.

Figure 15.

Required Subordination for Senior and Mezzanine Tranches

No. of Bonds in Portfolio 20 40 60 Subordination as % of Collateral * Senior Tranche Mezzanine Tranche 21.9 14.4 16.8 12.5 14.8 11.5

*The subordination levels shown correspond to a simplified CDO structure and are intended to illustrate the sensitivity of subordination levels to the number of independent bonds in the underlying portfolio.

from 20 to 40 allows the senior tranche subordination to decrease by about one-third. In practice the subordination levels in a CDO are chosen so that the expected losses of rated tranches precisely match their targets. The exact number of independent bonds in the portfolio is an essential piece of information for structuring the transaction.
Default Correlation Weakens Diversification

Bonds have positive default correlation if the probability that they would default together is greater than the product of their individual default probabilities. Positive correlation between bond defaults in the underlying collateral portfolio weakens diversification and increases the probability of senior tranche losses. The effect of default correlation on the riskiness of the senior tranche is demonstrated in Figure 16, where the distribution of losses is shown for a portfolio of 30 bonds (each with 15% default probability and 50% recovery assumption) under four default correlation assumptions: 0%, 5%, 10%, and 15%. Positive default correlation has no effect on average portfolio losses but increases the standard deviation.6 Higher standard deviation of portfolio losses raises the probability of extreme default scenarios and therefore of senior tranche losses. Measuring diversification
6 The

distributions are found by Monte Carlo simulation.

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when bond defaults are correlated is not easy. Moodys method of measuring diversification along with its Diversity Score table are presented in the accompanying box.

Figure 16.
Probability (%)

Sensitivity of Default Distribution to Default Correlation

30 bond portfolio (15% default probability, 50% recovery assumption)

30

25 correlation = 0% correlation = 5% correlation = 10% correlation = 15%

20

15

10

0 0 5 10 15 20 25 30

Number of Defaulted Bonds

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Moodys Diversity Score The expected loss of a CDO tranche is a central concept in the Moodys rating process. To calculate the expected tranche loss, the probabilities of collateral default scenarios must first be derived. When bonds in the collateral portfolio have correlated defaults, there is no simple expression for the probability of default scenarios. Moodys reasons that since both a decrease in the number of independent bonds in a portfolio and an increase in default correlation produce higher standard deviation, a portfolio of correlated bonds can be approximated by a smaller portfolio of independent bonds. The question is how to find the right number of independent bonds to approximate the loss distribution of the original portfolio. For a portfolio of bonds with correlated defaults, Moodys Diversity Score D is the number of similar, hypothetical bonds with independent defaults such that the loss distribution of a portfolio of these bonds approximates the loss distribution of the original portfolio. The loss distribution of the hypothetical bonds is the binomial with D independent bonds. For example, the original portfolio of 60 correlated bonds may have a Diversity Score of 35. That means that the probability of, say, 20 defaults in the original portfolio is equal to the probability of 20 defaults in a portfolio of 35 independent bonds. Moodys provides a method of converting the number of correlated bonds in the original portfolio into the corresponding Diversity Score. The underlying CDO portfolio is first sorted into industries defined by the Moodys Structured Finance Group. The number of bonds in each industry is matched to the equivalent number of independent bonds using the Diversity Score table. This table is constructed by Moodys using a proprietary method under the assumption that the intra-industry default correlation in the original portfolio is 30% and the inter-industry default correlation is zero. The total Diversity Score for the

portfolio is found by adding the industry Diversity Scores. The portfolio Diversity Score is used in the binomial expansion method (BET) to calculate the probability of default scenarios and evaluate the riskiness of CDOs.* The Moodys Diversity Score depends on the number of industries represented in the portfolio. The assumption that only bonds in the same industry have positive default correlation means that a portfolio with many Moodys industry groups will have a higher Diversity Score than a portfolio with the same number of bonds but fewer industries. The figure below shows how the portfolio Diversity Score varies with the number of represented industries. The number of bonds is held constant at 100. The Diversity Score increases from 28 to 66 as the number of industries increases from 6 to 33. The implication is that a relatively low level of subordination in a CDO is adequate for a portfolio containing bonds of many industries.
* Moodys Investors Service, Structured Finance Special Report, The Binomial Expansion Method Applied to CBO/CLO Analysis, 1996.

Moodys Diversity Score versus Number of Industries for a 100 Bond Portfolio
Score 75

65 55 45 35 25 6 9 12 15 18 21 24 27 30 33
Number of Industries

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IV. ASSESSING VALUE IN CDOs

CDOs offer an efficient way to invest in a well diversified portfolio of loans and/or bonds. By choosing among senior, mezzanine, and equity classes, an investor can select a level of exposure to the risk represented by the collateral. At every risk level, from AAA/Aaa bonds to first loss equity tranches, CDOs currently offer value over comparable investments. CDO tranches are attractive to many types of investors including traditional ABS, investment grade, and high yield bond investors. For traditional ABS investors, who are typically exposed to consumer credit risk, senior CDO tranches offer portfolio diversification. Mezzanine tranches of CDOs are currently attractive because they offer wider spreads than comparably rated high yield securities. By investing in equity tranches, high risk investors such as LBO funds, insurance companies, bond insurers, and high net worth individuals can take leveraged positions in the collateral and in the skill of the manager. VALUATION CONSIDERATIONS WITHIN THE CDO MARKET AAA/Aaa tranches of CDOs have priced and traded at significantly different levels. Since rating agencies assign ratings to CDO tranches corresponding to their risk characteristics, securities with the same rating should theoretically trade at similar spreads. We analyze valuation differences of bank CLOs with the same rating, and traditional CDOs and bank CLOs with the same rating.
Factors behind Tiering in Bank CLOs

Significant tiering is evident in the bank CLO market with some transactions trading as much as 10-13 bp wider than other comparably rated CLO securities. Variables such as ratings linkage, information disclosure, and domicile country of the issuing bank have influenced spreads on these securities.
Ratings Linkage

Delinked CLO structures are similar to other ABS. The senior tranches of these bonds are rated AAA/Aaa and appeal to ABS investors. We expect the market for delinked senior CLOs to become similar to the credit card market in size, liquidity, and structural homogeneity. Linked CLOs are structured so that the rating of the most senior bonds is capped at the rating of the issuer. Bank CLOs that are linked to the issuers rating have initially priced 2-4 bp wider than delinked CLOs. However, with increasing concerns about issuing banks exposure to Asia, these securities are now trading 8-10 bp wider than delinked transactions. In evaluating these

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structures, it is important to monitor the credit quality of the bank that is issuing the bonds. Ratings of senior classes of linked CLOs move with the rating of the issuer. However, the linkage is usually in only one direction. If the issuer is downgraded, the CLO will always be downgraded; CLOs have upgrade potential (in the case of an issuers upgrade) only if their credit enhancement levels correspond to the higher rating. Although all linked transactions to date have been rated AA/ Aa, their ratings, which are based on the issuers rating, differ slightly (e.g., Glaciers senior class is rated AA+/Aa1 while ROSEs senior class is AA/ Aa2). This makes for less homogeneity in the product and reduces liquidity. Some ABS investors may be less willing to invest in these securities because of their rating links or because the investors are limited to purchasing AAA/Aaa securities. This reluctance results in a liquidity penalty for linked bonds.
Information Disclosure

Client relationships and competitive and legal issues generally result in nondisclosure of the underlying obligors in bank CLOs. Investors in senior tranches are often concerned about nondisclosure since CLO pools, unlike typical consumer pools, have obligor-specific credit risk and less actuarial predictability. Investors in lower rated tranches generally receive more collateral information upon executing confidentiality agreements. For senior investors, nondisclosure is mitigated primarily by strict collateral guidelines and ongoing disclosure of collateral performance. The guidelines generally mandate minimum collateral quality requirements. The trustee of the transaction monitors guideline compliance. However, varying amounts of disclosure influence the value of CLOs. For example, NationsBank Commercial Loan Master Trust disclosed significant information about the collateral before and after issuance. The quality of this collateral information led to tighter spreads than on some other transactions.
Japanese Name Premium

Driven by regulatory capital considerations, Japanese banks are active issuers of CLOs. Due to the recent deterioration in the Japanese economy and financial system, Japanese bank CLOs have offered an 8-11 bp premium over comparably rated U.S. bank CLOs. If the collateral contains loans to Japanese entities, a spread premium may be justified. However, if the collateral contains only U.S./European commercial and industrial loans, any additional risk arises only from the quality of the loan underwriting and servicing process. This risk is minimal for transactions backed by syndicated loans, where a group of banks (including U.S. and European banks) participate jointly in a loan transaction. Servicing risk is also mitigated by back-up servicers and provisions to prevent commingling risk.

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Other structural differences such as ERISA eligibility, callability, currency risk, collateral guidelines, and amortizing versus bullet repayment result in minor spread differences.
Why Do AAA/Aaa Tranches of Traditional CDOs Trade Wider than AAA/Aaa Tranches of Bank CLOs?

We analyze these two market segments to understand the spread difference between AAA/Aaa traditional CDOs and AAA/Aaa bank CLOs (see Figure 17). Liquidity and structural differences between the two market segments are the primary reasons for the spread differences. The bank CLO market is significantly more liquid than the traditional CDO market. Liquidity differences between AAA/Aaa tranches of bank CLOs and traditional CDOs are due to transaction size, investor segmentation, number of agencies rating the transaction, and number of broker-dealers participating in the deal. Like credit card ABS transactions, bank CLO transactions are expected to be ongoing capital issuance programs and are usually over $1 billion in size. While some issuers such as Alliance Capital have issued several CDOs, traditional CDOs are still viewed by the market as intermittent capital-raising activities. Issuance sizes of traditional money manager CDOs have ranged from $200 million to $1 billion. Unlike traditional CDOs, bank CLOs have received significant sponsorship from floating rate ABS buyersan extensive investor base. The structural similarity (such as bullet repayment, short average lives and legal final maturities, and master trust structures) of bank CLOs and credit cards has played a significant role

Figure 17.
Collateral type

Differences between Bank CLOs and Traditional CDOs

Typical Bank CLOs BBB-BB quality commercial and industrial loans 2 AAA (delinked)/AA (linked) $1-$4 bill. 8%-15% 35 to 70 Bullet/Controlled amortization 3-, 5-, and 7-yrs Typical Traditional CDOs B quality high yield debt and emerging market sovereign and corporate debt 1 AAA or AA $200 mill.-$1 bill. 45%-50% (AAA), 20%-25% (AA) 25 to 35 Variable after noncall period 5.5- and 7-yrs

Number of ratings Ratings of senior classes Size of deal Subordination levels Diversity score Principal repayment Typical average lives Spread over 3-mo. LIBOR for AAA tranches (5/31/98) ERISA eligibility Number of syndicate participants Callability

7-21 bp less than 100% 3-10 Varies between transactions

25-30 bp 100% 1-2 Yes (3- to 5-yr call)

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in stimulating ABS investor interest. In addition, ABS investors are generally more comfortable with the higher quality collateral of bank CLOs. The single rating of traditional CDOs has also limited the buyer base since some conventional ABS investors cannot purchase securities that carry only one rating. The trend is toward obtaining two ratings for traditional CDOs to broaden the investor base. Structural characteristics such as principal variability and callability justifiably lead traditional CDOs to trade at wider spreads than bank CLOs. In traditional CDO transactions, the issuer/equity holder has the option to call the senior classes, generally at par plus accrued interest, after the reinvestment period of 3-5 years. The call option is in the money when the collateral has performed well (spreads on the collateral have tightened), and equity holders have an incentive either to realize returns or replace the funding source with cheaper financing. Another motivation for the equity holder to call the deal is decreased leverage. As the senior tranches pay down, the amount of leverage on the equity investment falls, making it less attractive. Equity investors may seek to redeploy their capital on a leveraged basis in a new structure. From the perspective of a senior/mezzanine bondholder, the more the collateral has deteriorated the lower the likelihood of the bonds being called. Since most CDOs are floating rate securities, interest rate exposure is low. However, investors in senior/mezzanine tranches are exposed to reinvestment risk in an environment of tight credit spreads. An improvement in collateral performance (reflected in tightening corporate spreads or low defaults) should normally lead to spread tightening for senior/mezzanine CDO tranches. However, this tightening effect may be offset by a widening effect due to the increased callability of the CDO tranches in a tighter credit spread environment. Another distinction between the two market segments is the trading flexibility available to the asset manager of a traditional CDO, generally leading to a spread premium on these securities. In bank CLOs, the issuing bank has the flexibility to sell credit-impaired assets from the trust and add assets to increase the master trust, but it does not actively make portfolio decisions. Depending on the managers reputation, trading flexibility can cause wider or tighter spreads.
Model Risk: Why All AAA/Aaa Tranches of CDOs Do Not Trade Alike

Structural and liquidity differences between traditional CDOs and bank CLOs alone cannot explain the spread difference between their senior tranches. Model risk also contributes to the spread premium on the overall CDO asset class in general and traditional CDOs in particular. Model risk reflects investors skepticism about assumptions for collateral default and

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recovery rates as well as the extent of portfolio diversification. The extent of model risk depends on the type of collateral. CDOs issued to date have been backed by various collateral including U.S./European investment grade and higher quality noninvestment grade (e.g., Ba quality) loans, U.S. high yield bonds, and emerging market sovereign and corporate debt. Default and recovery rate uncertainty varies with collateral quality and amount of historical data available on the performance of the collateral. Since bank CLOs on average consist of high Ba collateral and traditional CDOs consist of B collateral, we examine default rates on Ba and B bonds. Available data on investment grade corporate debt indicate that historical default rates have been extremely low. Even at the peak of the last recession when corporate defaults were a major concern, annual Ba default rates were less than 5.3%. In contrast, B corporate bonds have experienced not only higher default rates (peaking at 16.1% in 1990) but also more default rate volatility (5.0% for B bonds versus 1.4% for Ba bonds over the period 1970-1997).7 Defaults on emerging markets collateral are particularly difficult to gauge given the paucity of historical information. As a result CDOs backed by emerging markets debt have wider spreads than other CDOs. Collateral diversification decreases the risk of the collateral pool. However, uncertainty about measures of collateral diversification is another issue that CDO investors face. Collateral diversification depends on default correlation in the portfolio (see Section III). Default correlation is difficult to measure and may be unstable over time. CDO subordination levels depend on diversification as measured by the rating agencies. Pricing of CDO tranches likely incorporates a premium for the model risk associated with rating agency diversification measures such as Moodys Diversity Score. The impact of possible inaccuracy in measuring diversification is more apparent in traditional CDOs, which generally have a smaller number of borrowers than bank CLOs. Finding accurate measures for diversification of the collateral could uncover relative value among existing CDOs. Although present in other ABS such as credit cards, model risk is not as significant in ABS as in CDOs. Large pools of consumer loans lend themselves to actuarial default analysis and forecasting better than the less homogeneous and smaller corporate pools. To compensate for model error, the rating agencies appear to be more conservative in sizing subordination levels for CDOs than for structurally similar consumer credit ABS. For this reason, we argue that any spread differential between AAA/Aaa tranches of CDOs and comparable ABS should not be driven by model risk.
7

Moodys, Historical Default Rates of Corporate Bond Issuers, 1920-1997.

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RELATIVE VALUE OF CDOs VERSUS COMPARABLE SECURITIES

Senior and Mezzanine CDO Tranches

Senior tranches of CLOs are generally rated AAA/Aaa or AA/Aa and represent high credit quality, liquid securities that are good ABS substitutes. Currently, benchmark CLOs incorporate a new asset class premium. Delinked bank CLOs backed by investment grade collateral are comparable in structure and credit protection to credit card ABS. Both types of securities typically have master trust structures and bullet/controlled amortization repayments. The collateral quality of bank CLOs is generally better than that of credit cards, and both types of collateral are highly diversified (see Figure 18). With typical tranche sizes of $500 million-$1 billion and significant issuance volume, delinked CLOs are likely to become as liquid as credit cards. As structures converge and the CLO market grows, these securities should trade at spreads similar to credit card ABS. At spreads 2-4 bp wider than credit cards, these securities offer relative value. Deviation from benchmark transaction characteristics such as ratings linkage, Japanese headline risk, and structural variation, result in an additional 2-10 bp spread premium. Spreads on CDOs backed by high yield collateral (traditional CDOs) are significantly wider than those on CDOs backed by high grade collateral (bank CLOs) and structurally comparable ABS floaters (such as home equity loan ARMs). By accepting some reduction in liquidity, investors can find value in traditional CDOs. The lower liquidity of traditional CDOs and less sponsorship from ABS investors causes these transactions to trade at wider spreads.

Figure 18.

CDOs versus Comparable Floating Rate Investments

Collateral Quality Medium-High Low-Medium Low-Medium Medium Low-Medium Cash Flow Stability High High Low Low High

a) Security Features Security Type Bank CLOs Credit Card ABS CDOs (High Yield/EMG) HEL (LIBOR ARMs) CMBS Diversity High Very High Medium Very High Medium Window Bullet1-year Bullet1-year 3-10 years 6-7 years Bullet/2- 5 yr window

b) Bid Side Spreads over 3-mo. LIBOR, bp (5/31/98) Spread 5-yr 10 17 7 25 45 NA 27 40

Security Type Bank CLOs Credit Card ABS Traditional CDOs HEL (LIBOR ARMs) CMBS

Rating AAA (delinked) AA (linked) AAA AAA AA AAA AAA AA

3-yr 7 NA 4 NA NA 17 22 35

7-yr NA 21 10 30 55 NA NA NA

10-yr NA NA 15 NA NA NA NA NA

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Principal variability and callability of traditional CDOs also accounts for some of the spread differential. A parallel in the ABS market is the 11-15 bp spread premium that wide window, variable principal AAA/Aaa HEL ARMs command over bullet repayment AAA/Aaa credit cards. Another potential source of spread difference is investor concern that the subordination levels in traditional CDOs may not protect against extreme credit quality deterioration since the quality of collateral is lower than that of bank CLOs. This perception is even stronger when the collateral consists of emerging markets debt; senior tranches of these types of CDOs trade 5-15 bp wider than senior tranches with high yield-backed collateral. The conservative subordination levels on senior tranches of traditional high yield CDOs mitigate this risk. Mezzanine classes (generally rated BBB) offer value over substitute investments for investors less sensitive to liquidity concerns. Figure 19 shows spreads on mezzanine classes compared to other floating rate ABS. Mezzanine tranches will experience losses before the senior tranche if defaults are very high. Mezzanine tranches, particularly those backed by high yield collateral, are more sensitive to model risk than senior tranches. Given the wider spreads on CDO mezzanine tranches versus comparably rated securities, investors are compensated for assuming more model risk. For example, bank CLOs trade 10-15 bp wider and traditional CDOs trade 40-80 bp wider (depending on type of collateral) than comparably rated credit card ABS. Compared to commercial MBS, which also have more model risk than consumer ABS, mezzanine CLOs offer a 5-10 bp spread pick-up.
Equity Tranches of CDOs

Equity tranches of CDOs offer an efficient method of leveraging an investment in corporate debt and locking in funding for a term of several years. As first-loss, leveraged instruments, these equity investments are riskier than the underlying collateral. In compensation, equity investors earn higher excess returns than the collateral for default scenarios higher than twice the default experience since 1992. We compared CDO equity for different collateral types with the leverage available in the traditional collateralized financing (repo) market.

Figure 19.

Mezzanine Tranches versus Comparable Securities, as of 5/31/98

3-yr 65-70 75-80 NA NA 70-75 Spreads over 3-mo. LIBOR (bp) 5-yr 10-yr 75-80 NA 80-85 NA 60-70 85-95 NA 125-175 70-75 NA

Security Type (BBB) Bank CLOs (U.S. Bank) Bank CLOs (Japanese. Bank) Credit Cards CIA Class Traditional CDOs CMBS

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CDOs Versus ReposWhich Form of Leverage Is More Efficient?

The repo market provides a common way to leverage investments. As Figure 20 shows, equity investors in CDOs face higher implied financing costs than investors in the repo market. For example, the weighted average cost of funding an investment in an equity tranche of a traditional CDO with 9 times leverage and a 7-year average life is approximately 110 bp over Treasuries for B rated collateral (including an annualized underwriting fee of 19 bp). Financing similar collateral in the repo market would cost an estimated 61 bp at 4x leverage. Similarly Baa rated collateral at 15x leverage has an all-in funding cost of 61 bp over Treasuries in the CDO market, versus a funding cost of 52 bp over Treasuries and 4x leverage in the repo market. We also compute funding costs of CDOs at 4x leverage to make a comparison with repo funding costs at the same level of leverage. At comparable leverage levels, repo funding is 34 bp less expensive than CDO financing for B collateral and 7 bp less for Baa collateral. Although CDOs are more expensive, they offer several compensating advantages over repos. First, an equity investor can raise substantially more leverage with a CDO (9-15 times) than with a repo (4 times). Second, in a CDO the equity investor has nonrecourse financing; that is, the investor absorbs default losses only up to the amount of the investment. Losses above the equity value are passed on to senior/mezzanine bondholders. By contrast, in a repo transaction the investor owns the collateral and absorbs all default and mark-to-market losses. Third, CDOs lock in funding and leverage for 3-7 years. In the repo market, only overnight or onemonth term funding is easily available for high yield collateral. Investors are exposed to changes in funding costs and in the amount of leverage (the haircut) the repo market requires. If the market value of the collateral were to depreciate, the investor would need to post margin money. This in effect forces the investor to deleverage. Cash flow CDOs are not sensitive to changes in the market value of the collateral. Such CDOs deleverage when the senior/mezzanine bonds amortize or when the portfolio fails a coverage test. Finally, raising financing in the repo market requires the equity investor to lock up the balance sheet since assets and liabilities cannot be netted. For some investors, this can be more expensive than investing in

Figure 20.

Estimated Funding Costs over Treasuries, as of 5/31/98

Collateral Type B bonds/loans Baa bonds/loans Typical CDO* (9x or 15x) 110 bp 61 Hypothetical CDO* (4x)** 95 bp 59 Repo (4x)** 61 bp 52

*Leverage ratio for B collateral is 9x and for Baa collateral is 15x; also, includes annualized underwriting costs of 19 bp and 5 bp per annum for B and Baa collateral, respectively. **4x leverage implies a 20% haircut.

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the equity class of a CDO where the investor holds only the value of the investment (net of liabilities) on the asset side of the balance sheet.
Assessing Risk/Return Characteristics on Equity Investments

Equity tranches of cash flow CDOs can be valued by estimating the expected excess return on the collateral and accounting for the cost of leveraging. We estimate the expected excess return on the collateral by using a simplified cash flow model of a CDO. Since cash flow CDOs are not subject to changes in the market value of the portfolio, we assume that all bonds are priced at par at the time the collateral pool is created and bonds that do not default earn the average coupon until maturity. Defaulted bonds are assumed to have recoveries similar to historical experience. These recoveries are assumed to be reinvested in securities with similar yields and similar default risk as the collateral. The internal rate of return of these cash flows minus the return on a reference Treasury is the expected annual excess return on the collateral (see formula in Figure 21).

Figure 21.

Collateral and Equity Expected Excess Returns

Annualized Default Rate Expected Collateral Excess Ret. 239 bp 204 70 Expected Equity Excess Ret. 1408 bp 1054 200 Outperform. of Equity over Collateral 1103 bp 801 130

Scenario

a) Scenario 1: Recent Experience B Bonds 2.0% B Loans 2.0 Baa Loans 0.0

b) Scenario 2: Long-term Historical Average B Bonds 6.5 -27 B Loans 6.5 33 Baa Loans 0.4 51 c) Scenario 3: Breakeven B Bonds 4.1 B Loans 4.4 Baa Loans 0.2

-1255 -657 -110

-1247 -708 -161

110 110 61

110 110 61

Formulas and Assumptions: Expected collateral excess return = E(R) = IRR[Expected cash flows] (1+r), Expected cash flows per period = [(1+r+s)*(1-p) + Recovery rate * p]* Collateral value, Expected equity (leveraged) excess returns = (1+Leverage)*E(R) Leverage * WAC, where r = Return on reference Treasury (assume r = 5.5%), s = Collateral spread over reference Treasury, p = Default rate = % of portfolio that defaults, WAC = Weighted average coupon on senior and mezzanine bonds plus an annualized underwriting fee. Nominal Spreads and Recovery Rates: i) B unsecured bonds 350 bp and 51% ; ii) B secured loans 275 bp and 71%; iii) Baa unsecured loans 70 bp and 51%.

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We calculate equity expected excess returns for three illustrative CDOs backed by diversified portfolios of B rated senior unsecured bonds, B rated senior secured bank loans, and Baa rated senior unsecured bank loans. The three portfolios typify collateral of traditional CBOs, traditional CLOs, and bank CLOs, respectively. Average spreads of collateral over Treasuries represent expected excess returns in the absence of defaults. Current market spreads over Treasuries for B rated bonds are 350 bp, and 275 bp and 90 bp for B- and Baa- rated loans. To calculate expected excess returns on the collateral, these spreads need to be adjusted for expected losses. We consider three possible default scenariosa recent average (over the past economic expansion since 1992), a long-term historical average (19701997), and a breakeven scenario. For recovery assumptions, we assume average recovery rates on senior unsecured public debt to be 51% and 71% on senior secured bank loans. Default and recovery assumptions are based on the Moodys default study. Scenario 1: Default rates over the past economic expansion (since 1992) for B and Baa rated bonds have been 2% and 0%, respectively. At current market spreads and recent default rates, a portfolio of B rated bonds is expected to outperform Treasuries by 239 bp, whereas bank loans outperform Treasuries by 204 bp for B quality and 70 bp for Baa quality collateral. Current market spreads are at all-time tights and reflect low default expectations. In this scenario, equity backed by B rated bond collateral is expected to outperform collateral by over 11%. Scenario 2: The annualized average 7-year cumulative default rates on B and Baa bonds have been 6.5% and 0.35% over the period 1970-1997. (Since CDOs typically have a 5- to 7-year average life, we use 7-year historical cumulative default rates.) If default rates increase to their historical average levels, the B rated bond portfolio will underperform Treasuries by 27 bp, and expected excess returns will be 33 bp for the B rated loan portfolio and 51 bp for the Baa portfolio. Although these excess returns are based on historical default rates, they do not necessarily reflect historical excess returns. Historically, high default environments have been characterized by spreads 100-200 bp wider than current spreads, and therefore, historical realized returns in the past several years have been high. In this scenario the equity tranches significantly underperform the collateral. Scenario 3: For a breakeven scenario, the breakeven default rate is the default rate for each collateral type at which the equity tranche has approximately the same excess return as underlying collateral. An investor would be indifferent whether returns were leveraged or unleveraged in such

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a scenario. All the above collateral types have breakeven default rates that are more than twice the default rates experienced since 1992. For example, the 4.1% B rated bond breakeven default rate lies between the recent 2% and the long term 6.5% historical average. We conclude that if an investor expects default rates on the underlying collateral to be lower than the breakeven rate, the equity tranche provides an attractive riskreturn trade-off. CONCLUSION The CDO market has grown quickly. CDOs promise to become a widely accepted structured security. The key to the success of CDOs is their ability to reapportion credit risk from a well-diversified collateral portfolio. As we have shown, the versatility of the CDO structure can serve a variety of issuer needs. The structure also provides assurance to investors that the risk characteristics of the tranches match the ratings. At the present time the rating agencies and the issuers are conservative when determining the size and structure of CDO tranches. As measures of credit risk and diversification improve, collateral portfolios and CDO structures are likely to be constructed more efficiently.

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References Altman. Edward. Corporate Bond and Commercial Loan Portfolio Analysis, New York University, September 1996. Duff & Phelps Credit Rating Co. Criteria for Rating Cash Flow and Market Value CBOs/CLOs, September 1997. Fitch IBCA. Bank Collateralized Loan Obligations: An Overview, December 18, 1997. _____. Emerging Market CBO Criteria, September 5, 1997. _____. CBO/CLO Rating Criteria, March 17, 1997. Moodys Investors Service. Historical Default Rates of Corporate Bond Issuers, 1920-97, February 1998. _____. CBO/CLO Market Market Update: Full Speed Ahead in 1997, October 3, 1997. _____. The Binomial Expansion Method Applied to CBO/CLO Analysis, December 13, 1996. _____. Emerging Market Collateralized Bond Obligations, October 25, 1996. _____. Rating Cash Flow Transactions Backed by Corporate Debt: 1995 Update, April 7, 1995. Standard & Poors Corporation. Cash Flow CBO/CLO Rating Criteria,1996 and 1998 updates.

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