To begin our analysis of SF CDO structures, Table 17 provides a comparison to traditional term ABS transactions, as well as CLOs (the most popular CDO sector).
As seen, SF CDOs have longer average lives than traditional ABS, ranging from 6 to 14 years. While expected losses on the underlying collateral are expected to be fairly minimal, due to the leveraged nature of the transactions, triple-A credit enhancement levels are substantially higher than traditional structured products.
Table 17
Structural Comparison: Traditional SF CDOs v Other CDOs & Structured Products
SF CDOs HY CLOs IG Syn CDO Credit Cards HEL
Collateral Mezzanine ABS BB/BB- Leveraged BBB / single-A Revolving Term Loans (0 - 15 years) Loans (5 years) credit default unsecured credit (15 - 30 years)
swaps (5 years) Secured by real estate
Average Size $400 mm $400 mm $1-4 bn $775 mm $750 mm
Cash flow Amortizing Amortizing Bullet Bullet Amortizing
structure
Average Life 6 - 12 years 6 - 12 years 5 - 8 years 3 - 10 years 0 - 10 years Coupon Primarily Floating Primarily Floating Primarily Floating Primarily Floating Fixed and Floating Credit Senior/Sub or Senior/Sub or Senior/Sub or Senior/Sub, Senior/Sub or Enhancement Insured, Excess Insured, Excess Insured, Excess Spread Accounts, Insured, Excess
Spread, O/C Spread, O/C Spread, O/C Excess Spread Spread, O/C Net Excess 60 - 80bp 150 - 160bp 75 - 85bp 6% - 7% 3.5% - 4.5%*
Spread
Expected Loss 0.12% - 0.30% 0.45% - 1.00% 0.15% - 0.20% 5% - 8% 0.75% - 1.00%
Typical AAA 20% 20% - 27% 12% 10% - 20% 10% - 20%
Enhancement
Source: JPMS.
* ARM HEL assuming flat LIBOR.
SF CDOs have higher subordination requirements compared to traditional structured products partly because the rating agencies use a conservative approach in evaluating them (see Rating Methodologies section). Furthermore, the tranches which make up the SF CDO portfolio themselves have structural and credit protection in the form of paid-in subordination, excess spread, overcollateralization, and cash flow diversion triggers, all of which are lacking in the collateral (e.g. consumer loans) used for traditional structured products.
SF CDOs can be broken down into three different types: traditional cash, high grade cash, and synthetic, all of which have material differences, which are driven by the underlying collateral. Table 18 below compares the basic characteristics of each type in order to help investors better assess risk and value in each. Following Table 18, we provide an analysis of unique structural issues in structured products, and how these issues are addressed in SF CDOs.
Table 18
SF CDO Comparative Analysis
Cash (Mezzanine) Cash (High Grade) Synthetic
Source: JPMS. Class A O/C test (when the class B is PIKable), which is typically in the 106-110%
area.
A/B: 113-116%
C: 104-109%
Less liquid than other more established CDO sectors
Most do not require I/C tests.
New sector: little trading to-date. Relatively easier analysis of underlying HG structured products is posi-tive for liquidity. Relaposi-tively smaller amount of term
Synthetics issue very little in funded liabilities, hence the secondary market for synthetic paper may be limited. Generally less liquid than cash deals.
Credit exposure in synthetic SF CDOs is governed by the credit event language in each transaction. In some ways, SF CDO credit events (i.e. events that result in the settlement of a credit derivative trade) mirror corporate credit event definitions as defined by the International Swaps and Derivatives Association (ISDA). However, there are important differences. We provide an overview below. For more information, see Moodys Approach to Rating Synthetic Resecuritizations, October 29, 2003.
Chart 29
Structural Overview of a Typical Synthetic SF CDO
Source: JPMS.
In most cases, SF CDOs use portfolio CDS (one contract for the entire reference portfolio) to create exposure. This structure is necessary because the single name market has struggled to develop since, although there are plenty of potential sellers (i.e. investors), there are few natural buyers of protection. In contrast, corporate synthetic CDOs typically use single-name CDS (one contract per reference entity) to create exposure.
Unlike credit events in the corporate market, there is not yet an accepted standard (or set of standards) for structured products. Although the rating agencies have made some progress in defining appropriate structured product credit events and impose penalties (e.g. default or recovery rate stress) for non-compliance, the market is not yet uniform. The lack of an accepted market standard has two primary implications. First, investors must perform appropriate due diligence to ensure that they understand the credit event definitions in a particular transaction.
Second, secondary market liquidity may be impaired to the extent that a transaction utilizes exotic definitions.
Both the lack of consistency, as well as the relative youth of the structured product credit default swap (CDS) market, mean that there is a relatively smaller sample of actual triggered credit events, and less certainty as to how events will function in practice. However, due to the high credit quality (AAA/AA) of the reference entities and subsequent low probability of default, many investors place less emphasis on credit event definitions.
Portfolio credit
Another difference is that, unlike corporate credit events, which reference any obligation of the reference entity, structured product events reference a specific tranche within the structure. In other words, if there is a credit event in a
mezzanine tranche and the SF CDO references a senior tranche, the credit event will not be triggered. This eliminates the cheapest-to-deliver option embedded in corporate CDS, which has been a factor in depressing recovery rates in that market.
Below, we review credit event definitions for SF CDOs, which have been vital to the growth of this sector. Although definitions will vary from deal-to-deal, typical provisions are detailed below.
Failure to pay: This credit event applies to both interest and principal. Typical provisions exclude deferrable securities and temporary failures due to clerical or other errors.
Loss: This credit event is triggered by write-downs to the reference obligation, but is restricted to write-downs that are irreversible (i.e. excludes securities that include various provisions for investors to be made whole at a later date). This credit event may be settled in part (only marginal amount written down) or in full.
Rating Triggers: This credit event applies to securities that have been downgraded to Ca or below and do not experience either (a) loss or (b) failure to pay within a six month waiting period or their downgrade to a certain rating level (typically Caa2 or Ca). This provision addresses the back-ended losses that are exhibited in a significant number of distressed structured product tranches.
Note that several typical/familiar credit events from the corporate market dont neatly fit into the structured product definitions. For example, bankruptcy typically does not apply to structured products, which are designed to be bankruptcy remote. In
addition, restructuring is also difficult to apply to structured products, since holders of the reference entity may have various non-credit related motivations for
restructuring (including reputation, and incentives outside the structure) that can lead to moral hazard in decision to restructure.
In some cases, bankruptcy and/or restructuring are included in SF CDO credit event definitions, primarily because regulatory bodies require institutions to have them for capital relief. In these cases, modifications are typically made to the event definition to mitigate the problems addressed above.
As a final point, we note that credit events in a SF CDO can be settled in either physical (protection seller pays par and receives reference entity) or cash (protection seller pays par and receives current market value) form. The distinction is important since the reference entities may be illiquid. Market value risk (from the need to sell an illiquid security) is typically avoided as long as settlement is not forced before the earlier of legal maturity, acceleration or final workout. In other cases, rating agencies will typically haircut recovery rates to address market value risk.
Investors that are uncomfortable with synthetic SF CDOs, but desire exposure to high grade structured products, may want to consider a high grade (HG) cash SF CDO.
Like their synthetic counterparts, HG cash SF CDOs reduce their weighted average funding costs by employing a low-cost super senior tranche. However, they do so in entirely cash form by using short-duration money market or medium term note tranches. These tranches are senior to the term AAAs and pay sequentially. In limited cases (post reinvestment period, performing deal) they may pay pro rata for a period of time.
Although not new to the CDO market, this type of funding has been appearing in several recent deals. Generally, money market tranches mature every three months to one year, leading to cheaper spreads than with term notes. Medium term notes typically mature every 2-3 years. This structure cheapens overall funding, but also introduces the risk that the short term paper, if re-issued at a discount, will eat into excess spread.
This remarketing risk created by the short term tranches is typically assumed by a third-party liquidity provider, who must purchase the short-term notes if they cannot be successfully re-marketed below some maximum spread (ensures timely repayment of 100% of maturing notes). As such, the rating of the short term notes are tied to the ratings of the liquidity provider.
Presumably, the high quality of the portfolio (AAA/AA) is a comfort to the liquidity provider, who holds downgrade risk (although it may be sold to a third party in some cases). We expect this is why most recent deals with money market features are backed by stable high quality collateral such as AAA/AA rated real estate ABS. Of course, it is possible to apply short term tranches to traditional subordinate collateral, although this would likely require incremental cost to the liquidity provider. The presence of a liquidity provider benefits the equity holder. Those holders would see excess spread deterioration without provisions for the liquidity provider to step in and prevent issuance at substantially wider spreads.
Money market tranches are favored by bank (e.g. Citibank) liquidity providers that have ready access to liquidity at short notice. Medium term notes are favored by non-bank liquidity providers that dont have commercial paper programs and have relatively less access to immediate liquidity.
In a typical structure, at the time of writing, money market tranches are sold in the L minus 2 to plus 10bp area. The liquidity put costs an additional 20bp and a remarketing fees cost an additional 4-6bp, leading to an all-in cost in the L+22-36 area, well below spreads on a typical SF CDO senior tranche (L+60). If remarketing is unsuccessful, the tranche can be put to the liquidity provider in the L+40-70bp area (i.e. liquidity provider is a backstop buyer at an agreed upon price). We note that money market tranche price is also a function of size of issuance, with tighter pricing often achieved on larger tranches because, for example, many institutions are limited as to the percentage of a tranche that they are allowed to purchase.
HG SF CDO:
Short Term Tranches
In contrast, spreads on medium term note issuance are slightly wider (L+12), but the liquidity put is slightly less expensive (15bp) because the notes mature less often. As such, the total cost for medium terms notes is a few bps higher than for money market tranches.
Senior and subordinate AAA tranches are becoming more common in traditional SF CDOs (unlike HG SF CDOs, both AAA tranches are term paper). In most cases, subordinate AAAs receive interest and principal after senior AAAs, and tend to price wider. These tranches have found demand from investors seeking to construct a barbell portfolio, who might use a subordinate AAA to overlay an existing position in lower quality CDO, ABS, or corporate paper. Such a fund benefits from a wider spread, but does not go down in rating.
Senior AAAs typically have shorter maturities (4-6 years) and have seen demand from insurance and reinsurance companies, as well as other highly risk-sensitive AAA investors. One issue worth noting for senior AAA investors is prepayment risk, which is primarily a reinvestment concern from an investor perspective. In several recent deals, prepayment risk has been addressed by using a pro rata pay structure for all senior notes, subject to deal performance triggers being within compliance. This structure reduces reinvestment risk for senior AAA noteholders, and at the same time prevents the rising funding costs that would otherwise follow the amortization of the most senior (i.e. cheapest) tranche. As an added benefit, the resulting pro rata amortization of the single-A noteholders decreases credit risk for that tranche by reducing the notional balance.
Traditional SF CDO:
Senior/subordinate AAA structure
Technical Note:
Second-seniors are sometimes split-rated between AAA and AA based on differences in rating agency criteria. The critical difference between the rating agencies stems from the evaluation of loss. S&P rates a tranche by its likelihood of incurring the first dollar of loss. Put in the context of CDOs, the entire tranche above a certain attachment point can receive a AAA rating. Although based on a similar concept, Moodys rates a tranche using the expected loss concept. At the heart of this rating methodology is the idea of loss as a proportion of the total investment. The result of the differing methodologies is illustrated in the hypothetical diagram below. Although the expected notional loss amount is the same for both the 20% and 10% second-senior tranches, it is larger as a proportion of the whole for the 10% tranche. For this reason, the 10% tranche may receive a AAA rating from S&P but a Aa1 rating from Moodys.
90%
10%
80%
20%
Aaa / AAA Aa1 / AAA
Aaa / AAA Aaa / AAA Split-Rated All Triple-A
In addition to customizing risk profiles for specific investors, in certain cases (such as with top-tier managers, or high quality portfolios), the average spread of a senior-subordinate AAA structure may be slightly less than indicative AAA spreads, reducing the deals liability costs. This may be accomplished if the senior AAA is particularly large compared to the subordinate AAA, and prices especially tight.
Therefore, although terms are deal specific, issuing senior-subordinate AAAs may allow certain deals some additional flexibility to purchase higher quality assets without impairing the arbitrage available to equity.
In most cases, the aggregate amount of the AAAs is roughly equal to the size of a single AAA in a comparable deal. Since subordinate AAAs are generally not priority tranches, their expected loss assumptions are generally higher than first-priority AAAs, but of course still above the minimum required for a AAA rating.
Many structured products securities (which may, for example, have a 30 year legal final and five year average life) may extend beyond their expected maturity in the event that payment speeds or performance does not meet expectations. Any extension in the underlying structured products may result in an extension for SF CDO tranches, impacting the most subordinate tranche first, because CDOs pay principal sequentially. However, there are several factors that mitigate extension risk in both the structured product securities and the CDO structure:
Clean Up Call: Many structured products have a provision for a clean up call (at par value) at the option of the servicer or residual holder once the amount of collateral remaining falls below 10-20% of the original par amount. The call-holder may exercise the clean up call to collapse the deal and avoid ongoing deal expenses. In addition, the call-holder has an incentive to exercise the call to preserve its reputation and insure that future issuance will price to call.
Prepayments: As discussed below under the interest rate cap heading, prepayment speeds in some structured products, particularly Hybrid ARMS (HELs), are quite fast due to refinancing activity, which mitigates extension risk. We do note, however, that the loans that do not prepay (left in the pool) may include those that who couldnt refinance due to credit issues. These remaining loans typically have greater credit risk, which makes the clean-up call somewhat important.
CDO Structural Features: As discussed below, CDO auction calls exist to facilitate the liquidation of collateral once the CDO is past its expected maturity date. The mezzanine turbo feature uses excess spread to accelerate amortization of the most subordinate tranche, reducing extension risk.
Rating Agency Stress: SF CDOs typically assume that prepayments occur at the speed modeled in the transactions. The agencies then stress prepayment speeds.
Moodys applies a standard stress of up by 2x and down by half, and notes that more severe stress levels may be used for interest rate sensitive securities such as prime RMBS.
Other structured products may have a bullet maturity (Cards, UK RMBS) or balloon payments with low prepayment assumptions (CMBS), which make extension less likely for these securities. Finally, all else equal, extension risk is more significant Extension Risk and the
CDO Structure
for traditional mezzanine CDOs than for high grade CDOs, because mezzanine structured products tranches are more prone to extension.
Most SF CDOs have a 35-40 year legal final, which is appropriate given the long maturity dates for some structured products. Despite their long legal-final, most SF CDOs have a maximum collateral weighted average life of 7-9 years from issuance, which makes the expected life on the CDO notes considerably shorter.
The potential mismatch between the maturity of underlying SF CDO collateral (as much as 30 years) and the expected life of the CDO notes (7-10 years) is addressed explicitly in many SF CDOs. This is necessary because some institutions cannot buy notes with a long-dated legal final. To reduce the legal final, SF CDOs may include provisions for an auction call at the expected maturity (often 8 years).
The auction call will be repeated semi-annually until it is successful (proceeds are sufficient to pay out all notes and accrued fees). To encourage timely execution, both senior and junior notes may include provisions for coupon step-ups each period that debt remains outstanding. Alternatively, equity coupon may be diverted either immediately or after a grace period following the expected maturity. The rating agencies do not give credit for the auction call in their ratings.
Many deals include provisions that provide for early amortization of, or equity upside for, mezzanine note holders. These provisions are not uniform and may take different forms for high grade versus traditional cash SF CDOs.
Traditional cash SF CDOs often place a cap on payments to equity holders (e.g.
10-20% per annum), which vary according to market clearing levels for the equity tranche. Excess returns above this amount are redirected to pay down or turbo-pay the most-subordinate rated note (generally BBBs, which are often a large percentage of the structure at 4-6%), which shortens their duration and effectively lowers the weighted average funding cost for the CDO going forward. The cap may continue until the stated tranche is paid down, or for a given number of years after issuance (paying down the next-most subordinate after the most-subordinate tranche is fully amortized). The equity cap is beneficial for mezzanine investors, and tranches with this feature typically exhibit a small spread give-up to like-rated longer duration securities.
The turbo feature is generally acceptable to senior investors as well, because by retiring the most expensive notes, excess spread is increased, improving the funding gap (which is available to senior note-holders should collateral deterioration trigger a diversion of capital to pay-down senior notes). In addition, the presence of a turbo feature also is positive for senior noteholders because asset managers (especially those with significant equity holdings in the deal) will be less likely to overheat
the deal by investing in risky collateral in search of high equity returns.
the deal by investing in risky collateral in search of high equity returns.