Structured Finance CDO Handbook
www.morganmarkets.com
Contents Overview 2 Whats In an SF CDO? 3 SF CDO Assets: 101 12Does SF Collateral Work for CDOs? 24
SF CDO Structure 32
Should SF CDOs be Managed or Static? 44 SF CDO Rating Methodologies 48 Appendix A: Rating Transition Matrices 51 Appendix B: Rating Agency Classification
of Structured Products 53
Appendix C: SF CDOs from
Seasoned Issuers 54
Christopher FlanaganAC (1-212) 270-6515
Rishad Ahluwalia (London)
(44-207) 777-1045 [email protected] Ryan Asato (1-212) 270-0317 [email protected] Benjamin J. Graves (1-212) 270-1972 [email protected]
Edward Reardon (London)
(44-207) 777-1260
The certifying analyst(s) is indicated by a superscript AC. See last page of the report for analyst certification and important legal and regulatory disclosures.
Overview
Structured Finance (SF) CDOs are leveraged investment vehicles that invest primarily in the senior and mezzanine tranches of structured products (ABS, RMBS, CMBS, and CDOs). They utilize the same technology as traditional credit CDOs with the only difference being their underlying collateral. SF CDOs issue securities to fund the purchase of collateral or assume risk synthetically via credit derivatives.
Highlights
SF CDOs are designed to exploit arbitrage opportunities by taking advantage of liquidity/complexity premiums and the credit curve, to be a source of funding, or to manage balance sheet exposures. They have been growing as a portion of total CDO issuance.
Overall, the SF CDO underlying collateral makeup largely mirrors the structured products market. Some adjustments are made to enhance arbitrage. Structured product collateral offers a spread pick-up, lower event risk, and
comparable default/recovery rates versus like-rated corporates, as well as diversification opportunities.
Rating agency structured product default and recovery assumptions are conservative compared with actual collateral performance.
SF CDOs have several variables, including quality of collateral (AAA/AA or BBB) and form of exposure (cash or synthetic). Each type has unique structural features.
Manager/issuer selection is critical in both actively managed and static deals. Chart 1
Structural Overview of a Typical SF CDO
Source: J.P. Morgan Securities.
AAA A Equity BBB AA CDO SPV ABS RMBS CMBS CDOs Asset Manager or Issuer Trustee & Custodian Hedge Counterparties
Overview
SF CDOs have been growing as a portion of total CDO issuance in both the US (currently about 45% of total) and Europe (currently about 20% of total).
SF CDOs offer a spread pick-up to most like-rated securities. This pick-up can be attributed to liquidity, complexity, and a new asset class premium.
Table 1
Spread to Swaps/Libor (bp)*
5-8 Yr 10 Yr 10 Yr UK 5 Yr
7-12 Yr IG Syn 6-10 Yr RMBS 10 Yr 3-5 Yr Floating Sterling 10 yr
SF CDO CDO HY CLO Jumbo CMBS HEL Cards RMBS Industrial
AAA 60** 70 46 30 25 18 15 -8
AA 125 125 90 100 38 50 34 6
A 175 175 140 120 45 105 61 28
BBB 375 375 265 175 88 170 105 107 60
*As of 1 February 2004.
**Indicative weighted average AAA spread for traditional SF CDO. Source: JPMS.
This spread pick-up, as well as the opportunity to diversify exposures, is attracting a growing investor base, which varies by position in the SF CDO capital structure. Senior investors include banks, conduits, SIVs, and finance companies. Equity investors are typically banks, pension funds, endowments, private banks, insurance companies, fund managers, and hedge funds.
SF CDO asset managers are keen to become involved in this market as a way to increase assets under management, build their franchise, and receive fee income. On the other hand, balance sheet transactions can enable entities to reduce economic and regulatory capital, manage credit risk, and achieve long term funding.
Chart 2
Funded CDO Issuance: 1996-2003*
US $ Billion (bar graph) % SF CDO (black line) Europe $ Billion (bar graph) % SF CDO (black line)
*Funded issuance includes all cash issuance and the funded (i.e. non super senior) portion of synthetics. Source: JPMS, IFR Markets, MCM, Bloomberg, CreditFlux.
0 10 20 30 40 50 60 70 80 90 1996 1997 1998 1999 2000 2001 2002 2003 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 0 5 10 15 20 25 30 35 1996 1997 1998 1999 2000 2001 2002 2003 0% 5% 10% 15% 20% 25%
SF CDOs are Growing as a Percentage of Total CDO Issuance
SF CDOs Offer a Spread Pick-Up to Most Like
Rated Securities
Growing Cadre of Market Participants
Whats In an SF CDO?
SF CDOs source collateral from several distinct sectors of the broader structured products market, including CMBS, RMBS, CDOs, ABS, and REITs. Collateral composition varies by deal, with individual deals sourcing from 0% to 100% of their collateral from each of the above sectors. Several factors, including asset manager experience, issuance volume, region, and arbitrage opportunity influence collateral composition. Despite differences between deals, US/European SF CDOs can be broadly characterized into two sub-sectors1.
Real Estate SF CDO: Greater than 60% of collateral is backed by residential or commercial real estate (RMBS, CMBS, or REITs). In 2003, Real Estate CDOs accounted for approximately 45% of funded SF CDO volume.
Diversified SF CDO: Also referred to as multisector or ABS CDOs. Deals in this category consist of a diversified mix of structured finance assets and, as such, dont exhibit asset concentration (in Real Estate) described above. In 2003, Diversified CDOs accounted for approximately 55% of funded SF CDO volume. In addition to the two broad categories
above, SF CDOs may be distinguished by several other characteristics, includ-ing: Cash/Synthetic, Arbitrage/Balance Sheet, or US/Europe. Chart 4 to Chart 9 on the following page show the aggre-gate collateral composition (Consumer ABS, Commercial ABS, RMBS, CMBS, CDO, REIT) for deals completed in 2003. Chart 10 to Chart 14 detail the collateral breakdown within each of the aforementioned sectors. We stress, how-ever, that different types of SF CDOs hold these underlying asset classes in materially different proportions.
Chart 3
2003 SF CDO Collateral Distribution (total)
Source: JPMS, IFR Markets, MCM, S&P, Fitch, Moodys. CDO 15% CMBS 19% Consumer ABS 16% Other ABS 2% Corp ABS6% REIT 3% RMBS 39%
SF CDOs can be classified as Real Estate or Diversified
SF CDO Sectors - Some Definitions
CDO: CLO, CBO, SF CDO, IG Synthetic CDO, Small-to-Medium Entity CDO, Other CDO CMBS: Conduit, Large Loan, Credit Tenant Lease
Consumer ABS: Student Loan, Auto, Card, Consumer Loan
Corporate ABS: Equipment, Health Care, Small Business Loan, Structured Settlement, Aircraft, Aerospace, Trade Receivables, Franchise
REIT: Unsecured corporate debt of company that invests in Regional Malls, Shopping Centers, Office Buildings, Warehouses
RMBS: Prime* (Jumbo, Alt A), Home Equity (Subprime or B/C, 2nd Lien), NIMS, Manufactured Housing, Prime European Mortgages (UK, Netherlands, Spain, Italy, Portugal)
*Note: Prime RMBS also traditionally includes the conforming Agency (Fannie Mae, Freddie Mac) paper, which is out of the scope of this paper because it is guaranteed and not typically included in SF CDOs.
1. CDOs-of-CDOs (majority of collateral is tranches of other CDOs) can also be considered SF CDOs, but they are beyond the scope of this paper.
2003 US/Europe SF CDO Collateral Distribution: By Deal Type
($billion notional)*
Chart 4
Cash: 16 Euro, 35 US deals ($29.1)
RMBS 48% CDO 6% REIT 5% CMBS 33% Corp ABS 4% Corporate 0% Consumer ABS 4% Chart 5
Synthetic: 22 Euro, 4 US deals ($39.8)
RMBS 34% CDO 23% CMBS 7% Corp ABS 8% Consumer ABS 28% Chart 6
Arbitrage: 19 Euro, 33 US deals ($32.5)
RMBS 44% CDO 11% REIT 5% CMBS 31% Corp ABS 4% Corporate 0% Consumer ABS 5% Chart 7
Balance Sheet: 19 Euro, 6 US deals ($36.4)
RMBS 37% CDO 19% Corp ABS 8% Consumer ABS 27% REIT 0% CMBS 9% Chart 8 US: 39 deals ($25.2) RMBS 43% CDO 9% REIT 5% CMBS 34% Corp ABS 4% Corporate 0% Consumer ABS 5% Chart 9 Europe: 38 deals ($43.6) RMBS 39% CDO 19% REIT 1% CMBS 11% Corporate 0% Corp ABS 7% Consumer ABS 23%
* As a percent of total notional value.
2003 US/Europe SF CDO Collateral Distribution: By Sub Sector
($billion notional)*
Chart 10 RMBS ($27.4) Prime 43% HEL 55% MH 2% Chart 11 CMBS ($13.5) Conduit 76% CTL 2% Large Loan 22% Chart 12 Corp ABS ($4.0) Aerospace 1% Small Business Loan 61% Structured Settlement 7% Aircraft 1% Equipment 28% Health Care 2% Chart 13 Consumer ABS ($10.9) Auto 34% Card 44% Student Loan 2% Consumer Loan 20% Chart 14 AllSource: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch. 0% 5% 10% 15% 20% 25%
RMBS: HEL RMBS: Prime CMBS: Conduit CDO
Consumer ABS: CardConsumer ABS: Auto CMBS: Lg Loan
Consumer ABS: Consumer Loan Corp ABS: Sml Business
REIT
Corp ABS: Equipment RMBS: MH
Other
The SF CDO collateral concentrations shown above are largely representative of the underlying collateral markets as a whole. That is, SF CDOs tend to source collateral from the largest sectors, such as home equities (HELs) and CMBS. The one possible exception (at least with US collateral) is the large prime RMBS market, from which SF CDOs source smaller amounts of collateral. This is due to both the relatively larger rate component of this sector (CDO technology is better equipped to take credit risk than rate risk), as well as the smaller supply of subordinates (due to relatively low credit enhancement associated with the prime quality collateral). European SF CDOs tend to source larger portions of Consumer ABS, Prime RMBS, and CDOs2, as these sectors represent a significant portion of the European structured products market. The tables below provide a breakdown of recent collateral issuance for the US and European markets, as well as JPMorgans 2004 forecast as of year-end 20033. Table 2 and Table 3 provide volumes for the overall markets. Table 4 and Table 5 provide volumes for subordinate tranches and indicate the percentage of the total structure that is non-AAA.
Table 2
US Structured Product Supply and Forecast ($Billion)
2001 2002 2003 2004 Forecast
% of % of % of % of
$bn Total $bn Total $bn Total $bn Total
RMBS: Prime 152.6 27.1% 228.9 32.7% 350.0 38.2% 325.0 36.6%
RMBS: HEL 94.2 16.7% 159.0 22.7% 219.9 24.0% 200.0 22.5%
Consumer ABS: Autos 70.2 12.5% 88.2 12.6% 77.2 8.4% 75.0 8.5%
Consumer ABS: Credit Cards 59.3 10.5% 65.8 9.4% 64.8 7.1% 75.0 8.5%
CMBS 67.2 11.9% 52.1 7.4% 77.9 8.5% 70.0 7.9%
CDO 62.8 11.1% 58.5 8.4% 66.4 7.3% 69.1 7.8%
Consumer ABS: Student Loans 9.5 1.7% 19.5 2.8% 30.7 3.4% 40.0 4.5%
Other 23.7 4.2% 6.6 0.9% 12.0 1.3% 12.0 1.4%
REIT 9.8 1.7% 10.6 1.5% 9.2 1.0% 10.0 1.1%
Corp ABS: Equipment 7.0 1.2% 5.9 0.8% 6.8 0.7% 8.0 0.9%
RMBS: MH 6.8 1.2% 4.6 0.7% 0.8 0.1% 3.0 0.3%
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.
Table 3
Europe Structured Product Supply and Forecast ($Billion)
2001 2002 2003 2004 Forecast
% of % of % of % of
$bn Total $bn Total $bn Total $bn Total
RMBS: Euro (non-UK) 27.7 21.0% 34.6 24.2% 83.8 37.5% 80.0 35.0%
CDO 29.0 22.0% 22.2 15.6% 28.8 12.9% 28.0 12.3%
RMBS: Aussie 9.5 7.2% 11.0 7.7% 21.5 9.6% 25.0 10.9%
RMBS: UK 8.8 6.7% 11.6 8.1% 19.6 8.7% 20.0 8.8%
CMBS 14.3 10.8% 13.7 9.6% 15.5 6.9% 17.0 7.4%
Corp ABS: Whole Business 7.8 6.0% 10.7 7.5% 14.2 6.3% 12.0 5.3%
Consumer ABS: Student Loans 0.0 0.0% 0.5 0.4% 4.5 2.0% 11.0 4.8%
Other 12.0 9.1% 10.4 7.3% 12.3 5.5% 9.0 3.9%
Consumer ABS: Autos 4.4 3.3% 8.9 6.2% 4.7 2.1% 8.0 3.5%
Other: Sov/Ag 11.8 9.0% 9.9 6.9% 9.8 4.4% 8.0 3.5%
Consumer ABS: Credit Cards 3.3 2.5% 5.8 4.1% 5.9 2.6% 7.5 3.3%
Corp ABS: Equipment 3.0 2.2% 3.3 2.3% 3.2 1.4% 3.0 1.3%
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.
SF CDO Collateral Mirrors the Overall Market
2. A significant portion of CDOs re-securitized in European SF CDOs are Small to Medium Entity (SME) CDOs, which are collateralized by receivables on a large number (typically thousands) of small business loans. The granular collateral pool makes arguably makes these CDOs more akin to ABS than to a traditional CDO. 3. Other includes Dealer Floorplan, Stranded Asset, RV, Boat, Consumer, EETC, Aircraft, Small Business Loan,
Table 4
US Subordinate (non-AAA) Structured Product Supply
2001 2002 2003
$bn % Sub $bn % Sub $bn % Sub
RMBS: HEL 9.5 10.1% 18.4 11.6% 32.4 14.7%
CMBS 13.0 19.3% 9.6 18.4% 10.5 13.5%
CDO 12.5 19.9% 12.4 21.3% 10.1 15.3%
Consumer ABS: Credit Cards 10.0 16.8% 10.5 16.0% 9.6 14.8%
REIT 9.8 100.0% 10.6 100.0% 9.2 100.0%
RMBS: Prime 5.0 3.3% 6.4 2.8% 8.8 2.5%
Consumer ABS: Autos 2.4 3.4% 3.2 3.7% 2.5 3.2%
Consumer ABS: Student Loans 0.3 2.8% 0.6 3.2% 1.3 4.3%
Other 6.9 28.9% 2.0 30.8% 1.2 9.9%
Corp ABS: Equipment 1.3 17.9% 0.6 9.7% 0.6 9.1%
RMBS: US MH 1.4 21.2% 1.1 23.5% 0.2 26.7%
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.
Table 5
Europe Subordinate (non-AAA) Structured Product Supply
2001 2002 2003
$bn % Sub $bn % Sub $bn % Sub
Corp ABS: Whole Business 5.0 63.6% 6.3 59.0% 6.1 43.1%
CDO 5.8 20.0% 4.4 20.0% 5.8 20.0% CMBS 7.3 51.4% 3.8 28.0% 5.6 36.3% RMBS: Euro (non-UK) 2.5 9.2% 2.4 7.0% 5.6 6.7% Other 4.9 40.4% 1.8 17.5% 2.7 22.2% RMBS: UK 1.4 15.8% 0.9 7.9% 2.7 13.8% RMBS: Aussie 0.7 7.8% 0.9 7.8% 1.9 8.9% Other: Sov/Ag 5.6 47.6% 1.6 16.6% 1.4 13.9%
Consumer ABS: Credit Cards 0.1 3.5% 0.6 9.6% 1.2 19.8%
Consumer ABS: Autos 0.2 4.1% 0.4 5.0% 0.2 5.1%
Corp ABS: Equipment 0.2 8.0% 0.3 10.1% 0.1 4.3%
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.
Seasoned SF CDOs under-performed in 2003 due largely to exposures in esoteric ABS sectors such as manufactured housing, tobacco, aircraft, mutual fund fees, and franchise loans. With the possible exception of manufactured housing, exposure in esoteric ABS was generally limited to a small portion of the portfolio, but it was enough to impair performance in many deals.
These small (and sometimes new) sectors were included in older vintage SF CDOs (2000-2002) because they offered some of the highest yields and added diversity to the portfolio. However, the drawback is that they were often unseasoned, with potentially flawed business models that take time to uncover. For example, franchise loan amounts were typically based on the business value, rather than the real estate value, leaving loans under-collateralized in the event of business failure. Another example is mutual fund fees, which were based on the assumption of a growing share of assets invested in equity funds, and did not anticipate the negative fund flows during the market downturn.
What's Not in SF CDOs and Why
The manufactured housing sector accounts for the bulk of structured products tranches that have defaulted. The sector was severely hit with loose underwriting, irrational competition, overproduction, and high exposure to the weakest sectors of the economy in the past few years. The result was a perfect storm where external forces totally changed the rules of the industry causing performance to significantly diverge from original expectations. This was combined with deals that were structured with lower initial required loss coverage ratios from the rating agencies and lower excess spread requirements.
Todays next-generation SF CDOs contain less exposure to these esoteric sectors, and have instead substituted established sectors such as HELs and CMBS. Although trading is allowed in SF CDOs, all collateral concentrations are subject to
limits/prohibitions set at the inception of the deal.
Another exposure that caused problems in early SF CDOs was exposure to CDOs, many of which have performed poorly (especially US HY CBOs) over the last several years. As a result, most traditional US mezzanine SF CDOs have scaled back CDO collateral concentrations (e.g. from a 20% bucket to a 5-10% bucket). Others continue to allocate to this sector, reasoning that newer CDOs benefit from the debt-friendly structures that characterize todays CDO market. European SF CDOs still often have moderate-sized CDO buckets, but these are typically concentrated in SME CDOs, which have developed a positive performance track-record. High grade SF CDOs may have 10-15% concentrations in non-PIKable AAA and AA tranches. We think that while a general reduction in CDO exposure is an understandable response to current investor sentiment, CDOs still make sense for the SF CDO structure, and there is no compelling reason to avoid CDO exposures once investor sentiment turns. Table 16 shows migration of the
Weighted Average Rating Factor (WARF) versus the trigger WARF as set in the indenture for all SF CDOs rated by Moodys between 1999 and 2002. The chart illustrates the problems in 1999 and 2000-vintage SF CDOs, which have rapidly deteriorating ratings on the underlying collateral. In contrast, 2001 and 2002-vintage SF CDOs have had far less rating deterioration. Whereas many esoteric ABS sectors are collateralized by business value or depreciating assets, most sectors in recent SF CDO transactions are securitized by real estate, which
should provide a backstop on losses (the property value) in the event of default. Those assets not secured by real-estate (cards, autos, equipment) are some of the Far Less Deterioration in
Later-Vintage SF CDOs
Chart 15
Weighted Average Ratings Factor vs. Ratings Trigger
(% compliance, negative number indicates non-compliance)
Source: Moodys. -250 -200 -150 -100 -50 0 50
May-02 Aug-02 Nov-02 Feb-03 May-03 Aug-03 Nov-03
most seasoned in the ABS market (although investors should still be diligent in evaluating the servicer risk in these sectors) and have well-established performance track records.
SF CDO allocations to various structured product sectors change according to deal vintage, and deals are designed to capitalize on a market anomaly or arbitrage opportunity at issuance. To illustrate this point, we look at the HELs minus CMBS spread differential for the 2002-2003 period (Chart 16). Chart 17 illustrates the change in SF CDO collateral breakdown during this same period.
During 2002, the exceptionally stable CMBS sector was pricing nearly in line with HELs, and SF CDOs concentrated 40% of their collateral in CMBS versus 18% in HELs. However, as spreads on HELs gapped out in 2003 (partially due to large issuance volumes), new SF CDOs altered their collateral makeup to exploit the opportunity, reducing CMBS exposure to 31% and increasing HEL exposure to 46%. As relative spreads and issuance continue to change in the structured products markets, we expect that new SF CDOs will adjust to achieve maximum advantage for investors. Of course, investors should perform appropriate due diligence to ensure that asset managers are staying within their area of expertise.
Table 6 illustrates the substitution of HELs for CMBS as well as the decline in esoteric assets in four deals issued by Declaration Management and Research4 between 2000 and 2003. We selected this manager because they have been a repeat issuer in the market, with a transparent history dating back several years. Note the dramatic rise in HELs and decline in CMBS. Also note the significant decline in manufactured housing, aircraft, and other smaller structured product sectors. SF CDOs Capitalize on
Arbitrage Opportunities
Chart 16 Chart 17
BBB Spread Differential: HEL minus CMBS Global SF CDO Collateral Distribution by FundedVolume: 2002 & 2003
bp
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch. 0 50 100 150 200 250
Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
RMBS CMBS ABS CDO REIT 2002 2003
Shifting Asset Allocation: A Real Life Example
Table 6
Investment Portfolios by Structured Product Sector
Independence I Independence II Independence III Independence IV
(2000) (2001) (2002) (2003)
Current Avg Rating/Trigger Avg Rating Baa3/Baa2 Baa3/Baa2 Baa2/Baa2 Baa2/Baa2 % of Total Portfolio RMBS: HEL 18.92 22.44 25.09 55.48 RMBS: Prime 10.63 11.56 13.14 13.73 CMBS 20.14 31.35 32.29 9.88 RMBS: MH 13.31 14.09 11.61 5.28 CBO (Baa) 4.92 3.95 4.01 4.97 REIT 1.71 1.65 4.75 Corporates 2.50
Corp ABS: Structured Settlements 0.63 1.32 1.25
Corp ABS: Aircraft Lease 12.29 7.50 2.48 1.16
Corp ABS: Small Business Loan 3.62 0.61 1.55 0.99
Other 4.15 3.47 2.95 0.01
Consumer ABS: Auto 2.41 2.00
Consumer ABS: Credit Card 4.66 2.19 1.10
Corp ABS: Entertainment 0.05
Corp ABS: Equipment Leasing 0.81 0.37
Corp ABS: Franchise Loans 3.85 0.50 0.44
RMBS: Property Tax Liens 0.24
Source: Fitch.
Since each of the aforementioned asset classes may issue notes of various ratings and with various levels of subordination, the quality of collateral is at least as important as the type of collateral. While traditional SF CDOs typically used collateral with weighted average ratings in the BBB vicinity (relatively higher spreads created attractive arbitrage), the advent of new securitization technology has allowed the development of high grade SF CDOs, which typically source AAA/AA collateral. Chart 18 and Chart 19 show weighted average ratings for cash and synthetic SF CDOs issued in 2003. Note that synthetics, with lower overall funding costs due to the presence of a large super senior tranche, are overwhelmingly high grade SF CDOs. Although cash deals remain largely backed by BBB collateral, the number of cash high grade deals has grown to 22%. This growth has been helped by the development of short term money market eligible tranches at the top of the capital structure. The advent of high grade SF CDOs bodes well for SF CDO supply, since there is a much larger supply of AAA/AA collateral, which typically makes up 80-85% of the capital structure in many structured product transactions. Supply of the (relatively smaller notional) subordinate tranches may be limited, especially in higher interest rate environments5. Potential lack of mezzanine structured products supply creates reinvestment risk in traditional managed mezzanine SF CDOs. Investors should insure that asset managers have sufficient access to collateral during both the ramp-up and reinvestment periods.
5. Although higher interest rates would also impact senior tranche supply, the reduction would have less impact on SF CDOs because supply is much larger in the first place.
Collateral Quality: Weighted Average Rating
Chart 18
Cash SF CDO Collateral Quality Breakdown: 16 Euro, 35 US deals ($29.1)
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.
AA 21% A 14% BBB 53% BB 7% B 5% Chart 19
Synthetic SF CDO Collateral Quality Breakdown: 22 Euro, 4 US deals ($39.8)
Source: JPMS, IFR Markets, MCM, Bloomberg, Moodys, Standard and Poors, Fitch.
AAA 61% AA 29% BBB 5% A 5%
SF CDO Assets: 101
Most structured products share certain similarities (ownership in a pool of
receivables, subordination, sequential pay structure, overcollateralization), but there are also key differences across asset classes (specific assets, weighted average life, structural variations). The following pages provide an introduction to the elementary characteristics of structured products typically found in SF CDOs, including
collateral, market participants, structure, and principal risks. This section may be skipped by investors that already possess a strong understanding of the structured products markets or used as a reference guide for those with a strong understanding of some sectors but not others.
We cover four of the largest SF CDO collateral components (HEL, CMBS, US Prime RMBS, and UK RMBS) in some detail, and provide a brief overview of other structured products. To begin, Table 7 provides an overview of four key sectors. Table 7
Structure Comparison
HEL CMBS UK RMBS US Prime RMBS
Major Currencies USD USD USD, GBP, EUR, USD
CHF
Typical New Issue Size $750mm $1bn $6-$7bn $750mm - $1bn
Weighted Avg. life 3 - 5 years 5 - 10 years 1.0 - 5.5 years 7 years
Spread Indices Libor, Swaps Swaps Libor, Euribor Treasuries
Coupon Type Fixed and Floating Primarily Fixed Fixed and Floating Fixed and Floating Rating Stability Relatively more Very stable and Very stable and Very stable and
volatile due to sector marked by upgrades marked by upgrades marked by upgrades consolidation and in seasoned in seasoned in seasoned transformation transactions transactions transactions Typical Structure AAA - 15.0% sub. AAA - 16% sub. AAA - 8% sub. AAA - 2.5% sub.
AA - 10.0% sub. AA - 13% sub. AA - 5% sub. AA - 1.25% sub. A - 6.0% sub. A - 10% sub. BBB 1.5% sub. A - .85% sub. BBB 2.5% sub. BBB - 6% sub. (plus Reserve Fund) BBB - .50% sub. (overcollateralization) BB - 3% sub.
Liquidity Medium liquidity; Very High High; one of the Very High largest issuers have most liquid sectors
the best liquidity in Europe
Key Issuers Ameriquest, Chase, CSFB, Goldman, Abbey National, Chase, Countrywide, Countrywide, Lehman, Morgan HBOS, Northern Washington Mutual,
GMAC/RFC, Stanley Rock Wells Fargo
Option One
The largest SF CDO collateral sector is RMBS. Chart 20 illustrates the difference between the most common forms of prime and subprime RMBS to appear in SF CDOs. There are also regional differences. Below, we explore several RMBS sectors in detail.
Chart 20 Types of RMBS
Source: JPMS.
RMBS: Home Equity Loans (HEL)
HELs are secured by residential real estate property, primarily first mortgages to borrowers unable to obtain prime funding due to the borrowers credit (sometimes referred to as B/C loans). Second-lien loans are also included under the HEL moniker, although these are a much smaller proportion of the market. HELs are the largest sector in the public ABS market. Volumes have increased dramatically due to the current low interest rate environment and home price appreciation. Chart 21 below provides a brief overview of the HEL market.
Home Equity Prime Borrower Lien LTV WAC FICO Originators B&C 2nd Lien Alt-A Prime Jumbo Credit Impaired Prime Documentation Property Type Pristine Credit 1st 2nd 1st 1st 80% 90% 75% 75% 7.5% 9%-10% 6.5% 6.0% 630 715 715 725 Chase Countrywide GMAC/RFC Countrywide GMAC/RFC First Franklin Countrywide IndyMac
GMAC/RFC CountrywideChase GMAC/RFC Well Fargo Prime Ameriquest Option One Subprime ARM Chase
Chart 21
Overview of the HEL Market
Source: JPMS.
Chart 20 provides an overview of different types of HELs. Note that Alt A and Prime Jumbos (addressed later on under the Prime RMBS heading) are included here for purposes of comparison.
HELs may be floating rate (Adjustable Rate Mortgage or ARM) or fixed rate (Fixed Rate Mortgage or FRM). ARMs currently account for approximately 75% of HEL volume. Most ARMs are indexed off 6-month LIBOR. Typically, ARMs are fixed for a period of time before resetting and are referred to as Hybrid ARMs. Types of Hybrid ARMs include 1/29, 2/28, 3/27, 4/26, or 5/25 loans, where the first number references the period the loan rate is fixed and the second references the period the loan rate is floating. Over the years, the majority of ARMs originated have shifted towards the Hybrid ARM product, with 2/28s the most popular. After the initial fixed period, ARM rates are determined by adding the loans margin to the
benchmark. On each reset date thereafter, typically every 6 months, the new rate is calculated and principal payments are adjusted so that the loan fully amortizes over its remaining life.
Certificates
Residential homeowners borrow funds which are collateralized by real property. Loan types include:
Subprime B/C: Fixed rate mortgage (FRMs)
Adjustable-rate mortgages (ARMs) 2nd Lien Mortgage: Closed-end fixed rate Revolving home equity lines of credit (HELOCs) Home improvement loans (HILs) High LTV loans (125s)
Lenders include banks and finance companies. To securitize, lenders sell a pool of receivables into a trust. They generally retain servicing of the loans. Lenders may alternatively sell the receivables to be packaged by Wall Street conduits. In this case, servicing responsibility is generally not retained by the lender.
Certificates are sold in the public and/or private markets and are secured by trust receivables. These certificates can have a variety of structures:
Fixed vs. floating coupon Wrapped vs. senior/sub Multi-tranche vs. single
tranche
Bond structure will depend on the underlying collateral, trust structure, and credit enhancement.
Most HELs are Floating Rate
Excess spread is the first line of defense against losses. It is composed of excess funds from interest paid on the HELs after expenses. Depending on deal structure, it may be (a) used to cover payment shortfalls in the current period, (b) used to
maintain target overcollateralization levels, or (c) flow out of the structure to the residual class holder.
Overcollateralization. Overcollateralization is equal to the par value of collateral minus the par value of issued securities. Overcollateralization may exist at inception or be built over time using excess spread. The overcollateralization cushion may be used to absorb principal losses as they occur. If overcollateralization levels are not in compliance with test levels, excess spread is used to accelerate principal payments to bondholders, thereby rebuilding overcollateralization levels.
Subordination. More senior securities have principal/interest payments subordinated to their own, which provides a natural layer of protection because they are not impacted by loss that is absorbed by the layer or layers below them.
HELs typically amortize over their term-to-maturity. Some loans require balloon payments (more common for 2nd lien) and others may have an interest only period. Loans may prepay in advance of the scheduled maturity due to voluntary prepayments (refinancing or sale of home) or involuntary prepayments (repossession or loss of home). When a prepayment occurs, principal is paid through to the security holders, thus retiring that portion of principal that is attributable to the loan that has prepaid. HELs exhibit much less interest rate sensitivity as compared to Conforming and Jumbo MBS. Contributing to the greater prepayment stability are: higher baseline speeds due to credit curing and the equity take-out component of the market, as well as prepayment penalties. Both FRMs and Hybrid ARMs have significant prepayment penalties. Penalties typically last 3-5 years for FRMs and the initial fixed period for Hybrid ARMs. An example of a typical prepayment penalty is 6 months interest on any prepayments in excess of 20% of the outstanding loan balance.
NIMs are typically securitizations of front-end residual cashflows (after bond coupons, fees, and losses) from a single unseasoned HEL deal. They are also entitled to overcollateralization releases after the step-down date as well as prepayment penalty income. NIMs typically achieve ratings of BBB by discounting the expected cash flow stream and applying various default, interest rate, and prepayment stresses. The notes have a weighted average life of 0.8 to 1.5 years and offer a spread
premium of 250-300bp to like-rated ABS. The high spread premium is the primary reason that NIMs appear in CDOs. NIM performance has been excellent over the past few years due to declines in floating rate funding costs associated with an accommodative Fed policy.
Credit Enhancement
Prepayments/ Prepayment Penalties
Net Interest Margin Securitizations
RMBS: Prime6
Chart 22 below provides an overview of the Prime RMBS market. Chart 22
Overview of the Prime RMBS Market
Source: JPMS.
The earliest, simplest of MBS classes, sequentials split pass-through cash flows into classes with different average lives. Sequentials are sensitive to prepayments, with all classes extending or shortening simultaneously.
Floating-rate MBS may have a variety of average life profiles, some stable and some volatile. Coupons typically reset monthly based on a fixed spread over a specific index rate (often LIBOR). The maximum coupon (cap), spread over index, and average life profile are main determinants of yield. Floaters, due to their shorter duration, generally have less price volatility than fixed-rate MBS (unless rates rise and the coupon reaches its cap).
Borrowers have the right to prepay at any time without penalty in effect calling their loans away from investors prepayments may be partial or complete. Timing and rate of prepayments vary and produce non-level, less-predictable cash flows. Given current interest rate expectations and following rapid prepayments over the last few years, prepayments are generally expected to slow in the coming years.
RMBS: UK
UK RMBS is one of the fastest growing sectors of the ABS market. UK RMBS is the largest sector in the European securitization market and a widely held asset class 6. A special thanks to Rajan Dabholkar and Eliza Hay for their help with the US Prime RMBS portion of
this publication. Residential homeowners borrow funds, collateralized by real property. Including: Conforming: Meet US Government Sponsored Enterprise (e.g. Fannie Mae, Freddie Mac) criteria. CDOs dont typically have exposure to GSE loans. Non-Conforming: Jumbo: Exceed the single-family loan limit for GSEs ($333,700 in 2004).
Alt A: Issued to prime borrowers that have documentation or other non-standard loan characteristics.
Wall Street dealers purchase pools of loans and structure securities based on demand
Mortgage cashflows are carved up to address:
Prepayment Risks & Cash Flow Uncertainty
Call and/or Extension Risk Negative Convexity Specific client needs Different Targets: Average Life, Yield, Duration, Credit Quality
Certificates
Structure
among European investors. It also provides an opportunity for investors to diversify away from US consumer credit into high quality secured asset-backed product. Chart 23 above provides an overview of the UK RMBS market.
Despite the growth in new product types, UK mortgages typically have a number of common characteristics, including a term of 25 to 40 years, a floating interest rate, full amortization over the life of the loan, and a first charge (i.e., lien) on the property. The mortgages interest rate (the standard variable rate, or SVR) is set at the discretion of the lender and is loosely tied to the central bank rate.
UK residential mortgages have historically been marked by stable mortgage prepayments. In recent years, the introduction of a number of flexible mortgage products and increased competition among mortgage lenders have led to increased remortgage activity among existing lenders. In turn, this remortgaging activity has pushed prepayment speeds marginally higher.
For investors familiar with the mechanics of a credit card ABS master trust structure, the UK RMBS master trust uses a similar technology to create a soft bullet repay-ment profile. Because the total amount of mortgage collateral in the trust exceeds the size of any RMBS tranche due, prepayment leverage ensures the trust can create a bullet payment in a short accumulation period. An issuer can issue additional series from the master trust by either adding new mortgage collateral to the trust or transferring part of the sellers share to the investor share (since the sellers share is very large when the master trust is first established). In anticipation of notes becoming due, principal payments are accumulated for the purpose of creating a bullet repayment for that series.
Chart 23
Overview of the UK RMBS Market
Source: JPMS.
The underlying collateral is prime UK mortgages for owner-occupied homes. Mortgage brokers are a vital source of new mortgage origination (up to 60% of new loans for some lenders), branches and telephone distribution are also important. UK Mortgage Product Standard variable rate mortgages (capital repayment over 25 year life). Flexible mortgages have
experienced dramatic growth in the past few years. Allow borrowers to prepay their principal and feature payment holidays
Fixed rate or hybrid mortgages. Initial fixed rate reverts to floating after specified time period (2-5 yrs).
UK mortgage lenders can be divided into three basic categories: banks, building societies (operate under the principle of mutual ownership), and specialized mortgage lenders (a focus on non-conforming borrowers). The UK market is dominated by the largest lenders, which are primarily banks.
The master trust structure used in global UK RMBS creates a clean bullet repayment profile similar to that of credit cards. An issuer can issue multiple series of Notes from the master trust and principal payments from each series (as in credit cards) may be shared among series to create a bullet or meet a repayment schedule for an individual series.
Certificates
Master Trust Structure
The sellers share represents the total interest in the trust collateral retained by the seller and is set to a minimum amount. The sellers share does not represent a form of credit enhancement, as it ranks pari passu with the investor share. Excess seller interest is the interest in the collateral retained by the seller that exceeds the required minimum seller interest. Excess seller interest absorbs temporary fluctuations in the collateral balance of the trust (i.e., higher than normal redraws).
Collections on the mortgage pool are split between interest charges and principal repayments. Interest income is allocated on a pro rata basis among each series of the master trust. The allocation of principal collections depends on the cash flow stage of each series. Principal repayments may be used to 1) amortize pass-through notes or to accumulate principal for a bullet repayment, 2) pay the seller and reduce the size of the trust (provided the seller maintains a minimum sellers interest, or 3) purchase new mortgage receivables from the seller during the revolving period. UK RMBS typically issue a portion of their liabilities (typically shorter term) as US$ denominated, SEC registered securities. This is due in part to lower short term rates in the US, with more aggressive pricing in the US on securities inside three years. US$ tranches also help to diversify the UK RMBS investor base.
UK RMBS use a senior/subordinate structure with credit enhancement provided by subordination and excess spread. In general, reserve funds provide liquidity and credit enhancement to the structure. The reserve fund provides liquidity in that it can be used to cover any interest shortfall on the notes and acts as credit enhancement in that it absorbs any losses in a calculation period to the extent that excess spread is insufficient. For master trusts with structured bullets, the reserve fund can also provide liquidity to pay AAA bullet principal (again, to the extent necessary). Additional structural features (eg, cash reserves and liquidity facilities) interact with the priority of payments to help ensure the timely payment of interest and principal to the notes.
RMBS: UK Non-Conforming
UK conforming mortgages are analogous to US HELs. Like HELs, non-conforming RMBS are secured by residential real estate property, primarily first lien mortgages to borrowers unable to obtain funding from conventional mortgage lenders. Borrowers in the non-conforming market include self-employed (without sufficient proof of income and financial history), foreign nationals working in the UK (no credit record), and those with County Court Judgements (CCJs). In the UK, County Court Judgments are recorded when an individual has not repaid some form of debt, ranging from credit card bills to an unpaid mortgage. As of year-end 2003, the largest originators are GMAC RFC (RMAC), Kensington Group plc, and Britannia Building Society.
RMBS: Continental Europe
Together, German, Dutch, Spanish and Italian RMBS represent a large source of European structured products issuance. While mortgage characteristics (e.g., loan-to-value, prepayments, fixed/floating, mortgage features, etc.) vary by country, the collateral is considered prime in that mortgage borrowers have not experienced past credit problems. The mortgages are typically first-lien (except Germany), US$ Securities
owner-occupied properties. Mortgage credit performance has been strong, and the sector has experienced a number of upgrades due to better-than-expected
performance and prepayments (i.e., deleveraging of the structure). Highly rated European banks seeking diversified funding and regulatory capital relief have been the primary source of these deals. While structures also vary by country, continental RMBS transactions typically pay down senior tranches sequentially and may only amortize subordinate tranches provided that certain performance criteria are met.
CMBS7
The CMBS market emerged in the last decade as a response to the real estate cycle in the United States, as traditional lenders (commercial banks, insurance companies) avoided real estate exposure during the real estate downturn of the late 80s and early 90s. CMBS allows lenders to spread underwriting risk, diversify geographically, and increase liquidity. It has also increased funding options for developers and large owners of commercial property. Chart 24 below provides an overview of the CMBS market. Chart 24
Overview of the CMBS Market
Source: JPMS.
Credit enhancement is achieved mainly through subordinated bond classes (AA to unrated classes). Default risk is a function of the initial LTV (Loan-to-Value) and DSCR (debt-service-coverage-ratio).
Newly originated fixed rate loan pools carry significantly less prepayment risk, as there are large prepayment penalties to the individual borrowers, typically in the form of strong loan-level call protection and a lock-out period followed by defeasance. 7. A special thanks to Pat Corcoran and Yuriko Iwai for their help with the CMBS portion of this publication.
CMBS are backed by mortgages on commercial and multifamily properties that are income-producing and operated for economic profit. CMBS are backed by a wide range of property types (total portion of issuance in parentheses):
rental apartments (22.4%) shopping centers and other retail facilities (36.2%)
office buildings (25.2%) hotels (1.8%)
warehouse/industrial (7.9%) nursing homes, mobile home parks and self-storage (6.5%)
Wall Street firms & other conduit operators securitize portfolios of newly originated loans to empty the warehouse and take profits Banks, thrifts and insurance companies securitize seasoned loans to clear the balance sheet, adjust exposures, or exit the sector Wall Street firms and real estate "opportunity" funds acquire and securitize portfolios of seasoned loans to finance the acquisition and/or cash out of the investment Owners of large commercial properties and pools of smaller commercial properties secure attractive financing as an alternative to a portfolio lender
Conduit/Fusion (67.9%): Conduit deals are well-diversified, about $1billion in total size. Fusion deals are conduit deals that include some large loans (>$50MM), which are typically high quality, shadow-rated investment grade loans but pose some concentration risk. Multi-borrower floater (19.3%): Backed by floating rate loans from several borrowers. They are generally shorter term deals with some adverse selection risk. Single asset/single borrower (9.8%): Either backed by a single property or a single borrowers portfolio.
Certificates
Structure/Credit Enhancement Prepayments/ Extension
Extension risk is created when not enough income and equity are available to pay the balloon payment. CMBS with low LTVs have less extension risk.
European CMBS can be differentiated from US CMBS by several factors. First, US issuance is typically more standardized and uses the conduit structure. In Europe, different countries have different underlying lease terms and the Conduit market is smaller because banks have (historically) been able to fund real estate on balance sheet very cheaply. This is changing over time. Broadly, the European cash CMBS market can be broken up into the following categories:
Single borrower, single property (mostly UK based deals, with trophy assets). Single borrower, single tenant with no disposal strategy on the properties
(typically linked to rating of underlying corporate).
Single borrower, single tenant with a disposal strategy on the properties (i.e. sell the properties to pay the principal on the bonds).
Multi-borrower
CMBS: Interest Only Strips
IOs are coupons stripped from an underlying pool of commercial mortgages. They allow an issuer to sell near par priced securities, even if the coupon on the underlying mortgages is greater than the bond coupons. A single IO strip (traditional form) is defined as the adjusted WAC of the loans minus the WAC of the principal bonds. An alternative form is two IO strips (PAC and Support). The PAC IO is stripped from the traditional IO. Its notional amount and size is determined assuming certain default and prepayment scenarios. PAC IOs generally have a WAL of 7.0 years. The Support IO is the leftover and bears most of the brunt in the event of early
prepayment. CMBS IOs are typically limited to at most 5% of the SF CDO collateral pool. They are not included in diversity score or WARF calculation and are typically haircut for purposes of par value tests.
CMBS: Non-Performing Loan (Europe)
Following the introduction of the Italian Securitization Law in 1999, non-performing loans (NPLs) represented a large percentage of the Italian securitization market. A key driver behind NPL securitization was the favorable tax treatment that allowed Italian banks to amortize any losses (over a five year period) arising from sale or securitization of NPLs. However, this special tax provision was terminated in mid-2001, which has caused Italian NPL securitization to decline. NPL securitizations are typically backed by commercial real estate properties. NPL securitizations frequently depend on a property disposal strategy for the repayment of bond principal and interest. Because the loans are non-performing, the loan servicer plays an important role in transaction performance (i.e., ensuring that the loans move quickly through any court proceedings). Going forward, German banks may begin securitizing non performing loan portfolios as well.
Real Estate Investment Trusts (REITs)
REITs are companies that own and (in most cases) operate income-producing real estate, with assets in the $300 billion area. Common REIT property types include diversified pools of regional malls, shopping centers, office buildings, warehouses, and residential facilities. REITs are typically financed using about half debt and half equity (equity pays out at least 90% of its taxable income as dividends). This is a significant improvement versus the early 1990s, when individual properties were typically financed by mortgages with LTVs in the 90% area, leaving companies less flexibility and more exposed to interest rate risk. There have been no REIT bond defaults in the last 10 years. Positive performance can be attributed to conservative debt ratios, the ability to access the secured market in times of distress, and the property cycle upswing.
SF CDOs invest in unsecured fixed rate REIT debt, the majority of which is rated BBB. In addition to an interest rate swap, the CDO structure typically also includes a timing swap to match semi-annual REIT payments to quarterly CDO payments. With BBB REITs typically pricing within +/- 20bp of CMBS BBBs (T+120 ten year average), the inclusion of REITs in a SF CDO is not yield enhancement. Rather, it helps to improve diversity, since rating agencies give some diversification credit versus CMBS.
Consumer ABS: Auto and Credit Card
Auto ABS securitize secured consumer installment loans or leases used to finance new and used car purchases. Receivables carry a fixed interest rate and usually have a 36, 48, or 60 month term. Receivables are originated by captive manufacturer finance subsidiaries (GMAC, Ford, DaimlerChrysler, Honda, Toyota), banks (Chase, M&I, Regions, USAA), and specialty finance companies (AmeriCredit, Onyx, WFS). Auto ABS typically use the Owner Trust structure, which provides flexibility in structuring cashflows, permitting multiple senior tranches, as well as floating rate tranches. Credit enhancement to senior notes are typically provided by subordinated certificates supplemented with a reserve account. Loans may prepay in advance of the scheduled maturity due to voluntary prepayment (refinancing or sale of vehicle) or involuntary prepayment (repossession or loss of vehicle).
Credit Card ABS are backed by receivables from unsecured consumer loans. Types of cards include revolving lines of credit (Visa and Master Card) as well as retail cards from issuers such as Macys and Neiman Marcus. Non-revolving charge cards from AMEX are also common. Large issuers include Chase, Capital One, Citibank, and MBNA. Nearly every Credit Card ABS issuer uses the master trust structure, similar to the UK RMBS structure discussed above. Structures include a revolving period of 1-10 years (where monthly principal collections are used to purchase new receivables), followed by an accumulation period. Notes may be fixed or floating, typically with a 5yr expected life. Excess spread, early amortization triggers, and subordination are key forms of credit enhancement.
Auto and Credit Card ABS are two of the largest, most mature, most liquid sectors in the ABS market. Both typically are priced at or near the tightest spreads in the ABS market. Because low spreads reduce CDO arbitrage opportunities, CDOs tend to limit exposure to most Auto and Credit Card ABS (although some is typical as a means of increasing diversity).
Consumer ABS: Consumer Loan (Europe)
Credit card penetration among Europeans remains low compared to the US and amortizing term loans represent a large part of unsecured lending in many countries. Unsecured consumer loans may be used for an auto purchase, home improvement, or other reasons, although the loans purpose does not always need to be stated. Consumer loan ABS transactions frequently have a revolving period, during which prepayments are used to purchase new loan collateral. Cumulative loss rates for consumer loan ABS have remained very low (less than 2%), while excess spread has remained healthy (e.g., over 5%). Italian consumer loan performance varies
according to the region where the loans are originated, with southern regions frequently experiencing higher default rates.
Corporate ABS: Equipment
Equipment ABS is backed by loan or lease receivables including agricultural, computer, industrial, medical, small ticket office, and trucking. Lessors include both independent leasing companies and captive subsidiaries of large manufacturing firms. Credit analysis includes a review of the projected remaining cashflows and underwriting standards. Leasing company receivables are typically diversified across geography, industry, and obligors, and additional analysis and credit enhancement are required in cases where concentrations are high.
Lease payments typically cover over 90% of equipment costs and 75% of the useful life for financing leases (essentially a monthly payment plan). Operating lease payments cover less than 90% of equipment value. Residual value (estimated value at the end of the lease term) can be realized via a buyout option or sale, and may be given some credit in rating agency analysis. Credit enhancement includes subordination, reserve funds, and de-leveraging performance triggers. SF CDOs typically purchase the single-A tranche. Bonds are typically fixed-rate, with a spread pick-up of 6-8bp to like-rated autos, and have a weighted average life of two to three years and experience low prepayment volatility. Equipment ABS supply is typically correlated with performance of the overall economy, with businesses willing to add/replace equipment in robust economies. In Europe, large Italian lease companies have originated the majority of equipment lease ABS. To date, equipment, vehicles and real estate leases have backed these transactions.
Corporate ABS: Whole Business Securitization (Europe)
Whole business securitizations are bonds that are backed by the cash flows from a company. WBS companies typically have very stable cash flows and usually benefit from regulation or other protections that make it unlikely that these cash flows will change. For example, water utilities, funeral homes, and pubs are all types of operating companies that have been securitized. Whole business securitizations
achieve higher ratings than unsecured debt through covenants (e.g. bondholders right to replace management) and committed liquidity. WBS may also include property or high profile assets that have real value for WBS bondholders. To date, whole business securitizations have been a UK phenomenon, due to the favorable legal status afforded to WBS bondholders.
CDOs
Other CDOs may be included in the SF CDO structure. Unlike CDOs-of-CDOs, where nearly 100% of the collateral pool is other CDOs, SF CDOs typically source a limited amount of other CDOs as collateral. This number was often 20% in earlier deals, but has been closer to 5-10% in more recent deals. The purpose for including CDOs in the collateral pool may be either yield enhancement or diversification. In addition to overall CDO concentration limits, SF CDOs also have limits on PIKable collateral. CDOs of small- and medium-sized enterprise (SME) loans are common in Europe. SME CLOs are not arbitrage-driven, and the primary motivation for banks to do these deals is balance sheet relief. SME loan pools usually offer a very large number of underlying obligors and thus a high degree of granularity in the portfolio. Germany, the Netherlands, Spain and the UK have all contributed to SME CLO volume.
Does SF Collateral Work for CDOs?
There is a good case, we think, for applying CDO technology to structured product collateral. Structured products offer a spread pick-up to like rated corporates, as well as comparable default and recovery rates. Low event risk, a relatively stable arbitrage opportunity, and low correlation with traditional CDO collateral are also positive.
Spread Pick-Up
The rise in SF CDO issuance was primarily the result of a sharp widening in structured products spreads in the fall of 1998. At that point, there was a severe dislocation in many non-government markets that injected huge liquidity premiums into spreads and presented attractive arbitrage opportunities. The resulting
exploitation of these opportunities resulted in the take-off of SF CDOs. Fortunately (for arbitrage purposes), structured products spreads have remained relatively wide, explaining their continued growth as an asset of choice in CDOs.
We make the case later in this section that structured product performance has been in line with like rated corporates. As such, we believe the spread pick-up arises from relatively less liquidity and higher barriers to entry (complexity) in the structured products markets. SF CDOs, in essence, monetize this premium, which arises from several factors:
Small size of the subordinate structured product market8 Small size of individual subordinate tranches
Small size of the subordinate structured product buyer base Complex structures that require more sophisticated analysis
To illustrate, Chart 25 shows a significant spread pick-up for BBB and single-A HELs to like rated finance corporates. By contrast, the most liquid structured products sector, Credit Cards, prices much closer to the corporate market (Chart 26). For this reason, SF CDOs typically have larger allocations to HELs and other less liquid sectors than to Cards.
Chart 25
HEL vs. Finance Spread Differentials
Source: JPMS. -150 -100 -50 0 50 100 150 200 250 300 350
Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 HEL Minus Finance (A) HEL Minus Finance (BBB)
Chart 26
Credit Card vs. Banks Spread Differentials
Source: JPMS. -60 -40 -20 0 20 40 60 80
Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Credit Card minus Banks (A 5-year) Credit Card minus Banks (BBB 5-year) 8. Small size of both the subordinate market and individual subordinate tranches also (arguably) leads to scarcity,
Stability/Event Risk
The CDO universe can be roughly divided into moderately leveraged sectors (HY CLOs at 12x, HY CBOs at 8x) and more highly leveraged sectors (investment grade corporate CDO at 25x, SF CDO at 20x). In general, highly leveraged sectors are able to apply greater leverage because they are backed by relatively more stable high grade assets. The problem with applying greater leverage to stable assets, however, is that these sectors become more exposed to single names and tail risk, where unusual (based on historical experience) scenarios can quickly eat through the small amount of equity subordination in the structure. Note that leverage can vary greatly across SF CDOs (8-25x), with less levered structures less exposed to event risk. The experience of IG CDOs in 2002 and 2003 when incidents of fraud, defaults, and fallen angel9corporates were high is illustrative. These unusual events (fraud in particular) were painful for IG CDOs. For example, in an IG CDO backed by 100 equally weighted corporates, a 4% equity tranche would be wiped out by four defaults (assuming zero recoveries). Although IG CDO portfolios may not have exposure to every case of fraud (e.g. Enron, WorldCom, Parmalat), exposure to even a few of these cases leaves little room for error.
Although SF CDOs employ similar leverage to IG CDOs, they are less exposed to event risk. This can be largely attributed to the higher levels of granularity in the underlying structured products, which are often referenced to a large number of individual consumers. In addition, the underlying structured products are themselves credit enhanced to withstand multiples of base case scenarios. Some idiosyncratic risk is clearly present in the form of issuer concentrations (model risk) and servicer risk. These risks, however, can be mitigated by concentration limits, limiting exposure to established sectors with proven models, and investing in sectors with adequate back-up servicing capability.
Stable Arbitrage Opportunity
The subordinate ABS and CMBS markets are particularly dependent on the CDO bid. We use the US HEL and CMBS market as an example, although a parallel argument could be made for Europe, where the CDO market has a similar importance. Weve calculated that newly issued cash SF CDOs purchased
approximately $10.2 billion in HEL subs and $7.9 billion in CMBS subs in 2003. In terms of 2003 issuance, this equates to approximately 32% of HEL subs and 80% of CMBS subs. The percentage of HEL subs was probably even higher in late 2003. Although CDOs purchase a significant portion of their collateral from the secondary market, these figures help put the CDO bid in context of the collateral market size. However, as we hope this paper makes clear, we believe the SF CDO market is here to stay, meaning the CDO bid is not expected to go away.
As such, the SF CDO bid can exert significant technical pressure on collateral spread levels. When collateral is cheap, CDOs will enter the market, supplying additional demand and effectively putting a cap on spreads. This effect is enhanced due to the lumpy (not smoothed over the year) nature of SF CDO supply, as large numbers of deals tend to begin ramping up collateral simultaneously when the arbitrage looks attractive. 9. Defined as a investment grade security (BBB and above) falling to high yield (below BBB) or default.
SF CDOs Exert Technical Pressure On Collateral Markets
When collateral is rich, CDO demand decreases. Since the structured products markets are dependent on the CDO bid for subordinate paper, SF CDOs effectively put a floor on subordinate spreads at the point where the CDO arbitrage disappears.
To a certain extent, this phenomenon can also be observed in the institutional leveraged loan market, where CDOs are significant buyers. In contrast, the CDO bid is less influential in investment grade CDS, due to the size of that market (approximately $5 trillion).
Chart 27 shows arbitrage levels in terms of the CDO funding gap (by definition, spread on assets minus cost of debt) for both SF and IG CDOs. Because SF CDOs put caps and floors on collateral spreads, the arbitrage has been much less volatile in this sector over the last several years.
Correlation
Exposure to structured finance offers strong diversification benefits for CDO investors. This is because SF CDOs have exposure to several different asset classes (CMBS, Prime RMBS, HEL) that each have low correlation to traditional CDO asset classes (High Yield Bonds, Leveraged Loans, Investment Grade Corporates). Higher diversification reduces risks since it implies lower correlation in the variability of returns. Please note that correlation in this sense means spread correlation, and not default correlation. Table 8
US Monthly Spread Correlation (2000-2003): AAA/AA Structured Products & Traditional CDO Collateral
10 Yr AAA 10 Yr AA 5 Yr AAA JPM USD 5 Yr BB/BB- 10 Yr BBB
CMBS MBS HEL HY Index Lev Loan Industrial
10 Yr AAA CMBS 1.0 0.5 0.2 0.4 0.4 0.4 10 Yr AA Prime RMBS 1.0 0.3 0.4 0.4 0.1 5 Yr AAA HEL 1.0 0.1 0.3 -0.1 JPM USD HY Index 1.0 0.1 0.7 5 Yr BB/BB- Lev Loan 1.0 0.2 10 Yr BBB Industrial 1.0 Source: JPMS, S&P LCD. Table 9
US Monthly Spread Correlation (2000-2003): BBB Structured Products & Traditional CDO Collateral
10 Yr AAA 10 Yr AA 5 Yr BBB JPM USD 5 Yr BB/BB- 10 Yr BBB
CMBS MBS HEL HY Index Lev Loan Industrial
10 Yr BBB CMBS 1.0 0.4 0.4 0.3 0.5 0.3 10 Yr BBB Prime RMBS 1.0 0.1 0.4 0.2 0.1 5 Yr BBB HEL 1.0 -0.1 0.1 -0.1 JPM USD HY Index 1.0 0.1 0.7 5 Yr BB/BB- Lev Loan 1.0 0.2 10 Yr BBB Industrial 1.0 Source: JPMS, S&P LCD. Chart 27
Normalized CDO Funding Gap10
Source: JPMS. -3 -2 -10 1 2 3 4 5 6 7 8 9 10
Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 IG CDO SF CDO
10. Note: The actual funding gap values are normalized at 10. It is the yield on CDO collateral minus the cost of CDO liabilities, fees, and expected loss.
Table 10
Euro Monthly Spread Correlation (2000-2003): BBB Structured Products & Traditional CDO Collateral
Dutch 5-7 Yr UK 5 Yr BBB Euro Leveraged JPM EUR
BBB RMBS Dollar RMBS Loan HY Index
Dutch 5-7 Yr BBB RMBS 1.0 0.3 0.0 0.1
UK 5 Yr BBB Dollar RMBS 1.0 0.2 0.0
Euro Leveraged Loan 1.0 0.0
JPM EUR HY Index 1.0
Source: JPMS, S&P LCD.
Table 11
Euro Monthly Spread Correlation (2000-2003): AAA Structured Products & Traditional CDO Collateral
Dutch 5 Yr UK 5 Yr AAA
AAA RMBS Sterling RMBS Pfandbriefe AA Financials
Dutch 5 Yr AAA RMBS 1.0 0.5 0.1 0.2
UK 5 Yr AAA Sterling RMBS 1.0 0.3 0.1
Pfandbriefe 1.0 0.4
AA Financials 1.0
Source: JPMS.
Default and Recovery Performance
Any analysis of default and recovery in the structured product markets is challenged by a lack of historical data. Nevertheless, now that the structured products markets have matured and been tested through several economic cycles, we do have some (limited) history and experience to start examining defaults in the market and to assess the ultimate recovery on these bonds. Ultimately, default and recovery data allows investors to evaluate current SF CDO portfolio assumptions, and should help guide investment decisions, as defaults and recoveries play a key role in the
structuring processes.
Unlike corporates, where a default is caused by a discrete event like a bankruptcy or a missed coupon payment, structured products typically suffer principal losses over time as loans default and as those move through the cashflow waterfall. Thus, it may take months or even years before losses eat through the credit enhancement and bonds take their first dollar loss of principal. Even after the bond starts taking principal losses, it still may take months, or even to the end of the deal, before the ultimate loss of principal can be determined. In addition, missed interest and principal may sometimes be deferred to the next period or a later period. Missed payments may also sometimes be capitalized and repaid over the remaining life of the transaction.
For our analysis of structured products defaults and recoveries, we use a recent Moodys study of material impairment rates11, a concept that Moodys has
introduced to address the vagaries of default discussed in the paragraph above. One of the downsides of this study is that it addresses US structured products only, and nothing of its kind yet exists for the European market (largely due to the relative youth of the market). Nevertheless, we think the conclusions reached using the Moodys US data are broadly applicable to European structured products given that 11. Payment Defaults and Material Impairments of US Structured Finance Securities: 1993-2002, Moodys
ratings are designed to have consistent meaning across regions. If anything, some conclusions are likely to be conservative given the exceptional rating stability of European structured products as shown in Appendix A.
Materially impaired securities are defined as follows:
Securities that have not paid promised principal and interest in entirety by the final maturity date (unambiguously in default).
Securities that have sustained a payment default that has not been cured.
Securities that are rated Ca or C and hence are expected to suffer a significant level of payment losses in the future.
Table 11 below shows the cumulative material impairment rates for both corporate and structured product securities (by sector). Table 12 shows the annualized material impairment rates by year, as well as the five year average.
Table 11 Table 12
Cumulative Material Impairment Rates of Annual Material Impairment Rates of US SF & Corporate Securities by Original US SF & Corporate Securities by Original
Rating, 1993 - 2002 Rating, 1993 200212
5 Yr. Annual Year 1 Year 2 Year 3 Year 4 Year 5 Year 1 Year 2 Year 3 Year 4 Year 5 Average Corporate Aaa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Aa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% A 0.00% 0.00% 0.00% 0.21% 0.21% 0.00% 0.00% 0.00% 0.21% 0.00% 0.04% Baa 0.58% 1.20% 1.86% 2.78% 3.87% 0.58% 0.62% 0.67% 0.94% 1.12% 0.79% Ba 4.10% 8.67% 13.38% 16.97% 20.82% 4.10% 4.77% 5.16% 4.14% 4.64% 4.56% ABS (including HEL)
Aaa 0.00% 0.00% 0.05% 0.05% 0.05% 0.00% 0.00% 0.05% 0.00% 0.00% 0.01% Aa 1.29% 1.94% 2.27% 2.71% 2.83% 1.29% 0.66% 0.34% 0.45% 0.12% 0.57% A 0.05% 0.49% 0.87% 1.10% 1.10% 0.05% 0.44% 0.38% 0.23% 0.00% 0.22% Baa 0.25% 1.36% 2.30% 3.76% 4.38% 0.25% 1.11% 0.95% 1.49% 0.64% 0.89% Ba 1.41% 8.57% 14.38% 18.26% 19.70% 1.41% 7.26% 6.35% 4.53% 1.76% 4.26% CMBS Aaa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Aa 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% A 0.00% 0.00% 0.00% 0.23% 0.23% 0.00% 0.00% 0.00% 0.23% 0.00% 0.05% Baa 0.13% 0.41% 0.55% 0.83% 0.83% 0.13% 0.28% 0.14% 0.28% 0.00% 0.17% Ba 0.29% 0.29% 1.47% 1.77% 1.77% 0.29% 0.00% 1.18% 0.30% 0.00% 0.36% RMBS (prime mortgages) Aaa 0.00% 0.00% 0.00% 0.36% 0.58% 0.00% 0.00% 0.00% 0.36% 0.22% 0.12% Aa 0.00% 0.00% 0.44% 0.89% 1.01% 0.00% 0.00% 0.44% 0.45% 0.12% 0.20% A 0.00% 0.16% 0.47% 0.47% 0.63% 0.00% 0.16% 0.31% 0.00% 0.16% 0.13% Baa 0.40% 1.33% 3.86% 5.06% 6.00% 0.40% 0.93% 2.56% 1.25% 0.99% 1.23% Ba 0.00% 1.10% 3.32% 4.42% 4.98% 0.00% 1.10% 2.24% 1.14% 0.59% 1.01% Source: JPMS, Moodys.
Overall, the default history has been favorable, with structured products performing in-line with or better than the corporate market in most cases. Structural protections, including subordination and excess spread, have helped to insulate ABS investors from taking principal losses. However, we expect that some of these figures are conservative, for the following reasons.
Material Impairment Rates
Material Impairment Data is Conservative