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[JP Morgan] CDO Handbook

[JP Morgan] CDO Handbook

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Global Structured Finance Researchwww.morganmarkets.com
 New YorkJ.P. Morgan Securities Inc.May 29, 2001Global Structured Finance ResearchDouglas Lucas (1-212) 834-5535
douglas.j.lucas@chase.com
CDO Handbook
C
ONTENTS
Overview . . . . . . . . . . . . . . . . . . . .1Introduction . . . . . . . . . . . . . . . . . . .2Assets, Tranches, Purposes, CreditStructures . . . . . . . . . . . . . . . . . . . .4Typical Structures . . . . . . . . . . . . . .8Why Do CDOs Exist and Why DoInvestors Buy Them? . . . . . . . . . . .11Market Value Credit Structure . . . .15Cash Flow Credit Structure . . . . . .18Synthetic CDOs . . . . . . . . . . . . . .24Parties to a CDO . . . . . . . . . . . . . .27Legal Considerations . . . . . . . . . . .31Accounting Considerations . . . . . .37Tax Considerations . . . . . . . . . . . .40Glossary and Notes . . . . . . . . . . . .42Rating Agency Publications . . . . . .49Asset Managers and Sellers . . . . . .50
 Distribution of this report is restricted in certain countries. Important information concerning these and other restrictionsis set forth at the end of this report.
Overview
Global CDO issuance has averaged $137 billion per year for the last three years.In the context of asset-backed securities (ABS), this figure is about one-half of public and private U.S. issuance. This sustained level of activity is remarkable,given that annual volume never exceeded $4 billion until 1996. We estimateoutstanding CDO volume at $500 billion. The current status of CDOs is due tothe acceptance of the product by investors and credit risk hedgers.This report is a comprehensive introduction to CDOs. It addresses:the structural components of CDOs;typical CDOs;why CDOs exist;the cash flow and market value credit structures;synthetic CDOs;the asset manager and other parties to a CDO;legal, accounting, and tax considerations;CDO terminology.
Chart 1
CDO Issuance
(US$ billions)
$0$20$40$60$80$100$120$140$160
        1        9        8        7        1        9        8        8        1        9        8        9        1        9        9        0        1        9        9        1        1        9        9        2        1        9        9        3        1        9        9        4        1        9        9        5        1        9        9        6        1        9        9        7        1        9        9        8        1        9        9        9        2        0        0        0
Sources: JPMorgan, MCM Corporate Watch, Fitch, Moody's Investors Service, and Bloomberg.
C
HRISTOPHER 
F
LANAGAN
 Head, Global Structured Finance Research
CDO R 
ESEARCH
Douglas Lucas(1-212) 834-5535
douglas.j.lucas@chase.com
Thomas Sam(1-212) 648-6794
sam_thomas@jpmorgan.com
A
SSET
-B
ACKED
ESEARCH
Ryan Asato(1-212) 834-5760
ryan.asato@chase.com
Linda Feinne(1-212) 648-2580
feinne_l@jpmorgan.com
Christopher Flanagan(1-212) 834-5520
christopher.t.flanagan@chase.com
Carmen Gellineau(1-212) 648-3837
gellineau_carmen@jpmorgan.com
Ting Ko(1-212) 834-5629
ting.ko@chase.com
Amy Sze(1-212) 648-6769
sze_amy@jpmorgan.com
Dmitry Yakimchuk(1-212) 648-6781
 yakimchuk_dmitry@jpmorgan.com
Linda Yu, CFA(1-212)834-3171
linda.yu@chase.com
I
NTERNATIONAL
ABS R 
ESEARCH
Edward Reardon(44-20) 7325-3528
reardon_edward@jpmorgan.com
Kazuhiko Toya(813) 5573-1331
toya_kazuhiko@jpmorgan.com
 
Introduction
1
Aperson new to collateralized debt obligations (CDOs) is faced with bewilderingterminology:Arbitrage CBOBalance Sheet CLOMarket Value CDOCash Flow CDOEMCBORepacksCBO of ABSSynthetic CDORe-REMICsSynthetic Arbitrage CLOInvestment Grade CBOCBO of Real EstateThese names, for different types of CDOs, reflect the variety of features and forms a CDOcan take and still be called a CDO. ACDO can hold bonds, loans, emerging market debt,ABS, RMBS, and CMBS. It can also gain exposure to these assets synthetically. TheCDO can issue floating or fixed rate obligations tranched in a variety of ways with respectto seniority and payment. Its obligations can be revolving, have delay draw features, andbe guaranteed by a third party. CDOs are done for one of two different purposes and useeither of two distinct credit structures or a combination of the two credit structures.The CDO names above do not fully describe any CDOs structure and are not mutuallyexclusive from one another. We think the easiest way to both classify and understandCDOs is by taking a component or a la carte approach. ACDO can be pretty completelydescribed by the choices made with respect to its:(1) underlying assets;(2) tranche structure;(3) purpose;(4) credit structure.Looking at CDOs this way will also allow future innovations to be placed in the context of an existing conceptual framework.The next section of this paper discusses these four structural components. The fourthsectionof this paper describes the most typical CDO structures existing today or, to stretch the menuanalogy, the most popular prix fixe CDO combinations. In these two sections, we hope toprovide a flexible definition of CDOs and a description of current market practice.The fifth through twelfth sections of this report address specific CDO topics. The sectionsare stand alone; they can be read in any order and sections can be skipped if they are notof current interest. These sections are:Why do CDOs exist and why do investors buy them?;Market value credit structure;Cash flow credit structure;Synthetic CDOs;Parties to a CDO;Legal considerations; Accounting considerations;Tax considerations.
 New YorkJ.P. Morgan Securities Inc.CDO HandbookMay 29, 2001Global Structured Finance ResearchPage 2Douglas Lucas (1-212) 834-5535
1
The author would like to thank Ade Adetayo, Andrew Chalnick, Jeremy Gluck, Bob Grossman, Ji-Mei Ma, BillMay, Edward Mayfield,Roger Merritt, Pat O'Brien, Allen Reiser, Marie Stewart, David Tesher, Katrina Tormey, and Lenny Zuckerman for their generous help inpreparing this report.
 
AGlossary and Notes section defines italicized terms in the text and discusses topicsremoved from the main concern of the paper. The two final sections of the report listuseful articles published by rating agencies and the names of CDO asset managers andasset sellers.Please note that CDO refers to the special purpose vehicle (SPV) that holds assets andissues obligations. CDO also refers specifically to the obligations the SPVissues, leadingto the seemingly circular phrase the CDO issues CDOs. Finally, CDO is an umbrella termencompassing the various subclasses, including the CDO species listed above.
 New YorkJ.P. Morgan Securities Inc.CDO HandbookMay 29, 2001Global Structured Finance ResearchPage 3Douglas Lucas (1-212) 834-5535

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