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November 17, 2006
Strategy David Covey email@example.com Michael Koss firstname.lastname@example.org Akhil Mago email@example.com Jasraj Vaidya firstname.lastname@example.org Brian Zola email@example.com Rahul Sabarwal firstname.lastname@example.org Quantitative Research Dick Kazarian email@example.com Dan Mingelgrin firstname.lastname@example.org Stefano Risa email@example.com Vivien Huang firstname.lastname@example.org Omar Brav email@example.com Gaetan Ciampini firstname.lastname@example.org
OVERVIEW The ABS Collateralized Debt Obligation (CDO) market came into being in late 1999 and has grown exponentially since then. Issuance in 2006 will exceed $150 billion, doubling issuance in 2005, bringing total outstanding to more than $300 billion. We expect issuance to continue to grow briskly, as new assets get securitized and the synthetic ABS market expands over time. Almost by definition, ABS CDOs are complex, adding structural complexity to underlying assets that are often themselves quite complex. As with any securitized sector, a better understanding of structure, collateral, and risks can help uncover value in the market. Our primer is designed to help investors increase their understanding of these facets of ABS CDOs; in addition, we present a brief history of the ABS CDO market and discuss current trends therein. We focus in particular detail on the risk factors and valuation considerations that investors face today. This report covers the following major areas: • • • • • • • What is an ABS CDO? Role of the Collateral Manager A Brief History of the ABS CDO Market Collateral Performance Structure Features Valuation Considerations Risk Factors
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 27
Lehman Brothers | ABS CDOs – A Primer
Table of Contents What Is an ABS CDO? Characteristics of CDOs The Importance of CDOs CDO Economics 101 Role of the Collateral Manager Portfolio Selection Eligibility Criteria Surveillance A Brief History of the ABS CDO Market Issuance Trends Diversified versus Real Estate Era Spread History Collateral Performance Rating Transitions Upgrade/Downgrade Statistics Structural Features Credit Enhancement Coverage Tests Priority of Payments Optional Redemption and Auction Calls Additional Features Valuation Considerations Rating Agency and Market Pricing and Stress Assumptions An ABS Loan-Level Approach to Losses and Prepayments Risk Factors Credit Basis Risk on Fixed-Rate Security Hedges Available Funds Cap Risk (AFC) Call Risk/Extension Risk Conclusion Glossary 3 3 5 5 8 8 8 8 9 9 10 11 11 11 12 13 13 14 15 16 17 20 20 20 22 22 23 23 23 24 25
November 17, 2006
AA (5%). Collateral Types: The breakdown of collateral types in 2003-2005 transactions is heavily weighted to real estate through the purchase of HEL. and in some circumstances allowing for future reinvestment in fixed-rate collateral (see our report on “FixedRate Collateral Risk in HG ABS CDOs” in the ABS Strategy Weekly. and A. RMBS. The average high grade transactions issued in 20032005 had 34% AAA. these asset classes include. high grade credit. Floating-rate and Fixed-rate Collateral: ABS CDOs purchase floating-rate and fixed-rate securities for the portfolio. A (19%). and rating. RMBS exposure is similar to mezzanine exposure. Characteristics of CDOs Before getting into the finer details of CDOs. The collateral manager may buy and sell assets • • • • 1 This is an average of about 100 transactions. November 17. 60%). The level of diversification is one of the drivers of rating agency models when determining the ratings of the debt liabilities. and CDOs. collateral type. Managed and static: CDOs have the ability to buy and sell securities after the closing date. Thus far. ABS CDOs attempt to mitigate the cash flow sensitivity to interest rate movements by purchasing amortizing swaps and caps. The use of CDOs as a technology. HY CBOs.Lehman Brothers | ABS CDOs – A Primer What is an ABS CDO? A collateralized debt obligation (CDO) is a bankrupcy remote special-purpose entity that purchases a pool of securities and funds the purchase of those securities by issuing debt liabilities collateralized by the underlying securities. high grade and mezzanine. Digging deeper into HG and mezzanine collateral highlights some differences (Figure 2). CLOs. The fixed-rate concentration typically ranges from 0% to 30%. June 2. August 25. leverage loans. and BB (7%) assets. 7%) (see our report on “ABS CDO exposure to CDOs of ABS” in the ABS Strategy Weekly. We assume that a portfolio with a BBB+ average rating or lower is mezzanine (WARF of 260 or higher). The assets in a high grade transaction tend to have a single-A rating or higher. whereas assets in a mezzanine transaction tend to be predominantly triple-B rated. and ABS. 2006 3 . but have higher CDO 2 exposure (18% vs. the purchase of fixed-rate securities as collateral tends to be limited in order to minimize basis risk. we focus specifically on the ABS CDO market. On average. Diversification: CDOs purchase collateral diversified by issuer. etc. but have not been limited to. 2006). 39% AA. high grade and mezzanine transactions have a weighted average rating factor (WARF) of 49 (Aa3/A1) and 413 (Baa2/Baa3). • Collateral Ratings: The ABS CDO market may be divided into two general categories. Managed transactions are permitted to buy or sell assets and reinvest principal payments from the assets. high yield credit. 2006).and higher is high grade. rather than an asset class. they also have diversification of ratings in AAA (3%). increases the universe of assets that may be purchased for a CDO. Currently. which now comprises about 65% of global CDO issuance. and 23% A exposure (Figure 1). some general understanding of CDO characteristics and definitions will be necessary (also see Glossary). High grade transactions have less HEL exposure than mezzanine transactions (52% vs. Since the CDO liabilities tend to be floatingrate. In this report. 1 While mezzanine transactions are composed of predominantly BBB (65%) assets. respectively (see Glossary for more on WARF). CMBS. 2 Includes ABS CDOs.
but less than a typical managed transaction. • Cash versus Hybrid/Synthetic: Cash CDOs have assets that are fully funded cash securities and pay a bond coupon (fixed or floating). 2003-2005 transactions. In both cash and hybrid/synthetic transactions. On the other hand. we will use the term “collateral manager” when referring to the manager or portfolio advisor of a managed and static transaction. “Lightly managed” or “substitution” transactions permit some trading flexibility. Intex data. asset sales/purchases are typically not permitted after the initial portfolio selection has occurred. November 17.Lehman Brothers | ABS CDOs – A Primer during the reinvestment period. Intex data. mark-tomarket volatility of the underlying instrument does not directly impact the transaction. ABS CDO Collateral Composition 100% Rating AAA AA A BBB BB WARF High Grade 34% 39 23 3 0 49 (Aa3/A1) Mezzanine 3% 5 19 65 7 413 (Baa2/Baa3) 80% 60% 40% 20% 0% High Grade HEL CDO RMBS Mezzanine Other Source: Lehman Brothers. Although this is an important subset of the market. Figure 1. Source: Lehman Brothers. 2003-2005 transactions. we will be focusing mainly on static and managed cash/hybrid transactions without the market value features throughout this primer. Going forward. Some static transactions will allow the portfolio advisor discretionary sales of assets that have appreciated or depreciated in value. The transaction’s portfolio advisor performs the initial portfolio selection and any ongoing monitoring that must be done. market-value CDOs. ABS CDO Rating Composition Figure 2. In a static transaction. may be affected by mark-to-market volatility if certain market value triggers are breached. which is typically the first three to five years of the transaction’s life. Hybrid CDOs have a portion of the assets in cash form and the remaining portion in synthetic form (which pays a fixed premium). another structure used in the marketplace. respectively. 2006 4 . The synthetic portion is typically in the form of a credit default swap or total return swap.
For instance. or having specific in-house expertise for each collateral type. 3 We chose not to further tranche the class A in this example for now. and hedge funds. Figure 3 provides additional information regarding the class sizes and their stated coupon. Arbitrage Vehicles: We will discuss this in more detail in the next section. We describe a few of the more important functions: • Easy access to a portfolio of assets: CDOs provide investors the ability to gain exposure to a portfolio of assets without doing all the heavy lifting that typically accompanies that task. but it is important to note that the class A may be split into “super-senior” and “mezzanine” AAA-rated securities. and equity 3. CDOs were originally conceived to provide an investor a leverage return on a portfolio of assets. class C (A-rated). Leveraged return on investment: In the traditional sense. In other words. class B (AA-rated). 2006 5 . sourcing the bonds on their own. November 17. if losses were to reach the class A level. the mezzanine AAA tranche would suffer 100% loss before the super-senior tranche experienced its first dollar of loss. being the manager of a CDO provides relatively stable fee income on a pool of assets which are effectively “closed-end” funds for anywhere from three to eight years. where the super-senior is senior in the waterfall to the mezzanine AAA to the extent losses are above the class A level. The assets are assumed to generate an average interest payment of L+180 bp. CDOs will typically be issued when the average spread of the assets less the average cost of liabilities is high enough to produce an attractive return to the equityholder. We will come back to this example throughout the primer. how is there an arbitrage in the first place and all investing parties are still satisfied? Let us first use a simplified example of the economics behind the CDO arbitrage and then look at the factors that drive it. issue CDOs to term fund their assets rather than rely on the repo market for ongoing financing.Lehman Brothers | ABS CDOs – A Primer The Importance of CDOs CDOs serve a variety of functions within the capital markets. the equity investor can gain leveraged exposure to 100% of the assets. • • • • CDO Economics 101 So how is the CDO able to purchase assets and make payments to liabilities and manager fees and still have money left to pay the equityholders? Or more simply put. an investor does not have to go through the process and large expenditure of building infrastructure to monitor performance. the super-senior is funded through the commercial paper (CP) market rather than through the term market. Assets under management: For traditional money managers. The CP is rolled on a periodic basis (1-6 months) and may experience liability spread tightening or widening over the life of the transaction. insurance companies. but a CDO may also be thought of as an arbitrage vehicle. In some high grade transactions. Through the purchase of equity in a transaction. We begin with a typical example of a managed mezzanine ABS CDO capital structure diagram (Figures 3). particularly hedge funds. class D (BBB-rated). This allows the issuer to lock in a financing rate for the term of the CDO rather than run the risk of monthly changes in their repo rates and margin calls. Term Financing: Some issuers. The CDO contains $1 billion in ABS assets and has issued CDO liabilities in the form of a class A (AAA-rated). while only dedicating 1%-6% of the capital.
attractiveness of returns versus other benchmarks. the asset spreads will adjust to ensure the arbitrage is high enough (see our report. Additionally. We approximate the equity internal rate of return (IRR) by multiplying the net excess spread (104 bp) by the equity leverage (20x) and get a gross 20. Asset Spreads: As long as asset spreads are high enough to support the liability cost (plus other fees and costs) and meet equity hurdle rates. or CDO arbitrage. this assumes no losses and does not account for upfront underwriting fees and hedging fees. helps determine what the CDO arbitrage level must be at any given point in time. the asset may or may not be desirable for the transaction and will heavily depend on the overall spread of the asset and whether it meets CDO investor and rating agency constraints. we calculate the gross excess spread as the difference between the average asset spread and the average liability spread.Lehman Brothers | ABS CDOs – A Primer To estimate the CDO arbitrage. For example. It might still make sense to purchase the security if it provides more diversification and less correlation within rating agency models (makes the capital structure more efficient) and/or investors are willing to buy CDO liabilities at tighter spread levels (for greater diversification. when CDOs are not the marginal buyer of the specific asset. Further subtracting transaction fees such as manager fees (25 bp) and administrative costs (trustee and rating agency fees. investors value the collateral manager’s ability to manage the deal over time and/or their security selection expertise. the ability to credit tranche the capital structure from AAA to equity classes allows for more efficient distribution of the underlying risk to investors with varying risk profiles. as discussed earlier. 2006). 2006 6 . or the minimum equity return required by investors to participate in a transaction. • • 4 Note: this is a simplification of the equity IRR calculation. Figure 4 looks at a simplistic CDO arbitrage calculation where the gross excess spread of 131 bp comes from subtracting the average liability spread of 49 bp from the average asset spread of 180 bp. hedge funds using CDOs to lock in term financing might retain the equity and could be willing to retain it at IRRs that are lower than what might be acceptable to a different investor. and so on. we would need to consider the changes in liability costs over time and deleveraging of the equity.8% IRR to the equity 4. 2 bp) from the gross excess spread leaves us with the net excess spread (104 bp). First. for example). Second. for example). we can look at why the arbitrage exists in the first place. “ABS CDO Demand: Outlook and Implications for HELs” of July 21. An investor’s hurdle rate will depend on the perceived risk. Third. For example. However. November 17. as discussed earlier. CDO investors value the ability to easily source ABS portfolios without having to have the expertise or infrastructure to purchase and monitor securities. In practice. Equity Returns: The equity hurdle rate. For example. Having reviewed the economics behind the CDO arbitrage. • Liability Spreads: The tighter pricing of liabilities relative to the spread on the collateral is a function of a number of factors. CDOs might purchase BBB CMBS securities at tighter spreads than BBB HELs even though doing so reduces the average asset spread of the transaction. a transaction may be issued. When CDOs are the marginal buyers of the specific assets (as is often the case with BBB HELs. It may also depend on the motivation behind issuing a CDO.
Admin.000 Average Coupon of Assets L+180 bp Class A (80%) AAA 3L+32 bp Ongoing P&I Issuance Proceeds Class B (8%) AA 3L+55 bp Class C (2%) A 3L+135 bp Class D (5%) BBB 3L+325 bp Equity (5%) Source: Lehman Brothers Figure 4. 2006 7 .000.000.8 Average Asset Spread (bp) Average Cost of Liabilities (bp) Gross Excess Spread (bp) Collateral manager Fees (bp) Trustee. Rating Agency Fees (bp) CDO Arbitrage (Net Excess Spread) (bp) Equity Leverage (=100%/5%) Approximate Gross Equity IRR (%) (=1.Lehman Brothers | ABS CDOs – A Primer Figure 3. Typical Mezzanine ABS CDO Capital Structure ABS CDO Liabilities ABS CDO Assets ABS Assets $1. Simple CDO Arbitrage Calculation 180 49 131 25 2 104 20 20.04%*20) Source: Lehman Brothers November 17.
manages to certain eligibility criteria. Eligibility Criteria Managed transactions have security eligibility criteria which must be met during the initial selection of the portfolio and when managing the portfolio during the reinvestment period. the “ramp” period for selecting and purchasing assets for a CDO ranged from eight to 12 months. Of course. This may incorporate surveillance of the underlying securities as well as overall transaction performance. or if the criteria are not satisfied. the better off the trust will be when selling the asset. to: • • • • • • Rating of securities Fixed-rate securities Specified types of securities (e. The initial portfolio selection is perhaps the most important job of the collateral manager. the collateral manager selects the credits in the portfolio. HG managers are constrained to purchasing assets through the new-issue and secondary cash markets. Future sales of discounted assets can have ramifications for the equityholders and could also reduce overcollateralization and interest coverage levels. As a result. the purchase or sale of assets during the reinvestment period may be permitted as long as the eligibility criteria are satisfied.” Surveillance An important role of the collateral manager is to provide ongoing surveillance for the life of the transaction. equipment lease) Average life of securities Weighted average life of the portfolio PIKable securities.g. replacing them within the transaction might be warranted. the ramp period has been dramatically shortened for synthetic/hybrid mezzanine transactions. the earlier a manager can catch underperformance. Portfolio Selection The collateral manager is first and foremost responsible for selecting the initial portfolio of assets. With the advent of single-name CDS.. High grade transactions still have extended ramp periods because there is limited availability of single-name CDS referencing HG bonds. making strong surveillance an important aspect of managing transactions. November 17. thereby increasing the likelihood of trigger failures (see sections on credit enhancement and coverage tests below). but not limited. The criteria incorporate maximum and minimum composition requirements pertaining.Lehman Brothers | ABS CDOs – A Primer Role of the Collateral Manager The collateral manager has a number of roles. and more In general. 2006 8 . To name just a few. as the majority of the portfolio may be purchased in a matter of weeks. Historically. to the extent the criteria are “maintained or improved. and conducts ongoing surveillance of the transaction. CMBS. The eligibility criteria are typically established in order to provide some boundaries for the manager in terms of what they can and cannot purchase. RMBS. Avoiding securities from the outset that have a high likelihood of being downgraded or incurring losses can help avoid discount sales of assets in the future. To the extent managers are able to spot assets that are underperforming and may be susceptible to future downgrades and writedowns.
2006 9 . the ABS CDO market comprised mostly mezzanine transactions (Figure 5). helping to fuel issuance of mezzanine transactions. compared to about $25 billion mezzanine transactions. CDO vehicles have had more than enough assets to choose from. providing increased comfort to investors.5 billion of high grade transactions priced. ABS CDO Issuance • • • • • Figure 5. Low default history: Given the low number of bond defaults experienced in the ABS markets. November 17. in 2004. investors have sought to increase their ABS exposure through CDOs. we estimate the total ABS CDO amounts outstanding to be more than $300 billion. However. especially the subprime mortgage market. From 2000 to 2003. The growth in ABS CDO issuance may be attributed to a number of factors: • Underlying ABS market growth: As the underlying ABS markets have grown. Through 9/30/06. investors looking for incremental spread have turned to the ABS CDO market. Growing investor base: The growth in investor sponsorship for the asset class across the capital structure has created more demand for CDO securities and equity. Initially. Increase in secondary market liquidity: Liquidity within the secondary market has increased in recent years as more dealers became active. Synthetics market: The growth of the single-name CDS market for subprime and CDOs provided additional supply. issuance of high grade transactions surpassed mezzanine transaction issuance. $bln 80 60 40 20 0 2000 2001 2002 2003 Issuance Year High Grade 2004 2005 2006 YTD Mezzanine Source: Lehman Brothers. only $4. Today.Lehman Brothers | ABS CDOs – A Primer A Brief History of the ABS CDO Market Issuance Trends The ABS CDO market came into being in late 1999 and has experienced exponential growth since. a trend that continues today. Search for yield: As spreads across a variety of asset classes have compressed in recent years.
issuers gravitated toward real estate (e. HY CBOs.g. and CMBS) sectors. Figure 6. CLOs. 2006 10 .g. etc. Rather than staying diversified across sectors. Oakwood. The average transaction pre-2003 had 37% HEL. and only 7% “other” exposures (Figures 7b). 24% CDO 5. Intex data Includes ABS CDOs. when the ABS CDO market endured distress in sectors to which it was heavily exposed. November 17. and franchise loans. resi-A. Real Estate Era (2003-2005) Other 29% Other CMBS 7% 5% HEL 37% CDO 14% HEL 55% CMBS 10% CDO 24% RMBS 0% RMBS 19% Source: Lehman Brothers. 14% CDO.Lehman Brothers | ABS CDOs – A Primer Diversified versus Real Estate Era When ABS CDOs were first issued in 1999. 19% RMBS. In stark contrast to pre-2003. Intex data 5 Source: Lehman Brothers. subprime. Conseco Finance.. spanning from credit cards and home equity loans to aircraft-leasing securitizations (Figure 6). transactions were diversified across a number of securitized sectors.) 2002 First ABS CDO issued in late-1999 ABS CDO market recovers after severe downgrades in underlying sectors. ABS CDO Timeline Diversified Era Aircraft ABS incurs significant downgrades and losses following 9/11 Multitude of downgrades in manufactured housing (e. etc. aircraft. Diversified Era (2000-2002) Figure 7b. the CDO market emerged with an entirely different look and purpose. the average transaction in 2003-2005 had 55% HEL. 5% CMBS. 10% CMBS. and 29% “other” exposures (Figure 7a). After a tumultuous period in late 2002 and early 2003. emerges with more residential mortgage concentration 2004 Real-Estate Era Single-Name CDS is standardized in late-2005 "Hybrid" CDOs become the norm in mezzanine High Grade CDO market begins its exponential growth 2000 2001 2003 2005 2006 2007 Source: Lehman Brothers Figure 7a. including manufactured housing.
and CDOs) has been a steady outperformer compared to corporates (when measured by rating stability). and greater leverage to weakening credit. 6.Lehman Brothers | ABS CDOs – A Primer Spread History Following the market disruption in late 2002. Collateral Performance Rating Transitions As an overall asset class. less liquidity in the secondary market. Still. less transparency in prices of the underlying securities. Figure 9. Triple-B structured finance securities. have experienced slightly higher downgrades than corporates (6. global structured finance AAA-. bp ABS CDOs 140 325 HEL 42 110 RMBS 40 100 CMBS 36 80 CLO 72 150 Source: Lehman Brothers. Data averages high grade and mezzanine spreads. AA-. 2006 11 . November 17. and CLOs (Figure 9). Rating A BBB Floating-Rate Spread Comparison. and A-rated securities have experienced lower downgrade ratios than similarly rated global corporates (Figure 10).2% vs. the ABS CDO sector has traditionally offered wider spreads compared to other spread sectors such as subprime.1%). CMBS. This is partly due to the complex nature of the structures and collateral. RMBS. Specifically. Figure 8. As of 9/30/06. bp 160 120 80 40 0 Jun-00 ABS CDO Spread History bp 400 300 200 100 0 Jun-01 AAA Jun-02 AA Jun-03 Jun-04 A (RHS) Jun-05 BBB (RHS) Jun-06 Source: Lehman Brothers. increased sponsorship by investors for ABS CDOs led to spread tightening across the capital structure (Figure 8). structured finance (inclusive of ABS. CMBS. RMBS. on the other hand.
5 7.6% 8.7 1.1 2. Half of the total withdrawn ratings for the given year are subtracted from the outstanding number of rated bonds for weighting purposes.0 4.1 Source: Moody’s. The 1-yr rating transitions for each of the years 1984-2004 are averaged to compute the numbers shown.5 0.1 -6.3 0.5 88. Each year’s transition numbers are then weighted by the outstanding number of rated bonds at the beginning of the given year.1 0.2% 5.8 downgrade/upgrade ratio since 1996. while HELs and CDOs experienced more downgrades than upgrades.2 92. as well as many ABS CDOs issued in 2000-2002.1 90.3 5.9 0.0% 0.3 Aa 0.4 -6. Sector HEL Upgrade/Downgrade Statistics by Asset Class Category Downgrade Rate Upgrade Rate Downgrade/Upgrade ratio 2005 1.5 0.2 0.8% 0.1% 8.2 6.7% 1.4% 0.4 RMBS Downgrade Rate Upgrade Rate Downgrade/Upgrade ratio CDOs Downgrade Rate Upgrade Rate Downgrade/Upgrade ratio CMBS Downgrade Rate Upgrade Rate Downgrade/Upgrade ratio Source: Moody’s Investors Service November 17.1 3.5% 1.5 88.1 91.3 1.1 4. CDOs stand out as the worst performing sector by far.3 2.9 4 1 0.4 3.2 1.2% 0.0% 1.2 Baa 0.8% 0.4 0.4 -3.6% 9.1 3. Figure 10.5 6.3 2.6 91.1 2.9 0.0 5.6 6. The 1-yr rating transition records any transition from the current rating at the beginning of the year for all outstanding securities to the final rating at the end of the 1-yr period. which experienced significant downgrades up until 2005.6 91.4 3.3 90.6 -2.6 0.0% 1.8% 11.1 1.4 0.0 0.4 5.6 6.1 2.7% 0.2 0. RMBS and CMBS experienced very strong upgrade/downgrade ratios throughout their history.1 0.9 7.2 A 0. This is mostly owing to the poor performance of HY CBOs. Figure 11.0 4. Average Annual Rating Transition Matrices Aaa 98.Lehman Brothers | ABS CDOs – A Primer Upgrade/Downgrade Statistics While overall structured finance rating stability has been strong.1 0.2 9.6% 1.2 91.5% 16.7 92.1 1.6 -5.3 7. 2006 12 .5 2.6% 0.7 1996-2005 2.2 0.7% 8.1% 1.4 91. a closer look at subsectors found in more recent ABS CDOs may show mixed results (Figure 11).4 7.0 5.7% 0.1 Upgrade Stable Downgrade Original Rating Aaa – SF Aaa – Corp Aaa – Diff Aa – SF Aa – Corp Aa – Diff A – SF A – Corp A – Diff Baa – SF Baa – Corp Baa – Diff 0.2 0.8% 2.7 6. with an 11.1 0.7 0.2 -2.3 2.3 98.4 91.3 -0.9% 6.8% 0.4 3.9 -4.9 4.9 0.2 2004 2.3 5.4 92.0 0.7 92.8 0.8 3.2 -2.9 0.9 3.
excess spread flows through to the equityholder. known as excess spread. we will discuss the class D turbo in more detail. structural nuances such as a class D turbo of principal. A.) Overcollateralization: All the debt classes begin with a certain amount of overcollateralization from the outset of the transaction. and swaps and reserve accounts for synthetic hybrid transactions may also be present. allowing for the liquidation of the assets and return of principal to bondholders and equityholders. the class B. the presence and timing of performance triggers (or lack thereof). November 17. (See Figure 12 for a typical high grade and mezzanine capital structure. where subordination acts as the primary form of credit enhancement for bonds that are more senior in priority. we discuss a number of structural features common to many ABS CDOs. To the extent losses are realized. and excess spread provide the majority of protection to the bondholders. Prior to failing • • 6 BB-rated securities may also be issued. or equity tranche. (In the “Additional Features” section. subordinate to the debt classes. Additional Features: Structures will vary deal-to-deal. The priority of payments will typically be determined by the deal age. in which case the size of the equity would be lower. and how quickly the collateral balance factors down. If the class D turbo is present in a transaction. In addition. and structure. Coverage tests: In traditional ABS CDO structures. 2006 13 . rating composition. This overcollateralization comes from having the first loss piece.Lehman Brothers | ABS CDOs – A Primer Structural Features In this section. • • Credit enhancement: The senior/subordinate capital structure. this is a feature that serves to increase overcollateralization over time. depending on such factors as the collateral composition.) Excess spread: The difference between the interest cash flow from the assets and the interest paid to the CDO liabilities (including ongoing fees in the transaction). respectively) provide protection from losses to the class A. In our earlier example of a mezzanine transaction. C. Priority of Payments: A transaction has payment rules that determine how cash flow is allocated to liabilityholders. For HG transactions. the excess spread may be redirected to paying down liabilities or “building par” if performance triggers begin to fail (more on this in the performance trigger section). The class C and D provide protection to the class B. and D (each with a rating of AA. Passing or failing the overcollateralization coverage tests (OC) or interest coverage tests (IC) will affect how cash flows are allocated to the liabilityholders. Optional Redemption and Auction Calls: Transactions are issued with call features. overcollateralization. additional protection may come from coverage tests. and so on. In the absence of losses. equity provides about 1% subordination to the class D 6 and about 5% for mezzanine transactions. The size of each class will vary from one transaction to the next. and BBB. status of performance triggers. • • • Credit Enhancement • Senior-subordinate capital structure: ABS CDOs are issued as senior/subordinate transactions. acts as a form of additional credit enhancement available to protect debt tranches from losses.
While the ability to sell assets is not credit enhancement in the strictest sense. 30% of the initial collateral balance may be substituted over the first 5 years) and must conform to the eligibility criteria. Certain managed and static transactions also have the ability to sell assets. % of transaction size High Grade AAA . In lightly managed or substitution transactions. priority of payments. Traditional ABS CDO transactions have two performance-related coverage tests: the overcollateralization (OC) and interest coverage (IC) tests. We assume a reinvestment period of four years. providing the manager with some flexibility to sell assets could benefit bondholders to the extent that a manager is able to identify assets that may have problems down the road and sell before the market fully prices in those risks. We also provide details on the coverage tests and their required levels. which share the class A/B coverage test. excess spread will continue to flow to the equityholder and any losses are effectively absorbed by the equity. the collateral manager may be able to sell highly appreciated or discounted assets 7. a collateral manager may be able to substitute collateral for assets in the pool to protect the pool from deterioration. an optional redemption period between the fourth and eighth year. class C. As discussed earlier.. Figure 12. asset sales may occur and proceeds are applied toward paying principal. and call provisions in transactions.Super Senior AAA . these are traditionally the only tests that have direct consequences on how cash flow is allocated through the CDO waterfall. with the exception of class A and B. and class D. In managed transactions. Typical ABS CDO Capital Structure. and an auction call beginning in year 8. Unlike certain collateral composition tests (e. The substituted amount is typically capped (i.Lehman Brothers | ABS CDOs – A Primer triggers. a typical transaction will have class A. weighted average spread).e.g. 2006 14 . class B. we expand on our earlier mezzanine example with some additional assumptions in Figure 13. WARF. In some static transactions. 7 In traditional static transactions.Mezzanine AA A BBB Equity Source: Lehman Brothers Mezzanine 65-70% 10-15% 7-9% 1-2% 3-5% 4-6% 80-85% 8-10% 2-3% 1-2% 1-2% 1% Coverage Tests Prior to analyzing the coverage tests. To the extent that one of the coverage tests is breached. cash flow may be diverted away from the class of bonds junior to the test (see the Glossary for a description of how coverage tests are calculated and how rating downgrades may affect the OC calculation). however. this may occur during the reinvestment period. Each class has a coverage test associated with it. November 17.
• Interest proceeds (coverage tests are passing): Certain taxes. and D. Additional Managed Mezzanine Transaction Assumptions First 4 Years Between the 4th and 8th Year Beginning of 8th Year Required 109% 104% 102% 112% 108% 105% % of Par 90% 80% 50% Reinvestment Period Optional Redemption Period Auction Call Coverage Tests Class A/B OC Ratio Test Class C OC Ratio Test Class D OC Ratio Test Class A/B IC Ratio Test Class C IC Ratio Test Class D IC Ratio Test Haircut Provisions Ba1. 2) whether the transaction is in its reinvestment period or post-reinvestment period (for managed transaction). • 8 If a CDO class has an interest shortfall. the shortfall will accrue at the coupon rate and such amounts may be repaid when interest and principal proceeds are sufficient according to the priority of payment rules. and 3) the collateral factor (how much of the original collateral balance is paid down).Lehman Brothers | ABS CDOs – A Primer Figure 13. When the class C coverage tests pass again. unpaid and deferred) is paid sequentially to the class A. B3 Caa1 or lower Source: Lehman Brothers Priority of Payments The payments of interest and principal to CDO liabilities follow specific rules that are dependent on 1) coverage tests passing or failing. The waterfall for hybrid transactions are slightly more detailed in that the super-senior swap payments and CDS termination payments must also be considered (see the “Additional Features” section). subordinate management fees and then to the equity. Any remaining interest proceeds are distributed to the class D as principal (see the “Additional Features” section). B. Ba3 in excess of 10% B1. Remaining interest collections are redirected to paying principal to more senior classes. B. interest is paid sequentially up to the level of the failed class. if the class C coverage tests fail. Using our mezzanine example. C. interest (accrued. interest payments may be made to class D 8. Figure 14 shows a typical interest and principal waterfall for a transaction with cash collateral. The shortfall amount is added to the outstanding principal balance of the bond for calculating current interest. B2. November 17. Ba2. and issuer expenses are paid prior to the debtholders receiving any interest. Interest proceeds (coverage tests are failing): If coverage tests are failing. 2006 15 . and C principal sequentially until the class C coverage tests pass. Once those payments are made. then any remaining interest collections after paying steps 1-8 of the interest proceeds waterfall (Figure 14) would be allocated to paying class A. fees. if coverage tests are passing.
the trustee will call the transaction at the auction call date.g. then the class D would PIK and interest and principal proceeds would be used to pay the class A. In our example. At the auction call date. and D. All coverage tests must be cured before any principal proceeds may be reinvested (if during reinvestment period) or normal principal distributions are made. B. B. this occurs eight years after the pricing date. C. C. diverted cash flow is paid sequentially as principal starting with the most senior class down to the failed class until the test is cured. Optional Redemption and Auction Calls In most transactions. In our mezzanine example. The transaction will not be called if the class A. and D their par amount. Once the class A.. In our mezzanine transaction example. junior classes will typically PIK (cease paying interest). the remaining principal proceeds are used to pay the class A. the trustee will instruct the manager to liquidate the assets. B. If the transaction is not called during the optional redemption period. Principal proceeds (coverage tests are failing): If coverage tests are failing and are not cured through the interest proceeds waterfall. and interest and principal proceeds would be used to pay the bonds sequentially through the failed class. • Now we consider cases that tie in both the coverage tests and priority of payments. If more senior coverage tests are breached (e. The transaction may not be called if the liquidation proceeds are insufficient to pay the class A. In those cases. Using the same example. class A/B. November 17. B. B. the equity cash flow could be diverted when the class D OC falls below 102% or the class D IC falls below 105% (Figure 13). In our example. if the class C OC falls below 104% or the class C IC falls below 108%. C. These tests are somewhat unique compared to most ABS transactions in that curing can occur in the same period. Cash that remains after the repayment of par on the debt classes and fees is then allocated to paying subordinate manager fees and equityholders. class C).Lehman Brothers | ABS CDOs – A Primer • Principal proceeds (coverage tests are passing): Principal proceeds are first used to ensure that steps 1-5 of the interest proceeds waterfall (Figure 14) are met. if the value of the assets equals or exceeds the amount of outstanding debt of the class A. 2006 16 . the remaining cash flow available after tests are cured would be allocated according to the “passing” priority of payment waterfall. and D accrued and deferred interest is paid) are used to purchase new assets if the transaction is still in its reinvestment period (first four years in our example). After the reinvestment period ends. C. any additional principal proceeds flow to subordinate collateral management fees and the equity. B. the equityholder has the right to call the transaction during the optional redemption period (Figures 13 and 15). B. The optional redemption period permits the equityholders (with a majority vote) to instruct the manager to liquidate the assets in the trust and pay down the class A. C. principal proceeds (after ensuring class A. and D note principal is paid down (typically through the call). If coverage tests are passing. the optional redemption period begins after the reinvestment period ends (year 4) and lasts until the auction call date (year 8). Depending on the structure. and C until the class C OC increased above 104% and the class C IC increased above 108%. and D note principal pro rata (if the outstanding collateral balance is greater than 50% of the original balance) or sequentially (if the outstanding collateral balance is less than 50% of the original balance). B. C. C. and D sequentially until the class D OC increases above 102% and the class D IC increases above 105%. and D outstanding principal balances at par. interest proceeds would be used to pay the class A. B. C. the principal distributions are used to pay principal to the classes senior to the trigger level until the tests are cured.
B. The class D may also turbo if the class D OC or IC test fails. Additional Features Our mezzanine example provides the basic structural features typically found in the market. are usually fully funded and pay a monthly or quarterly floating-rate coupon. D. 2006 17 . November 17. and D sequentially until the test passes.Lehman Brothers | ABS CDOs – A Primer and D outstanding principal balances are not fully repaid. typically known as the “super-senior” is issued as an unfunded swap 9. Therefore. Once the reinvestment period ends. For instance. • • • 9 This may also be issued as a variable funding note (VFN) rather than in a synthetic swap form. First and foremost. the transactions are referred to as “hybrid” or “synthetic” CDOs. as a protection to more senior bondholders in the event the OC declines above a certain level. When the majority of assets are synthetic. but clearly there are features that will vary from deal to deal. Hybrid or Synthetic Transactions: Most mezzanine transactions issued since late 2005 have a combination of cash assets and synthetic assets. which are issued subordinate in the capital structure (typically the bottom 30%35%) to the super-senior. This typically coincides with the reinvestment period. Triggerless: Transactions will not have the traditional OC or IC triggers throughout the life of the transaction. The turbo feature is typically subordinate in the interest proceeds waterfall (see item 15 in Figure 14). the top 65%-70% of the capital structure. We summarize these features below: • Class D or BBB Turbo: A BBB turbo feature may be used to pay down a portion of the class D principal early in the life of the transaction and/or over the entire life of the transaction. This is a feature that has been used in only managed mezzanine transactions to date. In that event. there is a trigger that allocates all principal proceeds sequentially rather than pro rata. and many have a structure that permits the majority of collateral to be sourced synthetically. where the trust pays the swap provider a fixed premium each month and receives cash payments from the swap provider to the extent the super-senior becomes undercollateralized (Figure 16). there is no mechanism in the waterfall to divert interest and principal from the class C. A certain percentage of the excess spread may be used to pay class D principal throughout the life of the transaction. Some turbo features allow 10%-15% of the initial balance of the class D to be paid down during the first three to four years of the transaction’s life. The notes. some transactions have an trigger holiday or no triggers at all. The addition of synthetic assets through CDS necessitates some structural changes to the traditional cash CDO model. the trustee will attempt another auction every quarter until the notes are redeemed. and equity. The proceeds are used to purchase cash assets and establish a reserve account to be used in the event payments must be made on the CDS positions (such as writedown payments to the buyer of protection). whether the transaction is still in its reinvestment period or not. some transactions provide additional principal payments to the class D. If the auction does not succeed. C. called a “BBB turbo”. However. Trigger Holiday: Transactions will not have the traditional OC or IC triggers during the first four to five years of the transaction’s life. However. the OC and IC triggers become active. rather than paying the class A. the class D is paid. This is a feature that has been used in only managed mezzanine transactions to date. the class D does not typically turbo principal if the class A/B and/or class C tests are failing as well.
Class D Accrued and Unpaid Interest 11. After Reinvestment Period & when Collateral Balance <50% of Original Balance: Class A. Hedge Fees & Payments. Example Interest and Principal Waterfall Interest Proceeds 1. and C Principal (sequential) 10. if any 4. Class A. Additional Hedge Payments 17. Class C Accrued and Unpaid Deferred Interest If Class C Coverage Tests are not met 9. and C Principal (sequential) 5. Subordinate Collateral Management Fee 14. Class D Accrued and Unpaid Interest* 7. Class A. Additional Trustee and Other Fees 15. Subordinated Notes (Equity) * To the extent not paid from interest proceeds.Lehman Brothers | ABS CDOs – A Primer Figure 14. Class D Accrued and Unpaid Deferred Interest 9. Additional Hedge Payments 15. Subordinated Notes (Equity) If Interest Proceeds did not pay in full If Class D Coverage Tests are not met If Class C Coverage Tests are not met If Class AB Coverage Tests are not met 2. Class A Accrued and Unpaid Interest 5. C and D Principal (sequential) 13. Additional Trustee and Other Fees 14. B. Class D Accrued and Unpaid Deferred Interest If Class D Coverage Tests are not met 12. Class A. B. Class C Accrued and Unpaid Deferred Interest 6. Reinvestments (during Reinvestment Period) 10. C and D Principal (sequential) 8. C and D Principal Sequential 12. B. B. if not paid in full 2. Class A. and only to the extent such payments do not cause a senior OC Ratio to fail. Class C Accrued and Unpaid Interest 8. B. Items 1-5 of Interest Proceeds. Subordinate Collateral Management Fee 13. Taxes. then Class B Principal (sequential) 7. 2006 18 . Source: Lehman Brothers November 17. Senior Management Fee 3. Class D Principal Turbo 16. Class A. Class A. C and D Principal Pro-Rata 11. After Reinvestment Period & when Collateral Balance >50% of Original Balance: Class A. B. Expenses Principal Proceeds 1. Class B Accrued and Unpaid Interest If Class AB Coverage Tests are not met 6. Fees. Class C Accrued & Unpaid Interest* 4. then Class B Principal (sequential) 3.
000. Millions 1. 2006 19 .000.) 96 120 144 Equity Source: Lehman Brothers BBB A AA AAA Figure 16.000 800 600 400 200 0 0 Paydown of CDO Liabilities (to Auction Call) Reinvestment Period Optional Redemption Period Auction Call 24 48 72 Deal Age (mos.Lehman Brothers | ABS CDOs – A Primer Figure 15.000 Issuance Proceeds Class A (10%) AAA 3L+45 bp Class B (8%) AA 3L+55 bp Class C (2%) A 3L+135 bp Cash Reserve Account $100.000 Senior Swap Agreement (70%) 15 bp Ongoing P&I Cash Collateral Debt Securities $200. Synthetic or Hybrid Transaction Structure ABS CDO Liabilities ABS CDO Assets Credit Default Swaps $700.000.000 Class D (5%) BBB 3L+325 bp Equity (5%) Source: Lehman Brothers November 17.
Standard & Poor’s CDO Evaluator incorporates the probability of default by asset types and correlations among. Each rating agency uses its own methodology for rating CDOs. We prefer to use a “bottom-up” approach that begins with a loan-level analysis of the specific securities in the transaction. For example. Each security is assumed to pass its triggers and be called at its call date. For example. the subprime loans themselves) 10 This summary of the rating agency process is an oversimplification of their methodologies. Investors. • • An ABS Loan-Level Approach to Losses and Prepayments We believe a more realistic method for developing prepayment and loss assumptions is warranted in order to capture the “ABS” nature of the collateral. The first analysis uses default. the rating agencies tend to split the task into two separate analyses. we summarize how transactions are rated by the agencies and typically analyzed by the market. recovery. or investor defined curve. Fitch’s VECTOR uses Monte Carlo simulation of defaults. tend to assess transactions by analyzing cash flows through a “topdown” approach originally developed by the corporate CDO market. asset types to arrive at an expected loss. let us consider a “normal” and “stress” credit scenario whereby we analyze the collateral of the underlying HEL securities (i. We should note that in addition to the collateral analysis. recovery. rating agencies are also very involved in the legal and structural features that are present in CDOs. and diversification assumptions to arrive at an expected loss for the portfolio. and prepayment assumptions are used to price and stress transactions as follows: • Prepayment rate: Each underlying security in the portfolio is priced using its pricing speed or six-month average historical prepayment rate (for seasoned securities). Rating Agency and Market Pricing and Stress Assumptions In rating ABS CDO liabilities. November 17. however. is applied to the aggregate balance of the portfolio as determined under the pricing speed prepayments assumptions discussed above. 2006 20 . recovery rate.e. and provide our more robust bottom-up loan-level approach to valuing ABS CDOs. The second analysis applies those losses as well as specific cash flow stresses to the specific CDO structure in order to determine whether the CDO tranches can withstand the stresses. but the assumption may differ from one transaction to the next depending on the asset mix. This generates the transactions aggregate collateral cash flow to which top-level defaults are applied.Lehman Brothers | ABS CDOs – A Primer Valuation Considerations In this section. and correlation inputs through CDOROM. accounting for the intricacies of the underlying loans and bond structures. and correlations to produce expected losses and loss distributions. We encourage investors to visit the rating agency websites for more details. Default. losses. a 60% recovery rate is often used for mezzanine transactions. and within. Recovery rate: A recovery rate is applied to the defaulted balance with a lag (typically 12 months).. This may incorporate a host of techniques 10: Moody’s uses its “correlated binomial method (CBM)” to produce the expected portfolio loss based on default. Using an approach of this nature can more accurately reflect the timing of principal paydowns of the collateral as well as the timing of losses which could impact the average life and evaluation of risk in the CDO liabilities. Default rate: A constant default rate. correlation.
CDO Cumulative Losses . Static Mezzanine CDO Collateral Balance Factor Balance Factor 1. We find that writedowns of the HEL tranches (and hence CDO collateral losses) tend to be more back-ended (by at least 12 months) than typical CDO-style stress assumptions imply (Figures 17a and 17b). we find that typical prepayment assumptions at pricing are generally consistent with the realistic prepayments in “normal” credit environments. CDO Cumulative Losses – Normal Cum Loss 2. see “Putting the “ABS” in ABS CDOs” in the U.Lehman Brothers | ABS CDOs – A Primer within a generic static mezzanine CDO by applying different voluntary prepayment. ABS Weekly Outlook.0 0.S. (For our more detailed report on the topic.5% 0. 2006 21 .5% 1.8 0. but can overstate the rate of paydowns in a “stress” case (Figure 18 – we use a static mezzanine transaction for simplicity). severity. default. Figure 17a.2 0. Assumes a seven year auction call.6 0.) Turning to the prepayment assumptions currently used in the market.0% 0 12 24 36 48 60 72 84 96 108 120 Deal Age (Months) Normal Source: Lehman Brothers Figure 17b.0% 0. First Auction Call Date 120 144 168 192 Normal Stress November 17.0 0 24 48 72 96 Deal Age (Months) Pricing Source: Lehman Brothers. April 21.4 0.0% 1.Stress Cum Loss 10% 8% 5% 3% 0% 0 12 24 36 48 60 72 84 96 108 120 Deal Age (Months) Stress Source: Lehman Brothers CDO Style CDO Style Figure 18. 2006. The reason prepayments on ABS CDO collateral could slow in a “stress” case more than what is implied by typical stress cases is that the underlying HEL performance triggers could begin to fail and cause the securities to extend significantly and underlying transactions are less likely to be called. and delinquency vectors to the HEL loans in order to project how HEL securities perform over time.
the CDO collateral losses will begin to increase at a more rapid pace than the HEL loans (Figure 19). and delinquency rates on the underlying HEL loans of HEL transactions. they would not be high enough to reach the HEL AAAs. For example. and BBB classes of the mezzanine CDO and a significant portion of the high grade classes. Figure 19. If losses continued to increase and were high enough to result in HEL BBB writedowns.Lehman Brothers | ABS CDOs – A Primer Risk Factors Credit A key risk in ABS CDOs is leverage. consider a mezzanine and high grade CDO transaction where. If HEL loan losses continue to increase until the HEL BBBs are completely written down. the CDO collateral losses would be zero. A. HEL loan losses must first be high enough to result in a writedown to the most subordinate HEL securities (say the BBs) before reaching the HEL BBBs. the high grade CDO begins to incur collateral losses. or CMBS. severity. but would result in 100% writedown to the AAA. Rating downgrades and losses on CDO liabilities could increase as a result of a worsening in credit of the underlying collateral securities. 2006 22 . If loan losses stopped increasing at that point. AA. MBS. this would result in 100% cumulative losses to the mezzanine CDO (assuming no paydown of principal occurred). While this is not unique to CDOs. for simplicity sake. the portfolio is comprised of 100% HEL securities and the mezzanine has BBB HELs and high grade has AA and A HELs. the CDO liabilities can be more leveraged to worsening credit than ABS. If losses were to stop there. If we project CDO cumulative losses in different credit scenarios by stressing voluntary prepayment. while the HEL collateral losses would be greater than zero. Cum Losses 50% 40% 30% 20% 10% 0% Meltdow n Mezzanine CDO Collateral Losses High Grade CDO Collateral Losses HEL Collateral Losses ABS CDO and HEL Collateral Cumulative Losses Stress Normal Source: Lehman Brothers November 17. default. the CDO would begin to incur its first collateral losses. we find that at a certain point. If HEL loan losses increase further and begin writing down the HEL AA and A tranches. This is fairly intuitive if one thinks about the timing of how HEL loan losses would permeate through the HEL securities and into CDOs in a high stress scenario.
Of course. 2006 23 . As interest rates rise. as the average spread on floating-rate securities will also drift based on similar variables. assuming there are no hedges in the transaction). the “coupon drift” is not just a risk for the fixed-rate securities in the transaction. An additional risk exists whereby the weighted average coupon of the fixed-rate collateral drifts higher or lower throughout the life of the transaction. This “coupon drift” impacts the excess spread.Lehman Brothers | ABS CDOs – A Primer Basis Risk on Fixed-Rate Security Hedges When a portion of CDO collateral is fixed-rate but CDO liabilities are all floating-rate. as there may be more or less interest cash flow coming into the transaction than initially expected. AFC risk stems from the fact that the underlying HEL securities are exposed to rising interest rates due to the basis risk between floating-rate bonds and a combination of their fixed-rate and hybrid collateral (which are subject to periodic and lifetime caps on the rate of the mortgage). For example. if one applies a credit scenario stressful enough to result in underlying HEL trigger failure and CDO losses. mismatches can occur when prepayments deviate from the pricing speed assumption. transactions will be called during the optional redemption period or at the auction call date. in a normal credit scenario. The amount of extension risk will vary depending on the underlying portfolio characteristics and credit scenario. bondholders are susceptible to extension risk. 2006). 2) HEL securities are downgraded because of their lower enhancement. However. the fixed-rate loans in the pool are unable to reset higher and hybrid loans may hit their caps. all variables that increase the uncertainty of fixed-rate interest cash flows in the transaction (see our analysis of “FixedRate Collateral Risk in ABS CDOs” in the ABS Strategy Weekly. and 3) AFC interest shortfalls on HELs result in less excess spread to the CDO. June 2. the types of fixed-rate collateral. The auction call will be exercised to the extent the liquidation value of the portfolio is 100% or higher. the trust is exposed to interest rate risk (either positive or negative. This can create problems later in the life of a transaction when losses are higher. AAA to BBB securities could have about two to three years of extension risk if the transaction is not called (Figure 20). to the extent the transaction is not called. resulting in excess spread being squeezed. The HEL trusts may purchase swaps and/or caps which partly offset the interest rate risk inherent in HEL transactions. November 17. However. While the trusts typically purchase amortizing swaps and caps to match the fixedrate notional over time in an attempt to hedge this risk. available funds cap (AFC) risk in HELs is also a risk for ABS CDOs. but for the entire portfolio. The risk to ABS CDO investors is that 1) a decline in HEL excess spread increases the chance of HEL writedowns. payment priority. and whether underlying transaction triggers are passing or failing (to name a few). Call Risk/Extension Risk Under normal circumstances. The coupon drift is dependent on the interest rate scenario. When short interest rates rise. Available Funds Cap Risk (AFC) Because upwards of 50% of the collateral in more recent vintage ABS CDOs are HEL securities. the extension risk could be much greater. This results in a decrease in excess spread. the average CDO liability cost increases while only a portion (the floating rate portion) of the collateral interest increases. The reverse occurs when short rates rally.
or CLO investments.4 9.5 18.3 21. to Call and to Maturity Average Life (Years. but offer attractive nominal spreads compared to investing directly in the ABS. Managed Mezzanine Liability Average Lives.8 6. collateral. Conclusion The tremendous growth of the ABS CDO market has created the second largest ABS sector by outstandings and has accounted for more than 60% of global CDO issuance YTD. 2006 24 .2 9. November 17.6* Tranche AAA – SS AAA – Mezz AA A BBB Normal 6.8 6. To Auction Call) Average Life (Years.4 16.Lehman Brothers | ABS CDOs – A Primer Figure 20.4 8. MBS. As with any securitized sector.4 9.3 Source: Lehman Brothers * The average life is significantly shortened because the BBB incurs a writedown in this example.8 6.8 6. ABS CDOs add additional complexity to what are already complex underlying sectors. CMBS. and risks can help uncover value in the market.6 Stress 11. a better understanding of structure.1 1. To Maturity) Normal 9.
and D refer to the outstanding balance of their respective classes at the beginning of the period. The calculation of the OC is as follows: Class A/B OC = outstanding collateral balance (plus paydowns received during the period) / (A + B) Class C OC = outstanding collateral balance (plus paydowns received during the period) / (A + B + C) Class D OC = outstanding collateral balance (plus paydowns received during the period) / (A + B + C + D) where A. the gain or loss on the sale will increase or decrease the OC level as a result. 5% of the portfolio (15% minus 10%) will be haircut by 10%. and Ba3. the difference between the actual exposure and 10% is haircut to 90% (Figure 13). Coupon Drift: Any deviation in the average coupon or spread of the collateral from the initial collateral spread. • • The calculation of the IC is as follows: Class A/B IC = (S – costs – fees) / (a + b) Class C IC = (S – costs – fees) / (a + b + c) Class D IC = (S – costs – fees) / (a + b + c + d) where S is the scheduled interest proceeds on the collateral debt securities and a. Coverage Tests: Performance-related triggers such as interest coverage (IC) or overcollateralization (OC) tests that can affect the payment priority through the waterfall. An important consideration when calculating OC is that the outstanding collateral balance is determined by the par value of the assets rather than the market value. or effectively carried at 90% of the par November 17. C. 2006 25 . c. Therefore. B. This typically occurs seven or eight years after the pricing date. Rating migration may also influence coverage tests. if the total Ba1. to the extent the average coupon on fixed-rate bonds drifts from the rate of the amortizing swap. and Ba3 exposure becomes greater than 10%. Costs and fees refer to hedging and trustee costs and manager fees. However. bonds that have incurred downgrades might incur a haircut to the par amount. b. With respect to fixed-rate collateral. Ba2. the trustee will attempt another auction every quarter. excess spread could be affected. appreciation or depreciation in the portfolio’s value will not affect the OC calculation for trigger purposes. Ba2. In other words. when an asset is sold at a premium or discount. If the auction fails. In our mezzanine example.Lehman Brothers | ABS CDOs – A Primer Glossary • Auction Call: The trustee instructs the manager to liquidate all the assets in the portfolio as long as all the debt classes receive par. Rather than assuming a par value for all the assets in the portfolio when calculating OC. and d refer to the scheduled interest plus interest on deferred interest amounts of the respective classes. if 15% of the portfolio is rated Ba1.
Lehman Brothers | ABS CDOs – A Primer value. • • • • • Excess Spread: The difference between the interest cash flow received from the assets and the interest paid on the liabilities (minus ongoing fees). Managed transaction: A manager is paid a fee to select the initial CDO portfolio of assets and make investment decisions during the reinvestment period. any B1. Sequential Pay Period: When the collateral balance is less than 50% of the original collateral balance. Reinvestment period: The period during a managed transaction. 2006 26 . transactions may be referred to as hybrids. or carried at 50% of the par value. For instance. Optional redemption period: For managed transactions. Hybrid Transaction: When a portion of the CDO collateral is synthetic. • • • • • • November 17.5% when calculating the OC coverage. Loan-to-Value (LTV): The aggregate debt outstanding divided by the value of the collateral. or the auction call is not successful. During this time period. WARF is useful in providing one number to help describe the average credit of the portfolio. The cumulative default rate is rating-specific. or WARF. if a transaction has $103 of collateral and $100 of debt outstanding. typically the first three to five years. or carried at 80% of the par value and any Caa1 or lower exposure will be haircut by 50%. when principal proceeds received on the underlying collateral may be invested for substitute collateral and/or the manager has some flexibility in buying and selling collateral securities. Overcollateralization: The notional of the collateral outstanding divided by the debt outstanding. the principal proceeds are used to pay down the debt sequentially by order of seniority. the OC is 103%. B2. is a concept originated by Moody’s. the bond is considered to be PIKing. It assigns a number to each rating which represents the expected cumulative default rate over a 10-year period (Figure 23). WARF: The weighted average rating factor. the optional redemption period begins after the “no-call” period. Static transaction: A portfolio advisor is paid a fee to select the initial CDO portfolio and conduct ongoing surveillance. the optional redemption period begins after the reinvestment period ends and lasts until the auction call date. This would lead to an OC decline of 0. The portfolio is typically fully ramped at closing. For CDOs. PIK (payment-in-kind): If a debt class does not receive its full stated interest payment. and B3 exposure will be haircut by 20%. the equityholders can call the transaction with a majority vote as long as the debt is paid back at par. For static transactions. rather than sector-specific. Additionally.
500 8. 2006 27 .070 10. 1 10 20 40 70 120 180 260 360 610 Rating Factor of Debt Securities Rating of Debt Security Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Rating Factor 940 1.766 2.720 3.770 6.350 1.Lehman Brothers | ABS CDOs – A Primer Figure 23.220 2.490 4.000 Rating of Debt Security Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca or lower Rating Factor Source: Moody’s Investor Service November 17.
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