CDOs October 19, 2006

Transcription

1 2006 Annual Meeting & Education Conference New York, NY CDOs Ozgur K. Bayazitoglu AIG Global Investment Group Keith M. Ashton TIAA-CREF Michael Lamont Deutsche Bank Securities Inc. Vicki E. Marmorstein Latham & Watkins LLP

2 Collateralized Debt Obligations (CDOs) Presented at the 2006 ACIC ANNUAL MEETING Moderator: Panelists: Ozzie K. Bayazitoglu AIG Global Investment Group Keith M. Ashton TIAA-CREF Michael Lamont Deutsche Bank Securities Vicki E. Marmorstein Latham & Watkins LLP 0

3 Introduction Outline Part 1 Part 2 Part 3 Collaterized Debt Obligations (CDOs) Structure Investor Concerns Credit Default Swaps Synthetic CDOs 1

4 Part 1 -- Collaterized Debt Obligations Assets Liabilities Cash Flows Senior - Class A Management of Portfolio of Portfolio Bank Loans Mezzanine - Class B Equity Aaa/AAA LIBOR + 25bp Baa/BBB LIBOR + 175bp Residual Cash Flow Collaterized Debt Obligations (CDOs) are a class of securities of which the performance is linked to the credit performance of a specific pool of assets. Within the CDO family are (1) Collaterized Bond Obligations (CBOs), for which the assets are corporate bonds, and (2) Collaterized Loan Obligations (CLOs), for which the assets are loans (generally loans originally issued to a bank syndicate). The model above is an example of a typical CDO model, called the cash flow model, meaning that the cash flows generated from the Portfolio are distributed to the notes issued by the CDO. The Class A notes have a first claim on the cash flow and bear the lowest amount of risk. The Class B notes are somewhat riskier than the Class A notes and receive a coupon to reflect that risk. The Equity is in a first loss position, and it bears most of the risk associated with the Portfolio. The Equity has a large upside potential because if the Portfolio performs well the Equity will receive all excess cash. 2

5 Part 1 -- Collaterized Debt Obligations CDO Time Line 12 to 15 Years Warehouse Period Closing; Continue Ramp- Up Reinvestment Period Amortizing Period Warehouse/Closing/Ramp-Up: A CDO will need time to build up the Portfolio. Initial purchases begin prior to closing through the use of a warehouse facility. After closing, the CDO will continue to purchase assets during a ramp-up period which may last up to six months. Reinvestment Period: Once a CDO is fully ramped-up, the Portfolio Manager will manage the portfolio via sales and purchases of loans from the market. The Reinvestment Period generally runs for five to seven years. Amortizing Period: After the Reinvestment Period, the CDO may reinvest only principal proceeds from unscheduled sales. All other principal proceeds must be used to pay down notes pursuant to the waterfall. 3

6 Part 1 -- Collaterized Debt Obligations Legal Structure and Documents A. The CDO The CDO Issuer is a bankruptcy remote entity for which the sole purpose is to hold the Portfolio assets and issue the notes. B. The Indenture The most important legal document is the Indenture. All of the Issuer assets are held in trust pursuant to the terms of the Indenture, and the Indenture will specify in detail the following: (1) the collateral--types of assets that the CDO may hold (2) the waterfall and the precise definition of the overcollateralization tests and the interest coverage tests (further discussed below) (3) the trading rules (buying and selling loans; reinvesting principal payments; treatment of interest and principal proceeds) (4) investors rights, including voting rights 4

7 Part 1 -- Collaterized Debt Obligations Legal Structure and Documents (continued) C. The Collateral Management Agreement The Collateral Management Agreement is an adviser agreement between the Collateral Manager and the Issuer. The Collateral Management Agreement will authorize the Collateral Manager to select, invest and reinvest the Collateral Debt Securities and any risk-free securities (Eligible Investments). The Collateral Manager s duty of care will be set forth in the Collateral Management Agreement. The CMA will set forth provisions relating to the replacement of the Collateral Manager, for cause and without cause (definition of cause). 5

8 Part 1 -- Collaterized Debt Obligations Legal Structure and Documents (continued) D. The Waterfall The details of a CDO cash flow structure are spelled out in the priority of payments section of the Indenture, referred to as the Waterfall. The Waterfall explains the manner in which principal and interest are distributed among the various classes of noteholders. Certain payments in the waterfall are triggered by tests, and a test must be in compliance before any payments are made to parties below that test in the waterfall. The most common tests are: Overcollateralization Tests For example, a Senior OC Ratio would be determined by a ratio: the numerator of which is (a) Performing Collateral Par Value, plus (b) Cash, plus (c) Defaulting Par Value discounted by the Recovery Rate; and the denominator of which is the Class A Par Value. Interest Coverage Tests A Senior IC Ratio is determined by a ratio: the numerator of which is the Performing Collateral Par Value multiplied by the Collateral Weighted Average Coupon; and the denominator of which is the Class A Par Value multiplied by the Class A Coupon. 6

9 Part 1 -- Collaterized Debt Obligations Interest Proceeds Taxes, Fees Hedge Payments Senior Mgmt. Fees Class A Interest Class A Coverage Test PASS Class B Interest Class B Coverage Test PASS Unpaid Fees, Subordinated Management Fees FAIL FAIL Class A Principal First, Class A Principal; Second, Class B Principal Equity The Indenture will outline provisions for two waterfalls: one waterfall will specify the distribution of interest proceeds (see above); and a second waterfall will specify the distribution of principal proceeds. 7

10 Part 1 -- Collaterized Debt Obligations Principal Proceeds Taxes, Fees Hedge Payments Senior Mgmt. Fees Class A Current Interest Class A Principal Class B Current Interest First, Class A Principal; Second, Class B Principal Unpaid Fees, Subordinated Management Fees Equity 8

11 Part 1 -- Collaterized Debt Obligations Investor Considerations and Concerns Why would an investor chose to purchase CDO securities instead of the portfolio assets directly? A CDO is a passive investment in the underlying market--let the Collateral Manager do the work The senior tranches will have high ratings, thus qualifying for different investment buckets applicable to the investor (for example, AIGGIG Securities Lending may not purchase BBB credit, but it may purchase the senior tranches of a CDO which could hold a portfolio of BBB credit) A Cash Flow CDO securities are less sensitive to the market price of each investment of the portfolio; thus the Investor risk is primarily based on the actual credit performance of the underlying portfolio Remember the principal concern to the investor of a CDO is collateral cash flow 9

12 Part 1 -- Collaterized Debt Obligations Investor Considerations and Concerns (continued) 1. Portfolio Structure Key Ratios (O/C; I/C) Evaluation of Reference Credits All (or almost all) credits must be rated a minimum average rating must be maintained; if violated, portfolio changes must improve the average rating of the portfolio Portfolio Evaluation Portfolio Concentrations (limits on individual credits) Diversification Requirements (limits on industry sectors) Maintenance of portfolio average life 10

13 Part 1 -- Collaterized Debt Obligations Investor Considerations and Concerns (continued) 2. Manager Evaluation Responsible for selection of the collateral and any subsequent purchases and sales Review of manager s qualifications and track record Investment Process 3. Structural Concerns Subordination of lower tranches Investment Process (trading parameters) Calculation methods for the O/C and the I/C 4. Legal Concerns Specific Language regarding Event of Default Rights; replacement of the Collateral Manager; duties of the Collateral Manager Responsibilities of the Trustee ERISA and QIB concerns 11

14 Part 2 Credit Default Swaps Credit Default Swaps A Credit Default Swap (CDS) is an agreement between two parties to exchange the credit risk of an issuer (the reference entity). A CDS does not directly involve the reference entity. The Seller under a CDS is said to sell protection, and the Seller will receive a periodic fee that reflects the credit of the reference entity. Selling credit protection has a similar credit position to owning a bond or loan. The Buyer under a CDS is said to buy protection. In other words, a CDS is a means by which an investor (the protection seller) may simulate an investment in a reference entity without a need to purchase bonds or loans issued by the reference entity. For added complexity, a CDS may reference a basket of credits, called first to default CDS. 12

15 Part 2 Credit Default Swaps Basic CDS Structure Below is an example of a CDS between Lexington Insurance Company and Lehman Brothers trading Coca-Cola credit risk. Reference XYZ Corp. Transfer of XYZ Corp. Credit Risk SPV Fee/Premium Protection Buyer Protection Seller Buy Protection Pay Periodic Payments Contingent Pay-Off upon a Credit Event Sell Protection Receive Periodic Payments Credit Risk Profile of Shorting a Bond Issued by XYZ Corp. Credit Risk Profile of Owning a Bond Issued by XYZ Corp. 13

16 Part 2 Credit Default Swaps CDS Documentation Over 90% of CDS Trades worldwide are conducted using an ISDA Master Agreement Primary Legal Documents include: ISDA Master Agreement, with Schedule Credit Support Annex Trades are executed on the phone, with a Confirmation to follow Current Trend Automated Confirmation Services Depository Trust & Clearing Corporation (DTCC) is the market leader Most CDS trade desks require all confirmations to be executed through DTCC If both parties to a CDS Trade are DTCC participants, the Confirmation will be executed through DTCC Confirmations on DTCC are confirmed through an online account system 14

17 Part 2 Credit Default Swaps Elements of an ISDA Master Agreement An ISDA Master Agreement is structurally similar to a loan document, except: (a) the representations and covenants apply to both parties; (b) payment obligations are written with reference to the Confirmation, and they apply to both parties; and (c) rights upon an Event of Default are written to act in favor of either party, as applicable. Specifically, an ISDA Master Agreement, with Schedule, will set out: General Delivery Obligations (details are set out in a Confirmation) Representations Tax Representations (withholding) Agreements (Covenants) Events of Default and Termination Provisions Miscellaneous (Transfer Provisions; Notice Information; Ancillary Documentation) 15

18 Part 2 Credit Default Swaps CDS Confirmations The terms of a Trade under an ISDA Master Agreement are set forth in a Confirmation. A typical CDS Confirmation will identify: The Trade Date; the Effective Date; and the Termination Date The Protection Seller The Protection Buyer The Reference Entity Criteria for a Deliverable Obligation (may be specific or general) Trigger for delivery of a Deliverable Obligation--Credit Event Method of Settlement: Physical Delivery or Cash Settlement (payment of money instead of delivery of a bond or loan) 16

19 Part 2 Credit Default Swaps CDS Confirmations (continued) The obligation of the Protection Seller to accept a Deliverable Obligation (a bond or loan issued by the Reference Entity) is triggered by the occurrence of a Credit Event with respect to the Reference Entity. Credit Events are events that reflect a deterioration of the Reference Entity s credit profile. Typical Credit Events include: Bankruptcy Failure to Pay Restructuring Restructuring was an area of much controversy surrounding the restructuring of debt issued by Conseco and Xerox during 2000 to ISDA responded by adding limitations, one set of which is referred to as Modified Restructuring, and a second is referred to as Modified Modified Restructuring. Acceleration Repudiation 17

20 Part 3 -- Synthetic CDOs Synthetic CDOs A Synthetic CDO operates much like a CDO, except that the underlying portfolio is comprised of Credit Default Swaps rather than bonds or loans. In a funded Synthetic CDO, the Issuer will also hold low-risk securities as collateral for the Credit Default Swaps and as a source of principal payment for the investors. Issuer Investors Low-Risk Investments LIBOR Senior - Class A Aaa/AAA LIBOR + 50bp Management of Portfolio Issuer (Protection Seller) Cash Flows Mezzanine - Class B Baa/BBB LIBOR + 250bp Swap Counterparty (Protection Buyer) Premium/Fee Equity Residual Cash Flow 18

21 Part 3 -- Synthetic CDOs Single Tranche Synthetic CDOs Single Tranche Synthetic CDOs are transactions in which only one slice of the portfolio credit risk is assumed by the CDO (and subsequently passed on to the investors). The remaining risk is retained by the Swap Counterparty. 19

22 Portfolio Manager SINGLE TRANCHE SYNTHETIC CDO CDS 1 CDS 2 Spread Highly rated collateral NOT MARKETED Super Senior + Junior Super Senior CDS 3 Collateral payment L + spread Par CDS 123 CDS 124 CDS 125 Portfolio Swap with a major Swap Desk L + (Protection Losses above Tranche Subordination) SPV L + spread Par AAA AA A NOT MARKETED Subordinated Tranches L + spread Par Investors 125 names selected and actively managed by the Portfolio Manager SPV owns two assets: Highly rated collateral and portfolio swap with the major Swap Desk Tranches not sold are risk managed by the Swap Desk 20

23 Part 4 -- Evolution of the CDO Market The The Products Products Single Name Credit Default Swaps/ Credit Linked Notes Small baskets (typically 5 names) Fully Distributed Synthetic CDOs Single Tranche CDOs Credit default swaps and synthetic securitization technology has led to a rapid expansion of the structured credit market. Investors can choose among a variety of structures specifically tailored to investor needs. 21

24 Part 4 -- Evolution of the CDO Market Notional CDS Outstanding (measured in $billions) $17,000 $8,420 $918 $2,150 $3, Measured in billions Source: ISDA, Financial Times 22

25 Part 4 -- Evolution of the CDO Market CDO market: $ Notional - Synthetic CDO market: Notional Synthetic $ billion 1600 Cash Notional Synthetic Notional¹ YTD 2006 Source: JPMorgan Securities 1 Represents outstanding notional of both public CDOs and tranche only CDOs 23

26 Part 4 -- Evolution of the CDO Market Innovations in Synthetic CDOs Fully Distributed Synthetic CDOs Single Tranche Synthetic CDOs Long/Short CDOs Principal/Protected CDOs Related Area: Long/Short Funds Long/Short Funds are not structured in the form of a CDO Returns are generated through long and short CDS trades 24