An Introduction to CDOs and Standard & Poor's Global CDO Ratings Analysts: Thomas Upton, New York Standard & Poor's Ratings Services has been rating collateralized debt obligation (CDO) transactions since they were first created in the late 1980s. The number of transactions and investment volume started to grow in popularity with institutional and wholesale investors after 1996, and to date Standard & Poor's has globally rated more than 1,000 CDO transactions. Increasingly, such transactions are beginning to be marketed to retail investors, with minimum investment amounts as small as $5,000. To help all investors better understand what CDOs are, and what Standard & Poor's ratings address, this article aims to answer some of the most frequently asked questions about CDOs and ratings. 1. What is a CDO? A CDO is a stand-alone, special-purpose vehicle (SPV) that invests in a portfolio of assets. Such assets are typically, but are not limited to, corporate debt (loans or bonds). To fund the investment in the assets, the SPV borrows money by selling notes to investors, who will be repaid once the assets mature. The investors assume the default risk associated with the asset portfolio; however, all investors do not assume the risk equally, since the notes are divided into different classes of seniority. The notes are typically sold to institutional and, increasingly, retail investors. 2. Are CDOs similar to mutual funds? No. In a mutual fund all investors share in the risk and rewards of the investments equally. In a CDO, the transaction is structured with different classes of notes, each having a different risk/reward profile. If any of the assets in the underlying asset pool default, the lowest note class (typically referred to as the CDO equity class) will suffer a loss. As losses increase in the asset pool, then the other classes of notes may also be affected. All investors investing in the same class of notes in a CDO share in the losses allocated to that class. 1
3. What is a simple example of a CDO? An SPV is created and issues four classes A, B, C, and D of notes to investors. Class A is the most senior class and class D is the most junior class. Each class is $5 million, thus the SPV raises $20 million in total. The money is used to purchase $1 million worth of bonds from each of 20 different companies, and to cover the expenses associated with setting up the SPV and doing the transaction. All bonds mature in three years, and all investors will be repaid their investment if none of the companies default on their bonds. When the bonds mature, the investor classes will be paid back in the order of seniority, that is, A, then B, then C, and lastly D. Each class of notes is also paid periodic interest that comes from the interest paid by the underlying portfolio of assets. Obviously, the class D investors are paid a higher rate of interest to compensate them for the higher level of risk, since they are exposed to the first default in the portfolio. 4. What happens in the above example if a company defaults? If there is a default there may not be sufficient money (see question 6 below) to pay everyone back. If there is one default, classes A, B, and C will be paid in full, but class D may lose up to $1 million of its $5 million in principal. 5. In the above example, will class D investors always lose money? No, it depends if any of the 20 companies default or not. 6. If there is one default, how much money will the class D investors lose? It depends and is based on the level of recoveries that may be realized on the defaulted asset. At worst, there will be no recoveries and the entire $1 million will be lost on a default. 7. Could classes A, B, and C in the above example lose money? Yes, depending on the level of defaults that the asset portfolio experiences. Assuming there are no recoveries on defaults, the entire class D will be lost after five defaults and class C will suffer a loss on the sixth default. 2
8. What is the main risk in a CDO transaction? The main risk in a CDO transaction structured as described above is the credit risk associated with the companies in the portfolio of assets. By investing in a pool of assets made up of bonds or loans of different companies, investors are, in effect (but indirectly), lending money to the companies and becoming creditors of the company. Should a company default, the creditors are at risk of not being repaid their money. There are also other risks in CDO transactions, such as variability of recoveries, changes in law, documentation risks, and, for actively managed asset pools, the risks introduced by the actions of the collateral manager. A small subset of CDO transactions is not based on credit risk (see question 41), but rather on changes in the periodic market values of loans or bonds. Such CDOs are referred to as market value CDOs. All investors are strongly encouraged to read the prospectus or offering memorandum to understand the specifics of the transaction and the associated risks. 9. How does recovery on the defaulted debt affect the risk of the transaction? The exact level of loss that an investor will suffer is based not only on the expected level of defaults, but also on the expected level of recoveries that will be achieved once a default has occurred. 10. What drives the level of recoveries on a defaulted security? There are many factors that drive post default recoveries in a CDO. All other things being equal, the major factor is the seniority of the debt obligations held by the trust relative to other debt that the company has issued. The typical hierarchy for company debt, in order of seniority, is senior secured, senior unsecured, and subordinated. Company shares or common equity is not company debt. 11. What other factors influence recoveries? Other major factors affecting recoveries are the laws of the country under which the company operates and whether, and how, insolvency proceedings will take place, and the manner in which the CDO will realize the recovery on the defaulted obligation. The manner of recovery may be different if the CDO assets are held and worked out 3
over time through the insolvency, or if there will be a quick sale or settlement shortly after the company defaults. 12. If the CDO transaction invests only in senior secured debt, does that mean that the likelihood that a company will default will be less? No. The seniority and security of the debt held by the CDO does not influence the default likelihood of any company. However, it does affect the expected level of recoveries that the CDO will get after company default, with higher ranking debt expected to have higher recoveries. 13. Are there other types of CDO transactions? Yes. The CDO structure described above is typically called a cash flow CDO, because the SPV uses the money received from investors to actually buy the assets. The cash flow generated by the assets is paid back to investors. But, it is not necessary to buy the assets. In fact, in certain transactions the assets could be simply referenced. Such transactions are called synthetic CDOs. 14. How does a synthetic CDO work? In a synthetic CDO, the companies in the portfolio of assets are only referenced through a credit default swap. The swap is between the SPV and a third party. The swap effectively transfers (synthetically) the risk of the portfolio of assets from the third party to the SPV. So instead of buying $1 million of debt from each of 20 companies, as in the previous example, the SPV could enter into 20 different credit default swaps each naming one of the 20 companies and having a notional exposure of $1 million each. If any of the companies referenced in the credit default swaps default, then the SPV must pay to the third party an amount up to $1 million. 15. What happens to the money paid in by investors in a synthetic CDO? The money can either be invested by the SPV in low-risk eligible investments, such as cash or government bonds, or paid to the third party upfront. If the money is held by the SPV, then upon a default of a company, the SPV must take some of the money and pay the third party. If the third party holds the money, the valuation is done upon a 4
default, and the third party must repay what is owed to the investors at the end of the deal. 16. How does the fact that the third party may hold the investor's money affect the risk of the transaction? In such cases the investors are exposed to two default risks: the risk that the companies in the reference swaps default, and the risk that the third party will default and will be unable to repay what is owed to the investors at the end of the term. But in such cases, most third parties are highly rated financial institutions, and the rating on the most senior class of notes offered to investors is capped at, and linked to, the rating on the financial institution holding the money. 17. Why is it that in a synthetic CDO the investors are said to sell credit protection? Effectively, through the credit default swap, the third party is buying credit protection from the investors on the company named in the swap. Should the company named in the swap default, then the investors must pay some amount to the third party. Effectively, the investors are reimbursing the third party for losses if the company named in the swap defaults. 18. What determines how much the investors must pay to the third party? There are many different ways of establishing this, but the most common market practice is to get market bids on the securities of the defaulted company. Once a company defaults, a calculation agent will get a number of bids from dealers trading the securities of the defaulted company. The dealers will indicate how much they are willing to pay for the defaulted securities of the company. This effectively establishes the recovery amount on the defaulted company. The investor must then pay to the third party the difference between the recovery amount and the reference amount in the swap. If the investor's money is held by the SPV, then the SPV must make a payment to the third party. If the third party holds the money, the amount is deducted from what the third party must repay to the investors when the deal matures. 5
19. How are investors paid interest in a synthetic CDO? As previously mentioned, in a synthetic CDO the third party could be viewed as buying credit protection from the investors. In return for this, the third party must make periodic payments to the investors, similar to paying an annual premium for maintaining the credit protection from the investors. The premium that the third party pays, plus any investment returns earned by the SPV if it holds the investors' money, is used to pay interest to the investors. If the third party is not highly rated, it must post the premium payment in advance. 20. What determines the default likelihood of a company? Standard & Poor's has been assigning ratings to companies for decades, and has found that there are many reasons why companies fail. In Standard & Poor's view, the best predictor of a company's creditworthiness is a Standard & Poor's long-term issuer credit rating. 21. What is a Standard & Poor's long-term issuer credit rating? A Standard & Poor's issuer credit rating reflects the ability of a company to meet its overall credit obligations. Standard & Poor's uses a letter rating system to indicate the strength of the issuer, as follows: AAA An obligor rated 'AAA' has EXTREMELY STRONG capacity to meet its financial commitments. 'AAA' is the highest issuer credit rating assigned by Standard & Poor's. AA An obligor rated 'AA' has VERY STRONG capacity to meet its financial commitments. It differs from the highest rated obligors only in small degree. A An obligor rated 'A' has STRONG capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories. 6
BBB An obligor rated 'BBB' has ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. Obligors rated 'BB', 'B', 'CCC', and 'CC' are regarded as having significant speculative characteristics. 'BB' indicates the least degree of speculation and 'CC' the highest. While such obligors will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions. BB An obligor rated 'BB' is LESS VULNERABLE in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions that could lead to the obligor's inadequate capacity to meet its financial commitments. B An obligation rated 'B' is MORE VULNERABLE to nonpayment than obligations rated 'BB', but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitment on the obligation. CCC An obligor rated 'CCC' is CURRENTLY VULNERABLE, and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments. CC An obligor rated 'CC' is CURRENTLY HIGHLY VULNERABLE. SD and D An obligor rated 'SD' (selective default) or 'D' has failed to pay one or more of its 7
financial obligations (rated or unrated) when it came due. A 'D' rating is assigned when Standard & Poor's believes that the default will be a general default and that the obligor will fail to pay all or substantially all of its obligations as they come due. An 'SD' rating is assigned when Standard & Poor's believes that the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner. Please see Standard & Poor's issue credit ratings for a more detailed description of the effects of a default on specific issues or classes of obligations. Plus (+) or minus(-) The ratings from 'AA' to 'CCC' may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. 22. What does a Standard & Poor's rating address? Standard & Poor's ratings address the first dollar of loss, not an expected loss amount. A company that fails to make a payment on its debt, as per the terms of its obligation, be it either interest or principal, would have an issuer credit rating of 'D' for default or 'SD' for selective default. Standard & Poor's also assigns long-term issue credit ratings on specific obligations of an issuer, be it an operating company or an SPV. Issue credit ratings are based, in varying degrees, on the following considerations: Likelihood of payment--capacity and willingness in the case of the operating company to meet its financial commitment on an obligation in accordance with the terms of the obligation; Nature of and provisions of the obligation; Protection afforded by, and relative position of the obligation in the capital structure of entity, and in the case of operating companies, the position of the obligation in the event of bankruptcy, reorganization, or other arrangement under the laws of bankruptcy and other laws affecting creditors' rights; and The issue rating definitions are expressed in terms of default risk. As such, they pertain to senior obligations of an entity. Junior obligations are typically rated lower than senior obligations, to reflect the lower priority in the structure, or in case of bankruptcy, as noted above. 8
23. Is a Standard & Poor's rating a recommendation to buy, hold, or sell any security, debt, or structured notes? No. A Standard & Poor's rating is an opinion of creditworthiness. It is not investment advice or a recommendation to buy, hold, or sell any security. Each investor should carefully consider the risks and returns associated with any investment and make their own decision as to whether the investment is appropriate for them. 24. How does a Standard & Poor's issuer credit rating relate to the likelihood of a company defaulting? Standard & Poor's has been keeping statistics since 1982 on the defaults experienced by each company that it has rated. Using these statistics, Standard & Poor's can estimate the likelihood of the company defaulting based on its credit rating today and the number of years that the investor is exposed to the company risk. 25. What does the number of years of exposure have to do with the default risk? In general, for any given rating, the longer the number of years of exposure, the higher the probability of default. Thus, for a given company with a specific issuer credit rating, investing in a bond that matures in three years is less risky than investing in a bond that matures in seven years. 26. How does Standard & Poor's use these default statistics in a CDO? The default statistics first serve as a basis for assigning a default probability for each company in the portfolio of assets in a CDO. Based on the current issuer credit rating on each company in the asset portfolio and the maturity of its debt, Standard & Poor's assigns a default probability to each company in the asset pool. The default probabilities used in CDOs are based on historical averages, but are modified to increase as the maturity of the debt increases and as the rating on the company is lowered. An example of the default probabilities is shown in the following table. 9
Default Probabilities (%) Years Ratings AAA A BBB B 1 0.023 0.136 0.225 8.594 3 0.119 0.542 1.182 18.594 5 0.284 1.111 2.5 23.488 7 0.517 1.814 3.941 26.151 10 0.988 3.041 6.084 28.453 27. What happens after a default probability is assigned to each company in the pool? Using a model named CDO Evaluator, Standard & Poor's models the defaults of all the companies in the portfolio of assets in all possible combinations, including the default correlation between pairs of assets. The results of this modeling generate a probability distribution of defaults for each individual asset pool. This distribution shows the likelihood that the portfolio will suffer a given amount of defaults. Based on this, Standard & Poor's can assign a probability that the portfolio of assets will suffer one, two, three, or any number of company defaults. 28. How does this probability of default result in a rating on the CDO notes that investors buy? Standard & Poor's uses the same default probabilities that it used to estimate the default likelihood of each company in the portfolio of assets to assign a rating to the investor notes. Using the example in question 26, a company rated 'BBB' has a default probability of 1.18% for three years, then, if the probability that the CDO portfolio will suffer $5 million of defaults (assume no recovery), based on the simulation explained in question 27, is also 1.18 %, then the class C notes of the CDO could also be rated 'BBB'. This rating could be assigned to the notes, since the probability of having no losses (default) on the class C notes is not any higher than a probability of default on a corporate credit rated 'BBB' for the same time exposure period. The class D notes in this example would not be rated since they cover the $5 million of losses. 29. Other than the ratings and maturity of the corporate debt, does anything else affect the credit quality of the portfolio of assets? 10
Yes, the concentration of the companies in any one industry is also very important. All industries go through cycles and there is a correlation of defaults between companies. Thus, the more a portfolio is concentrated in a given industry, the more likely it is that a higher level of corporate defaults will take place once a company in that industry defaults. CDO Evaluator factors in the industry concentration for the portfolio of assets in calculating the expected level of defaults for the portfolio. 30. So, what information is needed on each company in the portfolio of assets to run CDO Evaluator and get the expected default rates? The information needed for each of the portfolio assets is the Standard & Poor's issuer credit rating, the dollar amount and maturity of the debt, and the industry of the company. For companies domiciled in countries rated less than 'AAA', information of the country is also required. 31. What is the output for the CDO Evaluator? The output is the amount of defaults that are expected for the portfolio of assets under each rating scenario. For example: 'AAA' = 40%, 'AA' = 35%, 'A' = 30%, and 'BBB' = 25%. This means that for the investor's CDO notes to be rated 'AAA', the notes must not lose a single dollar if 40% of the assets in the portfolio default. 32. How do the default rates from the CDO Evaluator translate in the notes offered to investors? For each class of notes offered to the investor to get a specific Standard & Poor's rating, it must show that it can withstand the level of portfolio asset defaults that is projected by the CDO Evaluator at that rating level. How much credit support is needed below each class of notes is determined by looking at expected defaults, expected recoveries, and transaction structure. For example, assume that in a synthetic CDO referencing $100 million in assets, the 'AAA' default rate is 40%. This means that Standard & Poor's assumes $40 million would default. If there are no recoveries assumed, then $60 million could be rated 'AAA'. The transaction could be structured with two classes of notes. Class A would be $60 million, rated 'AAA', and senior to the class B notes. Class B would be $40 million and not rated, since it would suffer all losses up to the 'AAA' level. Now, assume that for the same transaction the expected 11
recovery rate is 25%, based on the assets in the pool and transaction specifics for achieving the recoveries. This means that for every $100 of defaults, $25 would be recovered and $75 would be lost. In the above example, the size of the class A notes could be increased to $70 million, since $40 million default but only $30 million is lost ($100 million x 40% defaults x 75% loss on defaults). With this recovery, the size of the class B notes would be reduced to $30 million, since this covers the amount of expected losses after recoveries in a 'AAA' rated case. Cash flow CDOs, in addition to recoveries, also typically have some level of excess interest that can be captured and used to cover losses. For cash flow CDOs, Standard & Poor's runs multiple cash flow simulations stressing all parameters, including interest rates, to see that the rated class of notes can meet its payment obligation at the assigned rating level. 33. How can one judge the relative risk of different classes of notes from different CDOs? Everyone's view of risk is different, hence no absolute answer can be given to this question. One relatively good way of comparing the risk of different CDO classes of notes is to compare Standard & Poor's ratings on the notes. This is indicative of risk within a given transaction and across different transactions. 34. Should I buy CDOs purely based on ratings? No. Standard & Poor's ratings are a good indication of credit risk, but are not an answer for how appropriate any investment is for any investor. Any decision should take into account a variety of factors, including, just to name a few: portfolio diversification across individual company exposure; desired risk reward profile; asset allocation strategy; and tolerance for risk. Investors may wish to seek the help of a qualified investment advisor. 35. Other than the ratings on the notes, how can one compare different CDOs? Investors can look at the asset portfolio and have a sense of the companies in the pool, how the companies are rated, and their line of business. Standard & Poor's also provides portfolio benchmarks of each CDO. The benchmarks include: 12
Weighted average rating (WAR): The average rating on the companies in the pool; Weighted average maturity (WAM): The average life of the portfolio; Default measure (DM): The expected annual average default rate of the portfolio; Variability measure (VM): The deviation around the average portfolio default rate; and Rated overcollateralization (ROC): The risk adjusted collateral available to support a rated tranche. The above benchmark results are already factored into the ratings assigned to the notes, but for the same rating and maturity, investors might prefer to have a portfolio with a higher WAR and ROC and smaller DM and VM. 36. What happens if the companies in the pool are downgraded? Most transactions offer some buffer to allow a certain level of rating change in the portfolio of assets. However, if a number of companies are downgraded, and such downgrades are not offset by upgrades of other companies, there will come a point where the rating on the CDO will be lowered, even though there have been no defaults. The downgrade of the CDO reflects the increased likelihood of defaults of the individual companies in the asset pools. 37. Does Standard & Poor's monitor the ratings on CDOs? Yes. Standard & Poor's maintains active surveillance on most transactions. However, on private placement transactions, Standard & Poor's may only be asked to assign a rating at a single point in time. 38. What types of debt can be included in a CDO? Many different types of debt can be included in CDOs. In addition to debt from large companies, CDOs may be structured to include loans to small businesses; project finance debt; structured finance debt, such as residential mortgages or consumer receivables; and even tranches of other CDOs. Most transactions limit themselves to one or two types of debt, but some can mix all different types. 13
39. Can the companies or assets in a CDO portfolio change once a deal is done? The answer depends on the transaction type. A fair number of CDOs are static, meaning that the composition of the portfolio of assets cannot change. But the majority of CDOs rated to date are actively managed by a collateral manager. The managers can typically buy and sell credits in order to manage credit risk and maximize returns to the investors holding the CDO equity notes. 40. How are CDOs typically classified? CDOs are typically classified by structure, collateral trading restrictions, and motivation for doing the transaction. The different structures are: Cash flow: Money invested is used to purchase assets having at the minimum the balance needed to pay back the investors. Cash flow generated by the assets pays back investors; Synthetic: Assets are referenced through a credit default swap. Money invested by investors is held by the SPV and paid out to the counterparty if a referenced asset defaults. The payments reduce what the SPV must pay back to investors; Hybrid: Transaction can purchase assets and also enter into credit default swaps; and Market value: Money invested by investors is used to buy assets. The market value of the assets is monitored and assets are sold to repay investors if market value drops. The different collateral trading options in a CDO are as follows: Static: Credits in pools do not change; Partially managed: A manger monitors the pool of assets and can sell any assets that are deemed at risk of defaulting; and Actively managed: A manager may buy and sell assets on a discretionary basis or if they deem them to be credit improved. They can also sell any asset that they deem at risk of default, then use the sale proceeds to buy new assets. 14
Different CDO transactions are originated by different sponsors based on the following motivations: Arbitrage: A sponsor can lock in a profit or derive an annual portfolio management fee. Such sponsors include collateral managers and investment banks; Capital relief: By selling the assets or buying credit protection from investors, the regulatory capital required to cover the assets is reduced. Financial institutions are typically the sponsor of such transactions; Risk management: Some financial companies do a lot of business with a number of large clients. To minimize their exposure to such clients, they transfer the default risk to investors through a CDO; and Funding: Some institutions originate loans and then securitize them in a CDO to free up and obtain funds again. The companies typically generate an origination and servicing fee for each loan. 41. Who picks the credit in a CDO? The credits are generally picked by the sponsor or collateral manager. The pools are generally picked to allow the transaction to be rated, and to meet the objectives of the sponsor. Investors should consider who has selected the portfolio of assets and what their motivation was. 42. Do sponsors typically invest in their own CDOs? Some do and some do not. Typically, the first loss class in a CDO is not rated, and receives as compensation all excess funds not paid out to the more senior classes. Returns on this class can be quite high if the transaction does not suffer defaults. The sponsors typically invest or retain a piece of the unrated first loss class. They can, however, invest in any class of the CDO. Standard & Poor's is neutral on the issue of whether the manager or sponsor should or should not invest in the transactions. 43. If a CDO is actively managed, does it affect its performance? The abilities of the collateral manager can affect the performance of a CDO quite 15
severely. Some managers have done quite well, while others have not. Investors should make sure they are familiar and comfortable with the collateral manager before investing in any actively managed CDO. 44. How important is the collateral manager to the performance of a CDO? In Standard & Poor's view, the collateral manager plays a paramount role in the performance of the transaction. To help investors, Standard & Poor's has published more than 40 CDO Manager Focus reports, each concentrating on one asset management firm and the CDOs that it manages. The reports can be found as detailed below. 45. Where can I get additional information on CDOs and Standard & Poor's ratings? Additional information is available on RatingsDirect, Standard & Poor's Web-based credit analysis system, at www.ratingsdirect.com and on Standard & Poor's Web site at www.standardandpoors.com. Standard & Poor's typically publishes a press release, presale, and postsale report on each public transaction. Standard & Poor's also publishes CDO rating criteria and market commentaries. 16