Collateralized Debt Obligations

DOUGLAS J. LUCAS is Executive Director and Head of CDO Research at UBS. He is also Chairman of The Bond Market Association's CDO Research Committee and ranked top three in CDO research in the Institutional Investor's fixed income analyst survey. Lucas has been involved in the CDO market for nearly two decades, having developed Moody's rating methodology for CDOs in 1989. LAURIE S. GOODMAN, PHD, is Managing Director and co-Head of Global Fixed Income Research at UBS. She manages U.S. Securitized Products and Treasury/Agency/Derivatives Research. Goodman has worked on Wall Street for over twenty years and is well regarded by the investor community, having won more #1 slots on the Institutional Investor All-American Fixed Income Team than any other analyst. FRANK J. FABOZZI, PHD, CFA, CPA, is an Adjunct Professor of Finance and Becton Fellow at Yale University's School of Management and a Fellow of the International Center for Finance. Fabozzi is the Editor of the Journal of Portfolio Management.

• Preface xiiiAbout the Authors xxiPart One Introduction to Cash CDOs 1Chapter 1 Cash CDO Basics 3Why Study CDOs? 3Understanding CDOs 4Credit Structures 10A CDO Structural Matrix 13CDOs Being Offered Today 14Parties to a CDO 14Chapter 2 Cash Flow CDOs 17Distribution of Cash Flows 17Restrictions on Management: Safety Nets 20Credit Ratings 23Call Provisions in CDO Transactions 38Part Two Loans and CLOs 41Chapter 3 High-Yield Loans: Structure and Performance 43The Loan Market 44The Syndication Process 46Loan Structure and Leaders 48Loan Interest Rates and Upfront Fees 49Loan Credit Quality 51Lender’s Liability 52Overview of Loan Terms 53Loan Terms versus Bond Terms 58A Tale of Two Loans 58The Secondary Market 60Loan Recovery Rates 61Loan Default Rates 63High-Yield Loan CLO versus High-Yield Bond CBO Performance 67Conclusion 74Chapter 4 European Bank Loans and Middle Market Loans 75European Bank Loans 75Middle Market Loans 91Conclusion 99Part Three Structured Finance CDOs and Collateral Review 101Chapter 5 Review of Structured Finance Collateral: Mortgage-Related Products 103Residential Mortgage-Backed Securities 103Commercial Mortgage-Backed Securities 125Real Estate Investment Trust Debt 129Chapter 6 Review of Structured Finance Collateral: Nonmortgage ABS 135Credit Card Receivable-Backed Securities 135Auto Loan-Backed Securities 137Student Loan-Backed Securities 139SBA Loan-Backed Securities 141Aircraft Lease-Backed Securities 142Franchise Loan-Backed Securities 145Rate Reduction Bonds 148Chapter 7 Structured Finance Default and Recovery Rates 153Structured Finance versus Corporate Default Rates 154S&P Rating Transition Studies and the Matrix Multiplying Approach 156Results of Multiplying S&P Rating Transition Matrices 158S&P on Structured Finance Loss Given Default 159S&P Constant Annual Default and Recoveries 159Moody’s Material Impairment Study 160Comparing and Reconciling Structured Finance Default Rates 162Moody’s on Structured Finance Historical Loss Rates 164Moody’s Constant Annual Default and Recoveries 166Blending S&P and Moody’s Studies 167Applying CDRs and Recoveries to SF CDOs 167Conclusion 170Chapter 8 Structured Finance Cash Flow CDOs 171SF CDOs versus High-Yield CDOs 172Rating Agencies on Structured Finance CDOs 174Structured Finance Assets’ Negative Convexity 182Extension Risk 183Conclusion 185Part Four Other Types of Cash CDOs 187Chapter 9 Emerging Market CDOs 189EM Sovereign Bond Defaults 190Why the Better Track Record? 192CDO Rating Differences: EM versus High Yield 193Conclusion 198Chapter 10 Market Value CDOs 201Cash Flow versus Market Value Deals 201The Rating Process 202How Advance Rates are Derived 212Conclusion 215Part Five Synthetic CDOs 217Chapter 11 Introduction to Credit Default Swaps and Synthetic CDOs 219Credit Default Swaps 219Synthetic CDOs 229Conclusion 239Chapter 12 Synthetic Balance Sheet CDOs 241Cash CLOs for Balance Sheet Management 241Partially Funded Synthetic CDOs 249Conclusion 253Chapter 13 Synthetic Arbitrage CDOs 255Full Capital Structure Synthetic Arbitrage CDOs 256Single-Tranche CDOs 260Standard Tranches of CDS Indices 261Conclusion 262Chapter 14 A Framework for Evaluating Trades in the Credit Derivatives Market 265Assessing Single-Name and CDO Tranched Exposures 266Assessing CDO Equity versus a Basket Swap 274Conclusion 280Chapter 15 Structured Finance Credit Default Swaps and Synthetic CDOs 281Differences between Corporate and Structured Finance Credit 282Difficulties in SF CDS 284SF CDS Effect on SF CDO Management 294Two New Types of SF CDOs 295Effects of SF CDS on CDO Credit Quality and Spreads 296Conclusion 297Part Six Default Correlation 299Chapter 16 Default Correlation: The Basics 301Default Correlation Defined 301Default Probability and Default Correlation 305Conclusion 321Chapter 17 Empirical Default Correlations: Problems and Solutions 323Empirical Results 323Problems with Historical Default Correlations 327Proposed Solutions 330Conclusion 344Part Seven CDO Equity 345Chapter 18 Why Buy CDO Equity? 347Nonrecourse Term Financing 347The Forgiving Nature of CDO Financing 354CDO Options 356CDO Equity as a Defensive Strategy 359Conclusion 360Chapter 19 CDO Equity Returns and Return Correlation 361Flawed Methodologies 362The Appropriate Lesson from History 365Loan Defaults and Recoveries 367Cash Flow Modeling Defaults and Recoveries 370Structured Finance Defaults and Recoveries 371SF CDO Cash Flow Modeling 372Return Correlation and Nonrecourse Leverage 374Conclusion 378Part Eight Other CDO Topics 379Chapter 20 Analytical Challenges in Secondary CDO Market Trading 381Important Developments: Spread Tightening, Increased Activity 382Pitfalls in Secondary CDO Trading 384Eight-Point Checklist in Evaluating a CDO in the Secondary Market 387Prescription for Making Primary Issuances Conducive to Secondary Trading 408Conclusion 409Chapter 21 The CDO Arbitrage 411Building Blocks 411Impact of CDO Arbitrage on Structure 422Conclusion 425Chapter 22 How to Evaluate a CDO and Manage a CDO Portfolio 427Incentive Clashes in CDO Structures 427Evaluate Structural Enhancements 428Evaluating the Manager’s Track Record 429Conclusion 434Chapter 23 Quantifying Single-Name Risk Across CDOs 435Collateral Overlap in U.S. CLOs 436Favorite CLO Credits 437Collateral Overlap in U.S. Structured Finance CDOs 439Single-Name Risk and Tranche Protections 441Excess Overcollateralization and Excess Overcollateralization Delta 443Monte Carlo Simulation of Single Credit Risk 446Comparing the Two Approaches 449Conclusion 450Chapter 24 CDO Rating Experience 453CDO Rating Downgrade Data 454CDO and Tranche Rating Downgrade Frequency 456CDO Downgrade Patterns 458Why Downgrade Patterns? 460Downgrade Severity 462Downgrades of Aaa CDO Tranches 464Extreme Rating Downgrades 464CDO Defaults and Near Defaults 469Conclusion 473Index 477