CDOs 101 London

CDOs : A Beginner’s Guide

Sharif Anbar-Colas & Aaron WongGlobal Cash CDO Trading

INTERNAL USE ONLY – DO NOT SEND OUT

April 21, 2006

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Agenda

♦ Section 1: How Does a CDO Work?

♦ Section 2: Benefits of a CDO

♦ Section 3: Different types of CDOs

♦ Section 4: CDO Investor Base

♦ Section 5: CDO Team in UBS

SECTION 1

How does a CDO work?

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What is a CDO – Interesting Facts

- A CDO is a mechanism whereby a third party (the collateral manager) achieves term, non-recourse funding on their portfolio

- This mechanism can be applied to several asset classes (loans, Bonds, CDS, ABS etc)

- First CDO was issued by Drexel in the mid 80s, today there are many players in the primary and secondary market

- UBS is a global leader in this market- Ranked #3 in Global CDO issuance (as per Thomson Financial)

- Issuance has been growing steadily and in Q1 2006 stands about $54bn

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What is a CDO – The CDO Structure

-Think of a CDO as a Corporate Balance Sheet with three components

Corporate Balance Sheet CDO

Assets Portfolio

Debt Liability Tranches

Shareholder’s Equity Equity Tranche

Cashflows

Assets / Portfolio

Interest Due

To Debt HoldersDebt / Liability Tranches

Equity is last in line to receive payout

Excess Spread

To Equity HoldersShareholder Equity / Equity Tranche

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How does it work?

♦ CDOs rely upon statistical diversity

– Imagine a certain bond has a 5% probability of default

– Put 100 bonds of similar characteristics and you expect that 5% of the portfolio will default but the rest will be OK

– If you can take out the risk of the top 95% of the portfolio and separate it form the bottom 5% of the portfolio then you have repackaged the risk of the portfolio

♦ By creating several tranches from one pool, you can tailor the risk to match the appetite of each investor

– Most CDOs have several Liability tranches rated AAA, AA, A, BBB and BB, the equity tranche is not rated

– The return is proportional to the risk, with the AAA investor getting the least return and the equity holder achieving the most

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How Do Debt Tranches Provide Leverage

Portfolio Collateral:

Average Spread Eur+250

Average Rating BBSize €350mm

AAA RatingSpread Eur+25Size €300mm

A RatingSpread Eur+65

Size €20mm

350mm X 250bp = 8.75mm Portfolio interest proceeds

300mm X 25bp = 0.875mm Interest Due to the AAA

20mm X 65bp = 0.13 mm Interest Due to the A

10mm X 175bp = 0.175mm Interest Due to the BBB

Excess Spread going to Equity Tranche

8.75 - 0.875 - 0.13 - 0.175 = 7.57mm

7.57mm / 30mm = 25% Cash on Cash Return

BBB RatingSpread Eur+175

Size 10mm

No Rating

Size 30mm

SECTION 2

Benefits of a CDO

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Why did the market invent CDOs

♦ Portfolio Managers would buy portfolios and earn their return from the interest proceeds on these portfolios

♦ To Enhance returns, managers started repoing these funds

♦ When spreads widen, the margin calls on repoed positions would erode the returns on the levered positions

♦ CDOs enable the portfolio manager to achieve term non recourse funding on his portfolio through the issuance of debt tranches

♦ The CDO manager is immunized from MTM risk during the life of his portfolio and can just focus on managing the credit risk

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How Do Debt Tranches eliminate MTM Risk

♦ When a CDO is issued the coupon on the liability tranches is fixed for the life of the deal

♦ This will lock in the cost of capital of the structure

♦ Excess Spread of Structure = Weighted Average Coupon on Portfolio –Weighted Average Cost of Liabilities

♦ Hence even in a spread widening or tightening environment, since the liability spreads will not change, unless the Average coupon on the portfolio changes, you can expect your returns to stay the same

SECTION 3

Different Types of CDOs

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Main Types of CDOs – By Motivation

♦ Cashflow Arbitrage CDOs

– Most common type of CDO

– Tend be done across all asset classes (HY bonds, Loans, ABS etc)

– Are done to arbitrage the spread of the portfolio relative to the liabilities

♦ Balance Sheet CDOs

– Tend to be much larger than Cashflow Arbitrage deals

– Are done mainly to achieve balance sheet relief by moving assets off balance sheet

♦ Market Value CDOs

– Are used to take advantage of relative cheapness of market

– Structure benefits from Cheap cost of liabilities (like Cashflow Arbitrage CDOs) as well as appreciation in the MV of the portfolio

– Not many of these structures relative to cashflow arbitrage

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Main Type of CDOs – By Asset Class

ABS47%

Leveraged Loans36%

EM1%

TRUPS2%IG Bonds

3%

HY Bonds11%

Source: Creditflux data from 1996-Present

933EM

514Others

1325TRUPS

5941,202Total

1940IG Bonds

67212HY Bonds

207447Leveraged Loans

274431ABS

Size (bn)# DealsDeal Type

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Static Synthetics vs Managed Cash CDOs

Manager goes through workoutNoneDefault Workout

Only to debt NoneCall Risk

After initial non-call periodNoneEquity Optional Redemption

Difficult due to active tradingFeasibleHedging

Manager able to sell and replace assetNo RemedyDeteriorating Credit

Deleverage through cashflow diversionApplied bottom-upLoss Realization

Passed to allNoneTrading gains or losses

Selected by managerNever changesPortfolio Composition

Managed Cash CDOsStatic Synthetics

SECTION 4

CDO Investor Base

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CDO Investors – By Tranche Rating

Banks, SIVs, Conduits, Negative basis playersAAA

Insurance companies, Structured funds and Real money accounts

Hedge funds, CDO equity funds, Alternative investors, and High net worth individuals

AA

A

BBBBB

Equity

SECTION 5

UBS CDO Team

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Global CDO Group

Ramesh Singh, MD

Securitised Products

Fixed Income & Rates (FIR)

Global Credit Group

Simeon Schwartz, MD

Global Rates Group

Chris Ryan, MD

Global CDO Group

James Stehli, MD

Fred EngelJi-mei Ma

Reggie FernandezCheng LeeMatt Rose

Harold HuangBrett HowellPaul Hanig

Global Credit CDO Global SF CDO Secondary Trading CDO ResearchProduct Manager

Lirenn TsaiAnastasios Argeros

Vaibhav Kumar Chi Lee

Steven Margetis Robert MorelliEric Rothman

James YaoRobert Hoke

Keith GrimaldiMalay Patel

Aaron WongSharif Anbar-Colas

(LDN)

Eur Credit & SF CDO

Paul Heyrman (LDN)Yugo Yamamoto (JPN)

Koichi Watabe (NY)Jack Xu (HK)

Simon Perry Harsh Varma

Mohit AgarwalKunal Sood

Douglas LucasLaurie Goodman

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Market leader in CDO origination

Source: Thomson Financial

UBS has ranked #3 in Global CDO origination for Q1 2006

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Sales Credit on CDO Tranches

0.5 pointsAAA

1.5 points

0.75 point

5 points7 points

2.5 points

SC can vary from deal to deal these are from Magii, the last European CLO

AA

A

BBBBB

Equity

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CDOs 101 London