Prof. Ian Giddy New York University Structured Finance: Synthetic ABS

Prof. Ian GiddyNew York University

Structured Finance:Synthetic ABS

Copyright ©2002 Ian H. Giddy Structured Finance 2

Structured Finance

Asset-backed securitization Corporate financial

restructuring Structured financing

techniques


Collateralized Debt Obligations

Collateralized loan obligations (CLOs) Collateralized bond obligations (CBOs)


Collateralized Debt Obligations

Cash flow backed CLOs and CBOs Market value backed CBOs Synthetic CLOs


Cash Flow Backed CLOs

BANK (SELLER)

SPECIALPURPOSEVEHICLE

LOANS

ISSUESASSET-BACKEDCERTIFICATES

SALE ORASSIGNMENT

LOANS

Motivations:

Free up capital

Lower cost of funding

Distressed loan arbitrage (3rd party sponsors)

Motivations:

Free up capital

Lower cost of funding

Distressed loan arbitrage (3rd party sponsors)


CLO Transaction Structure


CLO Rating Criteria

Initial ReviewOriginator’s credit evaluation systemPool composition & stress testing

On-Site Due Diligence Legal Integrity

Bankruptcy-remoteness of SPVValidity of asset transfer to SPVPerfection of security interests in underlying

collateral

Determining Credit Enhancement

Source: Fitch, ”Bank CLOs: an Overview”


Cash flow Backed CLOs

CREDIT

ENHANCEMENT

SPVLOANS Investors

Senior-Sub with priorities of cash flows

Cash reserve accounts Letters of credit Guarantees

Cash

flows

ABS

flows


Senior-Sub CLO Structure


Cash Flow Backed CBOs



SALE

BONDPORTFOLIO

BONDS MANAGER

Motivation:

Cash flow arbitrage (bonds have good returns relative to risk, but may be illiquid)

Motivation:

Cash flow arbitrage (bonds have good returns relative to risk, but may be illiquid)



Cash flow CBOs are built around a pool of assets with predictable cash flows. As such, these structures are restricted to investments that meet minimum credit quality, tenor and expected recovery characteristics. The analysis of a cash flow deal and determination of credit enhancement is based on the expected probability of default, severity of loss, and timing of default and recovery of the assets in the pool.

The ongoing market price of collateral assets is not important in a cash flow deal. Instead, it is the ability of each asset to pay scheduled principal and interest that makes these deals successful.



MANAGER

SPVBONDS Investors

Collateral cash flows meet ABS interest & principal needs

Cash

flows

ABS

flows

Selects portfolio


Market Value Backed CBOs



SALE

BONDPORTFOLIO

BONDS MANAGER

Motivation:

Price arbitrage (bonds are underpriced, and tradeable)

Motivation:

Price arbitrage (bonds are underpriced, and tradeable)


Market Value CBOs

A market value CBO can be generally described as an investment vehicle that capitalizes on the arbitrage opportunities that exist between high yielding investments and the lower cost funds of highly rated debt. The transaction is typically capitalized with multiple classes of rated debt and a layer of unrated equity and invests in a pool of investments that is diverse in obligor, industry, and, frequently, asset class. In order to gauge the performance of the transaction, the asset manager will mark the value of each investment to market on a regular basis, usually weekly or biweekly.


Market Value Backed CBOs

MANAGER

SPVBONDS Investors

Trades bonds to meet interest & principal needs

Cash

flows

ABS

flows


Characteristics of Market Value CBOs

Market value transactions are often collateralized by leveraged loans, high-yield bonds, mezzanine debt, distressed debt, and public and even private equity.

Market value transactions are less restrictive with respect to cash flow requirements, credit quality, and maturity of the collateral.

The manager can trade the securities.


Rating Agencies Analyze Price Volatility to Determine CE Requirements


Advance rates determine how much rated debt can be issued against the market value of an asset.


Example of Market Value CBO Asset Mix and Financing


Asset-Backed Securities:The Typical Structure

FORD (SPONSOR)


LOANS.


SALE ORASSIGNMENT

LOANS.

Servicing Agreement


The Alternative: Synthetic ABS

DB (Originator)


REFERENCE

POOL OF LOANS

(Stay on

balance sheet)


CREDIT SWAPAGREEMENT

TOP QUALITYINVESTMENTS


Synthetic ABS or Collateralized Loan Notes

CLNs are SPV debt backed by the credit of the selling bank (or better)

No loans are sold to the SPV But performance is based on the

performance of a reference pool of loansIf the reference credits perform, full debt

service is made on the CLNIf the reference credits default, the CLN is

deemed “defaulted”and payment is halted.


Synthetic ABS

GERMAN BANK (Originator)



REFERENCE

POOL OF LOANS

(Stay on

Balance Sheet)

TOP QUALITY

INVESTMENTS

CREDIT

SWAP

AGREEMENT


Synthetic ABS

GERMAN BANK (Originator)



REFERENCE

POOL OF LOANS

(Stay on

Balance Sheet)

TOP QUALITY

INVESTMENTS

EURIBOR

plus

“PREMIUM”

PROTECTION against

POOL DEFAULTS


Credit Swaps in Synthetics: Doubts

Problems with the collateralDebates about “events of default”Workouts and other pre-default losses

Problems with the sponsor bankObtaining title to the collateralThose “high quality investments”

And all those swaps


Typical Credit Default Swap Arrangement

The guarantee: Pledge of a deposit in the sponsor bank Part or all of that deposit will be forfeited if there are pool losses “Losses in the transaction are defined as amounts

written off in compliance with the bank’s usual procedures”

BANKSPV

ABSREFERENCE

POOL OF LOANSDeposit and

credit guarantee


Leveraged CDO (Super Senior Tranche)


Promises, Promises


Promising


Case Study: Global High Yield Bond Trust

What is the legal structure of this deal? What are the assets? What are the different classes of

securities, and their terms? How do the synthetic CLOs work?

(Draw a diagram) Should investors buy the subordinated

tranche?


Global High Yield Bond Trust

www.stern.nyu.edu

www.giddy.org

Documents

Prof. Ian Giddy New York University Structured Finance: Synthetic ABS