SPECIAL REPORT - NYU Stern School of Business | Full …pages.stern.nyu.edu/~igiddy/ABS/Cash Flow CDOs.pdf · · 2000-06-03transactions totaling $36 billion were closed that

EXECUTIVE SUMMARY

DCR

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DCR

Duff & Phelps Credit Rating Co.

SPECIAL REPORTAsset-Backed Securities

February 2000www.dcrco.com

n recent years, collateralized debt obligations(CDOs) have emerged as one of the largest andfastest growing sectors of the asset-backed se-curities (ABS) market. Due to increasing use of

bond and loan collateral within one transaction,the term collateralized debt obligation is becom-ing more popular, and the terms collateralizedbond obligation (CBO) and collateralized loan ob-ligation (CLO) are becoming less common. CDOsare segmented into two categories, cash flow and

market value. This article exclusively addressesDCR’s approach to rating cash flow CDOs.

The first CDO was issued in 1988, however issu-ance was limited until the mid-1990s. In 1996 theCDO market began to grow dramatically, and 108transactions totaling $36 billion were closed thatyear. Issuance increased steadily in the followingthree years as shown in Chart 1 on page 2. DCRplayed a significant role in this growth, havingrated 80 transactions totaling $45 billion since 1996.

DCR’s Criteria for RatingCash Flow CDOs

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Duff & Phelps Credit Rating Co. DCR’s Criteria for Rating Cash Flow CDOs

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In cash flow CDOs, overcollateralization isbased upon the aggregate par value of the col-lateral. Cash flows to investors consist prima-rily of the periodic interest and principal pay-ments from the underlying collateral. Thisstructure contrasts market value CDOs inwhich overcollateralization is based upon theaggregate market value of the collateral. Inmarket value transactions, cash flows to inves-tors are primarily received from capital gainsrealized through active trading of the collat-eral.

MotivationsCash flow CDOs are divided into “balance

sheet” and “arbitrage” transactions. With bal-ance sheet CDOs, the primary motivation ofthe issuer is generally regulatory capital reliefand/or risk management. These transactionsmost frequently take the form of a large bankselling a substantial portion of its commercialloan portfolio. Arbitrage CDO issuers are mo-tivated by capturing excess spread. Excessspread is the difference between the cash flowsgenerated by a higher weighted-average cou-pon on the underlying collateral over theweighted-average funding cost on the issuednotes. A portfolio made up of below-investment-grade securities can serve as thecollateral for a substantial amount ofinvestment-grade notes. Thus, an issuer canpotentially capture the excess spread betweenthe coupon payments on the below-investment-grade collateral and the couponpayments on the primarily investment-gradenotes.

In addition to the arbitrage opportunity,many collateral managers see the securitiza-tion market as a way to take on additional fi-nancial leverage and thus maximize their re-turn on equity. Most managers may also seethe CDO market as a means to grow their as-sets under management. CDOs present a rela-tively unique method of doing so because man-agers can obtain a more stable funding sourceand avoid the risk of being funded by “hotmoney.” Hot money refers to inconsistent

funding that comes from investorswho tend to quickly reward themanager with major inflows follow-ing strong performance, but alsoquickly punish the manager withmajor outflows following under-performance.

Investors find CDOs attractivefor many reasons. One of the mostimportant is additional spread. Theyields on CDOs continue to offerwider spreads than similarly ratedasset-backed securities. CDOs arealso fairly large transactions (gener-ally $250 million to $1 billion ormore) and, thus, allow for investorsto realize substantial economies of

scale. Another benefit of the large transactionsize is that issuers and their bankers are morewilling to tailor the characteristics of differenttranches to fit the needs of different investors.Thus, many transactions include both fixedand floating classes, both rated interest andunrated contingent interest classes, various ex-pected maturities from six months to 12 ormore years, and various ratings from ‘AAA’ to‘B-’ (as well as unrated equity). One final char-acteristic of CDOs that makes them attractiveto many investors is that they offer broad expo-sure to markets in which they lack direct exper-tise. Unlike a conventional high-yield fund,this broad exposure comes with a rating and aninvestor-selectable amount of leverage.

Typical Structure ofa Cash Flow CDO

In a typical CDO, a bankruptcy-remote,special-purpose corporation (SPC) is incorpo-rated solely for the purpose of investing in a di-versified pool of amortizing bonds and loans,engaging in appropriate risk management ac-tivities and issuing notes. The issuer buys thecollateral in the open market or from a sponsor(such as a bank) and finances its purchasethrough the issuance of asset-backed securities.The interest and principal received from theunderlying collateral is used to make pay-ments on the issued securities. These transac-tions are called arbitrage CDOs because theweighted-average coupon of the underlyingsecurities exceeds the weighted-average cost offunds on the notes, creating excess spread.Note that the asset-backed securities are de-signed to be completely amortized from cashgenerated by the underlying securities. Theability of a cash flow CDO to repay investors isindependent of market prices of the underlyingcollateral, while remaining dependent on thecredit quality of the underlying collateral debtsecurities.

The parties involved in a CDO transactioninclude a collateral manager, a trustee, a creditenhancement provider (which may be equity

Chart 1: Total Market CDO Insurance

Source: Asset-Backed Alert

DCR’s Criteria for Rating Cash Flow CDOs Duff & Phelps Credit Rating Co.

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holders, mezzanine lenders or a surety bondprovider) and a risk management counter-party. See Parties to the Transaction section onpage 7.

Typically credit enhancement is provided inthe form of subordination and overcollater-alization. Excess spread and sometimes asurety bond are used to achieve the desiredlevel of credit enhancement. Regardless ofcredit enhancement, the senior notes have firstclaim on all cash flow from the underlying col-lateral1. After the senior notes come the mezza-nine and equityholders. For a discussion on therating of equity tranches, please see DCR’s spe-cial report/methodology titled Criteria for Rat-ing ‘Equity’ of Cash Flow CDOs dated January2000, which is available on DCR’s Web site atwww.dcrco.com (Quick Search: Equity). Vari-ous triggers and tests are used to measure theperformance of the underlying collateral, andmust be maintained in order to avoid either apartial or complete early amortization of thetransaction. Credit enhancement is discussedin more detail below.

Prior to the transaction closing, the collat-eral manager begins acquiring collateral for theissuer. Typically, collateral managers will haveacquired a significant percentage of the collat-eral before closing. The remainder is acquiredduring a “ramp-up” period that lasts any-where from 60 days to six months. All pur-chases must meet the eligibility criteria, as dis-cussed below.

After the ramp-up period, the transactionenters a revolving period that typically lastsfour-to-six years. During this time, the pro-ceeds from the collateral, after paying fees, ex-penses and interest on the notes, are reinvestedin new collateral. The collateral manager is al-lowed to manage the collateral pool, subject tocompliance with the eligibility criteria and cov-erage tests (discussed subsequently). After therevolving period ends, the transaction entersan amortization period during which principalpayments are made on the asset-backed secu-rities. Notes are generally retired sequentiallyduring the amortization period, with all re-maining payments due by the stated final ma-turity dates.

Eligibility CriteriaDCR examines the collateral eligibility crite-

ria as stipulated in the indenture to determinethe appropriate stresses for each transaction.The eligibility criteria determine, among otherthings, the mean expected cumulative grossdefault rate and the subsequent recovery rateof the collateral. Within the eligibility criteria,the following items are of particular impor-tance:

■ The weighted-average credit rating of col-lateral;■ The collateral composition (e.g., senior un-secured bonds versus subordinated loans);■ The weighted-average life of the collateral;■ The obligor concentration in the collateralpool;■ The industry concentrations;■ The weighted-average coupon rate of thecollateral; and■ Other factors including the fixed-rate ver-sus floating-rate mix of the pool.

The weighted-average credit rating of theportfolio is an indication of its overall creditquality. This statistic is one of the best predic-tors of future default rates because each ratingcorresponds directly to a probability of default.Each item of collateral should have a rating as-signed to it, or DCR will assume it is rated‘CCC’. If DCR rates the collateral, then DCRwill use its rating. If no DCR rating exists, DCRwill use the lowest available public rating.

Recently there has been increased activity inconverting bank loan portfolios into CLOs. Of-ten banks have their own internal credit ratingsystem that reflects default expectations. How-ever, each item of collateral may not have apublic rating. To establish a weighted-averagerating for these portfolios, based on a sampleof loans, DCR establishes a “mapping” systemthat translates the bank’s internal system into aDCR credit rating score. DCR then uses theseratings to establish credit enhancement levelsfor bank balance sheet CLOs.

Each rating category is assigned a numericvalue corresponding to the default probability.DCR’s rating factors are shown in Table 1. The

1 The typical priority of payments actually contains some claimants that are superior to the senior notes such as thetrustee, the risk management counterparty and issuer expenses. However, these expenses are usually small relativeto the claims of the senior and subordinate noteholders.

Rating FactorAAA 0.00AA+ 0.01AA 0.03AA- 0.05A+ 0.10A 0.15A- 0.20BBB+ 0.25BBB 0.35BBB- 0.50BB+ 0.75BB 1.00BB- 1.25B+ 1.60B 2.00B- 2.70CCC 3.75

Table 1: DCR Rating Factors


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credit rating of each piece of collateral isweighted against its par value, and thensummed. Note that the ratings scale is non-linear, which means that the increased defaultprobability between ratings classificationsdoes not progress at an even rate. For example,the increased default probability between‘BB+’ and ‘BB’ is less than the increase from‘BB’ to ‘BB-’.

The most common types of collateral inCDOs include high-yield bonds, loans, emerg-ing market sovereign and corporate debts, and“other” collateral. The types of collateral influ-ence the recovery rates on the collateral pool,but not the default rates. The collateral compo-sition does not affect the default rate becausethe default rate is presumed to be a function ofthe weighted-average credit rating of the collat-eral and not the type of collateral. For example,‘BB’-rated bonds and loans are presumed to de-fault at the same rate, although the recoveryexperience on the two collateral types has beendifferent. See the Recovery Rates section on page11 of this report for further detail.

Most CDOs include allocations for “other”collateral types. These include synthetic secu-rities, pay-in-kinds (PIKs), convertibles, splitcoupon, zero coupon, private securities, debtwith warrants and structured finance securi-ties. DCR is comfortable including these secu-rities in a CDO as long as the maximum allow-able percentage of each one of these types issmall and the coverage tests address their in-clusion. For example, the calculation of theweighted-average collateral coupon should in-clude all zero coupons, split coupon bonds,convertibles and others at their actual paymentrate without giving effect to accrual or otherfeatures. Furthermore, “yield enhancers” suchas warrants or participating payments shouldbe discounted. The effect of discounting the“yield enhancers” is to discourage their inclu-sion in the collateral pool. For instance, if a col-lateral manager needs to maintain a weighted-average coupon of 9.50%, any zero-couponbond included is going to negatively impactthe overall weighted-average coupon rating,forcing the inclusion of securities with a veryhigh coupon to compensate. However, includ-ing these high coupon securities is likely tonegatively impact the weighted-average ratingof the collateral pool, effectively limiting theamount of these securities that may be in-cluded. As a result, even though most CDOsallow for limited buckets of these collateraltypes, to date DCR has not seen many of theseactually included in collateral pools. A numberof collateral managers have stated flatly thatthey have no intention of including these secu-rities in their transactions.

Another significant predictor of defaults ina given portfolio is the weighted-average life ofthe collateral assets. A collateral pool with a

longer weighted-average life of the assets willhave a higher cumulative gross default ratethan a pool with a shorter weighted-averagelife, ceteris paribus. Although weighted-averagelife and weighted-average maturity are some-times used interchangeably, DCR does distin-guish between the two. A portfolio of non-amortizing “bullet” bonds will have an identi-cal weighted-average life and weighted-average maturity, while a portfolio of amortiz-ing loans will have a shorter weighted-averagelife than weighted-average maturity. Becauseamortization reduces the amount of defaultrisk, it is generally viewed as a positive at-tribute. Therefore, DCR will size credit en-hancement to the weighted-average life of thesecurities rather than the weighted-averagematurity.

One of the distinguishing characteristics ofa cash flow CDO, as opposed to a market valueCDO, is that the collateral is fully repaidthrough amortization of underlying collateral.No reliance is placed on the market value ofassets sold prior to their respective maturitiesto retire a rated class of notes. If a significantportion of the collateral pool matures after thestated final maturity of the CDO, some portionof the collateral might have to be sold at itsmarket value to retire notes. A cash flow CDOshould not contain a reliance on market values.Therefore, one of two situations should existfor DCR to rate CDOs that contain securitieswhose stated final maturities exceed the statedfinal maturity date of the CDO. First, all ratedclasses of notes are fully retired from availablecash flows without reliance on liquidationprior to maturity of any of the underlying col-lateral securities. Second, if such reliance is re-quired, those securities are treated as defaultson the stated final maturity date of the CDOand included in the cash flows at their respec-tive recovery rates.

Modern portfolio theory suggests that in-creasing diversification reduces overall risk.The biggest factor in determining portfolio di-versification is the obligor concentration level.Portfolio theory suggests that the benefit of di-versification increases as the number of obli-gors increases to 30. The benefit further in-creases from that level, but at a slower rate.Therefore, DCR has established its “base case”default rates assuming a maximum obligorconcentration level of 3%. For amounts abovethat level, an overconcentration penalty is ap-plied.

Recent CDO transactions have been largeron average in terms of total asset size than pasttransactions. Therefore, while older transac-tions often used a 3% limit, most newer trans-actions are finding it easier to continue toshrink the maximum obligor concentrationlevel down toward 2%. DCR recognizes the in-creasing benefit to the CDO over increased di-


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versification beyond the 3% level and adjuststhe cumulative expected gross default rate foradditional diversification.

Another factor affecting diversification isindustry concentration. DCR limits concentra-tion within a single industry to 8% of the totalcollateral pool. Furthermore, the sum of ex-cesses above 5% usually does not exceed 15%of the total collateral pool. Many collateralmanagers will tend to have more concen-trated pools for their other investment activi-ties than DCR’s CDO criteria allow. DCR pe-nalizes overconcentrated pools. A pool of well-diversified collateral is more likely to producelong-term results similar to those predicted bythe historical studies than what might be ex-pected from more concentrated pools. Concen-trated pools are likely to produce results thatare skewed from the historical studies that rep-resent a survey of the universe of high-yieldbonds. Skewed pools make an actuarial analy-sis more difficult. Therefore, DCR’s criterialimits overall industry concentrations.

The fixed-rate versus floating-rate composi-tion of the collateral pool does not drive thecredit enhancement levels because it is not, initself, a predictor of future default rates. How-ever, it is an important factor in assessing the

asset and liability risk profile of the CDO struc-ture. (Interest rate risk management is dis-cussed in a separate section.)

Similarly, the weighted-average coupon rateof the collateral pool does not directly drive therequired level of cumulative gross defaults thatthe CDO structure must withstand. This rate isbased on the collateral coupon and not theyield to maturity or “yield to worst” of the un-derlying securities. This discourages the collat-eral manager from buying deeply discountedsecurities to increase portfolio yield. Further-more, floating-rate collateral often has couponrates below that of comparable term fixed-ratesecurities. Floating-rate securities are includedfor the purpose of calculating the coveragetests at their current coupon rates.

While the weighted-average coupon ratedoes not directly drive the amount of requiredcumulative gross defaults, it does indirectly in-fluence the overall level of credit enhancement.This is because the weighted-average couponrate is a primary component of the excessspread in the transaction. Excess spread is animportant, although somewhat invisible, ele-ment of the overall credit enhancement. Ceterisparibus, transactions with significant excessspread can withstand more defaults than those

Table 2: Bar-belling Example

In this example, Generic CBO’s overcollateralization (O/C) ratio is near the low end of its required minimumlevel. In this case the ratio must be maintained at 110%, and its current O/C level is 111%. If the par value of thetotal collateral pool is $100 million and the O/C ratio is 111%, then the notes outstanding are $90.09 million.

The collateral manager is concerned about the low O/C ratio and wants to improve it. One possible solutionopen to the collateral manager is to sell an asset trading near par and used the proceeds to buy a deeplydiscounted one trading around 80% of par. The new asset costs less than the old asset, and therefore, thecollateral manager will be able to buy more par value for an equivalent amount of cash.

Sell existing collateral bond: par value $5.000 million price 99%proceeds $4.95 millionBuy new collateral bond par value $6.188 million price 80%cost $4.95 million

Result: par value increase of $1,187,500, net cost is zero.

Immediately after the sale, the collateral manager has increased the par value of the collateral pool to $100.1875million while the notes remain at $90.09 million, thereby increasing the O/C ratio to over 112%, without usingany cash. Whether this move benefits investors is a matter of open debate.

Note however, the new security is probably deeply discounted for a reason and that reason is most likelyreflected in its current credit rating. If the new security has a lower credit rating than the old security, the inclusionof the new security would drive down the overall weighted average credit rating (“WAR”) of the CDO, especiallysince the credit rating scale is non-linear.

Minimum allowable WAR of collateral from eligibility criteria: 1.60 (B+)Assumed actual portfolio collateral WAR (prior to collateral sale) 1.55Rating of collateral sold 1.25 (BB-)Rating of collateral purchased 3.75 (CCC+)WAR of collateral pool after purchase 1.70

Therefore, because the WAR of the collateral pool after the trade is below the minimally acceptable level asdefined by the eligibility criteria, the collateral manager would be prevented from making such a trade. Themultiple non-linear tests prevent the collateral manager from having a group of assets well above a certainminimum criteria level offset by a group of assets well below the minimum criteria level.


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with little or no excess spread. Typical high-yield CDOs have approximately 300 basispoints of excess spread in a “normalized” sce-nario (i.e., excluding the effect of defaults).

“Bar-belling” the Eligibility CriteriaSome investors have expressed concern

about the collateral manager’s ability to “bar-bell” the portfolio. “Bar-belling” refers to hav-ing collateral that meets the requirements of acertain test by having assets with attributes farbelow a certain required minimum offset byassets having attributes far above the same re-quired minimum. The concern is that meetingminimum requirements does not directly ad-dress the overall composition of the portfolioand that the collateral manager could manipu-late these requirements to produce a portfoliothat is materially different from the one origi-nally envisioned. In DCR’s view, this concernis balanced by the multiple and non-linear na-ture of the collateral constraints, as shown inTable 2 on page 5.

The Initial PeriodMany CDOs will not have purchased all of

their collateral at the time of closing, while allof the notes are fully funded. The excess of thenotes over the collateral purchased at closing isfunded into an account and invested in high-quality short-term instruments. The collateralmanager makes withdrawals from this accountover a specified period to purchase additionalcollateral. However, while the closing pro-ceeds are invested in these short-term ac-counts, the transaction could have a period of“negative arbitrage,” whereby the accrual rateon the notes is more than the accrual rate on thecollateral pool (consisting of high-yield securi-ties plus the cash in short-term instruments).As the collateral manager makes withdrawalsfrom the cash account to purchase collateral forthe CDO, the weighted-average coupon rate ofthe transaction rises. This quickly eliminatesthe negative arbitrage and establishes the ex-cess spread in the transaction.

DCR specifically analyzes the excess spreadin the initial period of the CDO to ensure thereis sufficient proceeds to pay timely interest toinvestors on the initial payment date. For thepurposes of this analysis, DCR assumes theminimally acceptable “ramp-up” rate. DCRfurther assumes an interest rate on the cash in-vested in short-term instruments at a rate sig-nificantly below current LIBOR. If the “ramp-up” is unsuccessful (meaning the collateralmanager failed to acquire the required amountof collateral within the specified time frame),the remaining uninvested cash is returned toinvestors.

The Revolving PeriodAfter the initial period, assuming the ramp-

up was successful, many CDOs enter the re-

volving period. During this time all principalcollections (and sometimes excess interest col-lections) that are received by the trustee are re-invested by the collateral manager in new col-lateral, subject to the eligibility criteria andcompliance with the coverage tests. For mostCBOs (where the collateral is typically bondsthat pay principal only at maturity), the aver-age life of the collateral is longer than thelength of the revolving period. This means thatlittle principal is usually scheduled to be re-ceived during the revolving period. However,whatever is received is reinvested. CLOs typi-cally have more amortizing and revolving debtsecurities so there is generally more cash re-ceived during the revolving period to reinvest.Prepayments on collateral debt securities willalso increase the cash received during the re-volving period. These amounts would be rein-vested by the collateral manager.

The Amortization PeriodAfter the revolving period, the transaction

enters the amortization period. All principalpayments received during the amortizationperiod are passed through to investors as prin-cipal reductions.

Portfolio TradingDuring the revolving period, the collateral

manager may trade in the portfolio subject tostrict limitations. In addition to reinvesting col-lateral that paid off or paid down during therevolving period (see above), the portfoliomanager may trade collateral from the pooland use the proceeds to buy different collateralsecurities.

The collateral manager may sell collateralthat has, in the manager’s opinion, either ap-preciated in value or depreciated in value be-yond some thresholds. In addition, the collat-eral manager may trade up to a certain percent-age of the collateral every year. A typical allo-cation for this “trading bucket” is 10-20%. Notethat with a 20% annual trading bucket and afour-year revolving period, the collateral man-ager has the ability to substantially alter thecomposition of the collateral pool during therevolving period.

The collateral manager’s ability to trade isgoverned primarily by the eligibility criteriaand the coverage tests. The collateral managermust buy collateral that meets the eligibilityrequirements. For example, if the maximumallowable obligor concentration is 2%, the col-lateral manager may not buy securities thatincrease the exposure of the pool to above 2%to a single obligor. In addition, the collateralmanager is limited by minimum thresholdsfor the weighted-average rating, weighted-average life, weighted-average coupon andother criteria. Also the collateral manager isconstrained by coverage tests such as a mini-mum overcollateralization test or an interest


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coverage test. If the transaction is out of com-pliance with these tests, the manager mayonly trade to improve compliance with thetests. Although the collateral manager hasconsiderable latitude to trade names withinthe portfolio during the revolving period,these restrictions do not allow the overallcharacter of the portfolio to change over timebecause replacement collateral must still com-ply with the eligibility criteria.

Parties to the TransactionThere are several parties that play key

roles in a CDO transaction. These roles typi-cally include the collateral manager, thetrustee, the credit enhancer and the swapcounterparty. As the rating agency, DCR isresponsible for the evaluation of risks asso-ciated with each of these parties. However,DCR does not numerically credit the transac-tion because of the demonstrated perfor-mance of the collateral manager or thetrustee above market norms. The focus ofDCR’s due diligence effort is to assesswhether each party can perform to industrynorms. However, the ratings of the swapcounterparty and credit enhancer can affectthe ratings of the notes.

The Collateral ManagerThe collateral manager is responsible for the

ongoing supervision and trading of the portfo-lio collateral during the life of the transaction.The collateral manager is frequently an affiliateof the issuer and often retains an equity posi-tion in the CDO transaction.

Before rating a CDO, DCR performs an on-site evaluation or due diligence of the collat-eral manager to evaluate its qualifications formanaging the related portfolio collateral.During this due diligence, DCR might exam-ine:■ Corporate affiliations of the investmentmanager;■ Assets under management—total and highyield;■ Management philosophy, style and experi-ence in related asset types;■ Investment objectives, attitude towardrisk/return tradeoffs;■ Organization of credit research function;■ Frequency of formal monitoring or reviewof portfolio holdings;■ Performance of high-yield funds: risk/re-turn analysis and comparison to market;■ Information on defaulted securities and re-coveries;■ Manager’s willingness to hold defaulteddebt through workout; and■ Organization chart and biographical infor-mation on key personnel.


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While many collateral managers focus on“total return” as a performance benchmark,DCR focuses on defaults and distressed sales asan indicator of portfolio management. Notethat most investors in senior and mezzaninetranches of cash flow CDOs will not benefitfrom upward price movement of the underly-ing securities, but will suffer from defaults ofthose securities. DCR will issue a separate re-search article with more detail on the evalua-tion of collateral managers in the near future.

The TrusteeThe trustee is a participant in every CDO

transaction and is responsible for administer-ing various transaction functions throughoutthe tenor of the deal. Although there are cer-tain approved trustees that seem to be morewidely used across the marketplace, DCR con-tinues to evaluate potential new entrants. Aspart of this process, DCR executes an exercisesimilar to the collateral manager evaluation.Some of the aspects examined during a trusteedue diligence are:■ Corporate affiliations;■ Primary assets types and total assets undermanagement;■ Quality of systems used for bookkeeping,etc.;■ Performance history on past securitiza-tions;■ Organization chart and biographical infor-mation on key personnel;■ Management structure and philosophy;■ Experience of management and staff withrespect to CDOs; and■ Crisis management and quality control.

The Credit Enhancer and Swap CounterpartyOften in CDO structures, there are inherent

risks such as interest rate, payment and asset/liability mismatches (see Credit Enhancement,below). Therefore, swaps, caps or other deriva-tives are often structured into the transaction inorder to mitigate these risks. Although not asoften, surety bonds may also be put in place tohedge similar risks on certain tranches. How-ever, these “wraps” are often investor-drivenand more expensive and, therefore, not used asfrequently.

Given the reliance on these parties through-out the life of the transaction, DCR requires cer-tain provisions and eligibility criteria for thesecounterparties and providers, which include:■ Ratings of parties should be at least as highas the desired rating of the senior notes;■ Replacement parties should be required tomaintain a corresponding rating level; and■ The termination events associated with

these contracts should not introduce additionalrisks to the CDO transaction.

Credit Enhancement

OverviewThe greatest threat to payment of timely in-

terest and ultimate principal to investorscomes from the default of the underlying col-lateral securities. Therefore, the focus of thecredit enhancement analysis is on the probabil-ity of default of the underlying collateral andestimated subsequent recoveries. While thedefault and recovery analysis is the primarydeterminant of the required credit enhance-ment levels, the analysis takes into account ahost of other issues that may also affect pay-ment to investors such as asset and liabilitymanagement and the transaction structure.

DCR’s rating addresses the probability ofdefault on the rated class of notes. The ratingfor any particular class of notes should reflectits probability of default, and that probabilityshould be equal to the overall expected defaultrate for all securities of an equivalent rating. Inother words, if the universe of ‘BBB’ securitiesdefaults at the cumulative rate of 5.00% over 10years, then the credit enhancement should besized so that the 10-year cumulative expecteddefault rate for that class of notes is 5.00%. Thisis akin to establishing a statistical “confidenceinterval” around an expected mean defaultrate.

This confidence interval is achieved bystressing expected defaults by multiple stan-dard deviations from the mean expected de-fault rate. The mean expected default rate isderived from the eligibility criteria as specifiedin the trust indenture. The number of standarddeviations from the mean is a function of theconfidence interval selected. A 5.00% defaultrate implies a 95% confidence interval, whichimplies a certain number of standard devia-tions from the mean expected default rate.

The stressed mean default rate is then ap-plied to the transaction structure through theuse of a cash flow model. The performance ofthe structure is evaluated through variousstress tests (which are described below). Thestructure is deemed to have passed the tests iftimely interest2 and ultimate principal pay-ments are received.

Calculation of the Cumulative GrossDefault Rate

The calculation of the cumulative gross de-fault rate is at the heart of DCR’s methodology.This rate must be withstood by the CDO struc-ture to garner the requested rating level. Thecumulative gross default rate is a function of

2 Depending on the tranche in question, DCR will rate the receipt of either timely periodic interest or cumulativeultimate interest. Periodic interest on mezzanine tranches may sometimes be deferred without causing an event ofdefault. For simplicity herein, both terms will be referred to as “timely interest”.


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the weighted-average credit rating, theweighted-average life, the obligor concentra-tion and the requested rating level.

DCR has reviewed the results of variouscorporate bond default studies. The primarysource for DCR’s mean default rates, the stan-dard deviation of default rates and recoveryrates is the Altman study. The Altman studyrefers to the annual study of empirical evi-dence of default and recovery performance forpublicly rated bonds. The study, a recognizedindustry benchmark, is authored by Edward I.Altman, et al and is conducted through theNew York University Salomon Center. DCRperiodically reviews the studies to determinewhether adjustments to the base case defaultrates are warranted based on new data. Thedefault rates, standard deviations and recoveryrates used by DCR represent the most recentrates and update prior DCR published statis-tics. The default rates represent an increaserelative to the 1998 Altman study because ofthe higher level of defaults experienced in thehigh-yield marketplace in 1999.

The cumulative gross default rate is deter-mined using the following formula:

a class of notes to earn the requested rating, theoutput of the cash flow model must demon-strate that the required cumulative gross de-fault rate is covered through the stress sce-narios outlined below and that timely interestand ultimate principal is received.

Interest Rate Risk ManagementCDOs will typically contain both fixed and

floating rate assets and fixed and floating rateliabilities. In many cases the interest rate sensi-tivity of the assets will not identically match theinterest rate sensitivity of the liabilities. In sucha case, the transaction may be exposed to therisk that movements in interest rates may im-pair the ability of the transaction to maketimely interest payments to investors. Thereare a number of ways to hedge the trans-action’s interest rate risk exposure. Commonhedging strategies include swaps and caps forthe interest rate risk and basis swaps for thebasis risk. DCR does not stipulate that particu-lar hedging strategies be employed by collat-eral manager, nor require that the collateralmanager eliminate the interest rate risk. In fact,many collateral managers will choose to retainsome interest rate risk within the CDO struc-

Stressed cumulative gross default rate = mean default rate + (rating multiplier * standarddeviation)

Where,Mean Default Rate = The expected cumulative gross default rate given the weighted-

average rating of the collateral, the weighted-average life of the collat-eral and the obligor concentration level.

Rating Multiplier = The multiple of standard deviations used to establish the “stress” onthe structure given the requested rating. The higher the requestedrating the more standard deviations from the mean that need to becovered.

Standard Deviation = The standard deviation of defaults taken from the empirical studies.

The combination of these items results in thecumulative gross default rate that must bewithstood by the CDO structure at the re-quested rating level.

The formula is designed to establish confi-dence intervals that are consistent with theprobability of default for other securities of anequivalent rating. For example, ‘AAA’ securi-ties are expected to default at the rate of 0.01%over 10 years. The cumulative gross defaultformula stresses sufficient standard devia-tions from an expected default rate to estab-lish a 99.99% confidence interval around thatmean. The cumulative gross default rate foreach class of notes is established by stressingstandard deviations of expected defaults to alevel that is consistent with its default prob-ability.

The structural elements of each transactionare incorporated into a mathematical model.The cumulative gross default rate is used as aninput into this cash flow model (see below). For

ture. However, any outstanding risk is factoredinto the rating.

DCR runs the transaction through the cashflow model and stresses the transaction in anumber of ways. Among these stresses areLIBOR up and down scenarios. The transactionshould be able to pay timely interest and ulti-mate principal to investors in the stressed sce-narios. This allows the collateral managermaximum flexibility while still maintainingtimely interest to investors.

Generally, these stress situations requiresome kind of active hedging strategy to passthe stress scenarios. In those cases where ahedging strategy is employed, DCR will re-view the selected counterparty and the termi-nation events under the ISDA (InternationalSwaps and Derivatives Association, Inc.) mas-ter agreement. The swap or cap counterpartyshould have a credit rating equal to at least therating of the highest outstanding class of notes.In addition, the termination events of the hedge


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agreement should exclude any events tied tothe performance of the underlying collateral.For example, the swap cannot be terminated ifdefaults exceed a certain level. The terminationevents should only cover the standard clausessuch as bankruptcy of the issuer (who shouldbe a bankruptcy-remote SPC). The intention isto determine whether the transaction is ex-posed to risk from the termination of the hedge(such as termination costs and the lack of ahedge).

Triggers and Coverage TestsCDOs contain various triggers and cover-

age tests. These tests stipulate such things as aminimum overcollateralization ratio, interestcoverage ratio or a default rate trigger. Thesetests serve as “early warning devices.” Theirpurpose is to stop collateral deterioration be-fore the outstanding notes are severely im-paired. Generally, failure to pass these tests re-sults in a partial amortization event. For ex-ample, if the minimum acceptable overcolla-teralization is 115% and the ratio drops to 110%on the payment date, excess spread wouldcease to be released to the equity holders. In-stead, excess spread is paid to the most seniorclass of notes then outstanding as a principalreduction. The senior notes would continueamortizing until compliance is restored, or allnotes are repaid.

DCR does not explicitly stipulate coveragetests and trigger levels when evaluating theCDO structure. However, DCR does implicitlyrely upon them. The cash flow model that isconstructed should represent every aspect ofthe CDO structure, including embedded cover-

average coupon rate to the noteholders. Usinga simple example, excess spread can be calcu-lated as shown in Table 3.

Most high-yield CDOs have substantialamounts of excess spread. Barring failure of acoverage test, this excess spread is passedthrough the CDO structure to the equity hold-ers. However, in the event that one of the cov-erage tests (see previous section) is breached,the excess spread is retained to pay down se-nior notes. Therefore, excess spread is a form ofcredit enhancement.

DCR does not require certain levels of ex-cess spread in a transaction. Doing so is nearlyimpossible because the actual excess spread inthe transaction is highly variable and depen-dent on a number of factors. These factors in-clude the cumulative levels of defaults and re-coveries and the interest environment and theeffectiveness of the hedge at that time. As withthe coverage tests and trigger levels, DCR im-plicitly relies on the credit enhancement fromthe excess spread. To the extent that excessspread is available to cushion the effect of de-faults and other stresses (e.g., interest ratemovements), that cushion will be evident in theoutput of the cash flow model. Excess spreadincreases the ability of the structure to paytimely interest and ultimate principal.

The Cash Flow ModelOne of the focal points of the ratings analy-

sis for a cash flow CDO is the cash flow model.The cash flow model is a mathematical abstrac-tion of the structure of the CDO. It contains allof the inputs previously discussed including:

■ The portfolio eligibil-ity criteria;■ The structure of thetransaction;■ The interest rate riskmanagement strategy;■ Applicable coveragetests and triggers;■ Recovery rate as-sumptions based on thecollateral composition;■ Stressed default as-sumptions;■ Stressed interest rate

scenarios; and■ Revolving and amortization periods.

The purpose of the cash flow model is tosimulate how the structure of the transactionreacts to various stresses. The reactions aremeasured in light of transaction’s ability to paytimely interest and ultimate principal. DCRmodels the transaction in parallel with thesponsoring underwriter or placement agentand compares the results of the models for con-sistency.

The construction of the model starts withthe portfolio collateral. The actual composition

age tests and triggers. For instance, excess de-faults may cause a coverage test failure in astressful scenario. In such a case, the cash flowmodel would reflect the amortization of thesenior notes. Early amortization events addprotection for investors. Thus, to the extent thatthe triggers increase the structure’s ability towithstand stress, the transaction is better ableto pay timely interest and ultimate principal.

Excess SpreadExcess spread is the difference between the

weighted-average coupon rate on the underly-ing portfolio collateral and the weighted-

Table 3: Excess Spread

Total Collateral Pool $500 millionMinimum weighted-average coupon 9.50%Total revenue from collateral $47.50 million

Total rated notes $450 million (excluding equity)Weighted-average note coupon rate 7.50%Total interest paid to notes $33.75 million

Annual excess spread $13.75 millionExcess spread as function of notes 306 basis points, or 3.06%


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of the collateral prior to the closing date is un-known because it has not all been acquired yet.Furthermore, because the collateral managerhas a wide trading latitude during the revolv-ing period, even if all the initial collateral wereidentified prior to closing, there is a high prob-ability that the composition of the same poolcould be very different by the end of the revolv-ing period. Therefore, for purposes of model-ing, DCR uses theoretical collateral. This is a setof collateral that has the same characteristics asthe eligibility criteria. For example, if the eligi-bility criteria state the collateral must have aweighted-average coupon rate of 9.50%, aweighted-average life of 8 years, and be 90%non-amortizing fixed-rate bonds, then thoseare the characteristics that the theoretical col-lateral pool will have.

The cash flow model runs this collateralpool through time and through the paymentwaterfall as specified in the transaction docu-ments. The differing stress scenarios are ap-plied to the structure. For each rated class ofnotes, DCR applies six stress scenarios as listedbelow:

During the term of the transaction, incom-ing cash flows (such as interest payments re-ceived on the underlying collateral) as as-sumed to be reinvested during the intra-periodtime frame at the then-current LIBOR rate(from the forward LIBOR curve) less 2.50%.

Evaluation of the Cash Flow ModelDCR’s primary concern in rating cash flow

CDOs is assessing the probability of paymentof timely interest and ultimate principal un-der stressful conditions. Therefore, the evalu-ation of the cash flow model is essentially adetermination of whether the structure is ableto withstand the prescribed stresses whilemaking interest and principal payments infull as rated.

Recovery RatesAn additional way of stressing CDOs is by

discounting historical average prices of de-faulted bonds immediately after default. Therecovery rate varies based on the seniority ofdebt in the capital structure of the company.For example, if the collateral is senior secured,it will generally have a higher recovery ratethan if it is senior unsecured. The Altman study

tracks mean “recovery” pricing data by posi-tion in the obligor’s capital structure. Thus,DCR has historical mean prices for each cat-egory, based on collateral prices immediatelyfollowing default.

In addition to varying recovery rates by col-lateral seniority, DCR varied recovery rates bythe desired rating level for each tranche of thetransaction. Higher desired rating levelsshould be able to pass more stressful (lower)recovery rates in the simulated cash flow runs.The more stressful recovery rates at higher rat-ing levels reflect the inclusion of more standarddeviations around the mean recovery rate. SeeTable 4.

DCR assumes base recovery rates of 20%and 25% for emerging market corporate andsovereign bonds, respectively. DCR may ad-just the recovery rate for emerging market cor-porate debt upward if the firm’s local currencyrating is higher than the foreign currency rat-ing of the sovereign. (For additional informa-tion on CDOs backed by emerging marketdebt, please refer to DCR’s Approach to RatingEmerging Market CBOs/CLOs which will soonbe available on DCR’s Web site).

Recovery rates are based upon the senior-ity, security and country of issuance, as wellas the desired rating on the notes. For ex-ample, if the indenture specifies only that thecollateral must be U.S. senior bonds, with theexception of 10% which can be U.S. subordi-nated bonds and 5% which can be bonds fromemerging markets, the blended recovery ratefor the “AAA” class would be determined asfollows:

The weighted-average recovery conceptgives the collateral manager more flexibility indetermining the collateral allocation than spe-cifically limiting exposure to certain categories(the traditional bucket requirement), while stillmaintaining a minimum desired collateralquality. The weighted-average recovery con-cept allows the portfolio to select a certainweighted-average recovery rate. The managercan then adjust collateral allocations as long asthe weighted-average is greater than or equalthan the minimum weighted-average recovery

Desired Rating Level Sr. Sec’d Sr. Sec’d Senior Senior EmergingLoans Bonds Unsec’d Subord. Subord. Markets

AAA/AA 60.00% 50.00% 40.00% 25.00% 25.00% 20-25%A/BBB 65.00% 55.00% 45.00% 30.00% 30.00% 20-25%< Investment Grade 70.00% 58.00% 48.00% 34.00% 31.00% 20-25%

Table 4: Recovery Rates

Default timing – front, middle and backInterest rate movement – LIBOR up and down

Senior Secured Bonds: 0.85 * 50% = 34.00%Subordinated: 0.10 * 25% = 2.50%Emerging Market: 0.05 * 20% = 1.00%

Weighted-Average Recovery Rate: 46.00%


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rate stated in the transaction documents. Forexample, if a 46.00% weighted-average recov-ery rate is selected for a ‘AAA’-rated tranche,the collateral composition could equal theabove-mentioned allocations. Or, it could beadjusted to any combination with the same46.00% outcome, such as:

Thus, the weighted-average recovery con-cept eliminates the need for collateral bucketsas a determination of recovery rates. In addi-tion to the inclusion of the weighted-averagerecovery test, some collateral buckets maylimit the pool’s exposure to certain types ofcollateral, like emerging market debt.

Recovery TimingDCR further stresses recoveries by assum-

ing a time lag from default to disposition of thecollateral. Sale of the bonds (the recovery) isrealized at the beginning of the next assumedpayment period, a six-month lag, instead ofinstantaneously. Most CBO managers will sellthe bonds at a discount in the public markets,rather than hold for an extended period of timethrough the workout process. For loans, therecovery is lagged further, by one full year.This additional lag reflects a longer workoutscenario for loans than bonds and the increasedlikelihood of the collateral manager to hold aloan through the workout period.

Legal AnalysisIn addition to the transaction structure,

DCR conducts a review of the legal documentsand opinions. Some of the critical issues areexplained below.

As in other asset-backed transactions, theissuer should be established as a bankruptcy-remote SPC, with its activities limited to pur-chasing collateral, issuing securities to inves-tors, and other actions that are incidental to itsrole in the transaction. This limits the risk of theissuer being put into bankruptcy.

DCR also evaluates the transfer of collateralfrom the seller to the issuer. If one entity trans-fers the assets to the issuer, DCR would usuallyexpect to receive the normal true sale, non-con-solidation and first-priority security interestopinions that DCR receives in other asset-backed securitizations. However, many CDOtransactions will begin with a sponsor ware-housing collateral for the issuer prior to theclose of the CDO transaction. The sponsor sellsthe collateral to the issuer at the closing with-out retaining any residual interest in the collat-eral. In other instances, the issuer may acquire

the assets in market transactions with unre-lated parties. In these situations, a true saleopinion is not necessary but DCR should re-ceive legal comfort that a valid transfer of theassets has occurred free and clear of adverseclaims. In this regard, an opinion may be ren-dered that the issuer is a “bona fide purchaser”under Article 8 of the Uniform CommercialCode.

In addition, DCR should receive a legal opin-ion that the trustee for the investors has a first-priority perfected security interest in the issuer’sassets for the benefit of investors. This perfectedsecurity interest gives the investors a first lien onthe assets of the issuer even if the issuer is forcedinto bankruptcy or the seller’s transfer of the as-sets to the issuer is recharacterized as a securedfinancing rather than a sale.

Standard corporate opinions regarding theenforceability of the transaction documentsagainst all parties thereto are also required.These opinions should be given based on thelaw of each applicable jurisdiction. Finally, de-pending on the structure of the transaction,DCR may require opinions that the issuer is notan investment company under the InvestmentCompany Act of 1940, and as to the tax struc-ture of the transaction.

MonitoringEach CDO transaction receives ongoing sur-

veillance after closing. At DCR this function isperformed by the monitoring group. Thatgroup functions as a security alarm and infor-mation focal point for CDO transactions. Thegroup uses both ongoing communicationswith the transaction parties and the analysis ofperformance data to detect changes in a trans-action. All anticipated risks to the securitiza-tion are addressed at the time of original rating,but many risk-imposing events may not occuruntil long after the transaction closes. Monitor-ing ensures that, if these events occur, they areidentified and evaluated in a timely manner.DCR communicates with the collateral man-ager to assess its strategy to mitigate whateverrisks may appear over time.

DCR conducts formal reviews for all DCR-rated CDOs. Soon after a transaction closes,DCR monitoring personnel create a model toassist in the review process. During these re-views, each transaction’s asset performance,credit enhancement levels and trigger compli-ance is evaluated based upon the original rat-ings guidelines and cash flow analysis. All in-formation received through communicationwith the portfolio manager, trustee or otherparties is also considered. Through these re-views, and any subsequent rating reaffirma-tion or ratings action, DCR validates that theintegrity of the rating is in line with the ratinganalyst’s and rating committee’s original ex-

Senior Secured Bonds: 0.73 * 50% = 36.50%

Senior Unsecured: 0.20 * 40% = 8.00%

Subordinated: 0.05 * 25% = 1.25%

Emerging Markets: 0.02 * 20% = 0.04%

Weighted-Average Recovery Rate: 46.00%


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pectations for the transaction. At a minimum,all DCR CDO ratings are reviewed by monitor-ing personnel monthly and by senior manage-ment quarterly.

Outlook for the CDO MarketDCR has been a major player in the CDO

market since its inception and DCR expectsthat its market participation will continue togrow as the market grows and evolves. Theconcurrent growth of the CDO market and thehigh-yield market is not a coincidence. CDOsare becoming a force within the high-yieldworld whose growing market share is begin-ning to directly influence high-yield debt issu-ance. Increasing liquidity in the market benefitsall players. Cash flow CDO collateral manag-ers benefit from increased liquidity eventhough they do not rely on current market val-ues as a source of repayment for the notes. In-stead, increased liquidity supports recoveryvalues and makes portfolio management moreefficient.

Although cash flow CDO issuance willmost likely continue to exhibit significant cor-relation with the performance of the high-yieldmarket, (although less correlation than marketvalue CDO issuance), cash flow CDO issuanceshould continue to grow in the coming years.Indeed, some arbitrage opportunities have in-creased in the wake of the liquidity crunch thatoccurred in the second half of 1998. The flightto quality during this period increased the ar-bitrage and thus increased CDO issuance (al-beit with a lag). The second half of 1998 alsodemonstrated to collateral managers and othermarket participants the desirability of havingmore “long-term” investors (such as cash flowCDOs) in the high-yield markets. Indeed, thehigh-yield sell-off appears to have been seri-ously aggravated by those managing signifi-cant amounts of “hot money” who were forcedto sell into a “down” market due to substantialredemption requests.

New collateral typesRecent transactions have shown an increas-

ing concentration of ABS/CMBS/REIT collat-eral. In the past these asset types have notbeen included for several reasons. These in-clude:■ Limited history regarding default rates and

recovery rates;■ The assets were considered “esoteric” andhard to understand;■ Predicting cash flows on asset-backed se-curities is more difficult than on assets thathave predetermined payment schedules;■ Some of these securities have stated finalmaturities that extend far beyond the stated fi-nal maturity of the CDO in which they are in-cluded;■ Some portfolio managers have limited ex-perience in managing similar portfolios;■ Some of these securities, especially the jun-ior tranches, allow interest to be deferred with-out being considered in default; and■ Limited secondary market activities.

DCR is comfortable including these assetswithin a CDO and has done so in a number oftransactions. However, DCR recognizes thatthe above concerns are valid and has taken spe-cial care to address them. In particular, cashflows, default rates and recovery values aremore difficult to predict. There is little empiri-cal evidence of actual defaults and, in the eventof default, their recovery patterns may besomewhat different than high-yield corporatedebt. The details of this analysis are beyond thescope of this commentary. The ratings for thesecollateral types will be discussed in a separatearticle.

Debt Securities from Emerging MarketsUntil fall 1998, emerging market debt secu-

rities had been a popular collateral type forCDOs. However, the well-publicized problemswith these securities (e.g., the Russian default)have severely curtailed investors’ appetites forsuch collateral. In the past year, DCR has seena significant drop in the amount of emergingmarket collateral in CDOs. In DCR’s view, thecredit rating is still the best predictor of futuredefault expectations, and those ratings are up-dated to reflect changing default expectations.Therefore, DCR will continue to rate CDOs thatcontain emerging market debt. However, re-cent experience has highlighted that recoveryrates on emerging markets debts are lowerthan recovery rates on other collateral types.DCR already uses substantially lower recoveryrates for emerging market debt than other as-set types (see the Recovery Rates section of thisreport).


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DCR Contacts

—Brian D. GordonAssistant Vice President(312) [email protected]

—Sajjad HussainAnalyst(312) [email protected]

—Stephanie SteenbergenAssistant Vice President(312) [email protected]

—Asma KhanAnalyst(312) [email protected]

—Jeffrey J. OrrGroup Vice President(312) [email protected]


15 ◆

Information was obtained from sources believed to be accurate and reliable. However, we do not guarantee the accuracy, adequacy or completenessof any information and are not responsible for any errors or omissions or for the results obtained from the use of such information. Issuers of securitiesrated by DCR have paid a credit rating fee based on the amount and type of securities issued. We do not perform an audit in connection with anyinformation received and may rely on unaudited information. Our ratings are opinions on credit quality only and are not recommendations to buy, sellor hold any financial obligation and may be subject to revision, suspension or withdrawal at any time as necessary due to changes in or unavailabilityof information or other circumstances.

Copyright © 2000 Duff & Phelps Credit Rating Co. All rights reserved. Contents may be used by news media with credit to Duff & Phelps Credit RatingCo.

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Documents

SPECIAL REPORT - NYU Stern School of Business | Full …pages.stern.nyu.edu/~igiddy/ABS/Cash Flow CDOs.pdf · · 2000-06-03transactions totaling $36 billion were closed that