CDO transactions structural basics
CDO structures contain various covenants and mechanisms that dictate the composition of the collateral portfolio, define the trading activities permitted, allocate cash proceeds to the rated notes and equity, and aim to protect noteholders by paying down debt if certain triggers are tripped. This section will focus on the features common to most CDOs, outline considerations and risks associated with each, and highlight Standard & Poor’s criteria developed to address such concerns.
I. CASH FLOW CDOS COLLATERAL DEBT SECURITIES/ELIGIBILITY CRITERIA
CDO technology allows for the accumulation of collateral across a wide range of assets. For example, the portfolio might include bonds, loans or synthetic securities, corporate securities, structured finance securities, assets denominated in U.S. dollar or other currencies, and investment- grade or noninvestment-grade securities. Absent constraints, investors and rating agencies would have great difficulty identifying the risks in the CDO as each type of assets introduces different cash flow characteristics and risk sensitivity factors.
The trading mechanism included in most transactions further complicates the issue as the risk profile of the portfolio may change during the reinvestment period. Constraints on the types of collateral and concentration limits are established through the definition of collateral debt securities and eligibility criteria to alleviate this concern. Such parameters define the types of assets the manager can purchase and place limits on the concentration of assets across characteristics such as type, issuer, credit rating, and industry to create diversity. These constraints might take the form of “buckets” that set maximum limits, outright exclusion on the purchase of certain assets, or a maximum/ minimum range for assets.
The collateral eligibility constraints typically cover the following:
* Types of assets eligible for inclusion in the transaction (e.g. corporate, ABS, synthetics);
* Form of the assets (loans, bonds, derivatives, etc.)
* Payment terms (frequency, interest, currency);
* Credit quality (investment-grade, high-yield, rating concentrations); and
* Aggregate pool characteristics (minimum coupon, recovery rates, concentrations).
For example, typical constraints found in corporate cash flow CDOs include:
* List of permitted asset types;
* List of permitted or excluded corporate industries;
* Range of bonds and loans as a percentage of total par;
* Range of fixed interest rate and floating interest rate assets as a percentage of total par;
* Buckets for assets such as structured finance securities, synthetic securities, and guaranteed securities;
* Buckets for assets that have unstable cash flows such as interest-only securities and assets that have the ability to defer or capitalize interest obligations;
* Limits on assets with bivariate or multivariate risk such as assets issued by foreign obligors, synthetic securities, and loan participations;
* Buckets to control concentration in single issuers or issuances;
* Limits on non-U.S. dollar-denominated assets;
* Prohibition by investors on purchasing credit-risk securities and defaulted securities; and
* Buckets for assets such as convertible bonds or bonds with attached warrants that introduce market value risk into the cash flow structure.
Typically such limitations and constraints are specified by the sponsor, banker, and collateral manager based on their perceptions of what the investor community wants and can be comfortable with. At certain times, investors also may request additional constraints to address specific concerns that they may have.
In its assessment of collateral debt security and eligibility criteria, Standard & Poor’s takes into consideration items such as the experience of the collateral manager along asset types and across the credit spectrum, the feasibility of adequately modeling cash flows, and the introduction of atypical risks. When warranted, Standard & Poor’s highlights collateral characteristics that increase risks.
A general trend among transaction arrangers is to want to include buckets for all different types of collateral. The belief is that this will give the collateral manager greater flexibility to manage the transaction. While in general this is true, if the collateral manager has no experience with such collateral and does not intend to use it, this flexibility might actually cost the transaction. Why allow a 20% emerging markets bucket in a transaction when the collateral manager has no experience with managing such debt and does not intend to purchase such? Recoveries on emerging markets corporate debt are very low, and by having such a bucket, the weighted average recovery for the transaction will suffer, since Standard & Poor’s will assume that the bucket will be used. Sponsors and transaction arrangers are encouraged to consider the consequences of including such buckets if the collateral manager will not use them.
Since, for most transactions credit support is sized through cash flows, the CDOs ability to adequately cover its principal and interest obligations under various stress scenarios is a key component of Standard & Poor’s analysis. Assets that introduce variability in cash flows and cannot be effectively modeled therefore require added scrutiny. Payment-in-kind (P/K) assets, which have the ability to defer or capitalize interest as shortfalls arise, are one such example. Modeling the behavior of these assets proves difficult due to the scarcity of empirical data on the likelihood and timing of payment shortfalls. This concern is typically addressed by limits to the inclusion of PIK securities and/or through the use of a liquidity facility to cover shortfalls in the payment of interest on the senior class of liabilities resulting from deferred interest on the PIK assets.
Convertible bonds, exchangeable bonds, and bonds with warrants attached introduce other risks. These instruments are convertible, and are allowed in transactions only if such convertibility is not mandated by the issuer of such debt hut rather only by the holder of the debt. Prior to conversion or exchange, convertible and exchangeable bonds that meet collateral eligibility guidelines will be permitted in collateral valuation and coverage tests. After conversion, if the securities are not eligible as transaction assets, these securities are no longer considered eligible collateral debt securities, and should not be included in the coverage tests. Furthermore, the collateral manager must consider the effect that such conversion has on the transaction prior to exercising the conversion option.
For example, since equity is not given credit (either as principal or interest) in these types of transactions, converting eligible debt to equity weakens the transaction. The collateral managers should only exercise this option if they are certain that they can sell the equity and reinvest to maintain or improve the transaction tests. Equity warrants can remain attached to bonds in the collateral pool, hut should not themselves be assigned any value in the collateral tests. As a result, bonds with equity warrants are generally constrained. Furthermore, certain debt having equity convertibility features might be considered margin stock, as in the United States, and subject the transaction to specific regulations should certain concentrations of this debt be held by the transaction. Transaction sponsors and organizers are strongly urged to consider all such implications before proposing inclusion of convertible instruments.
Interest-only securities are another example of assets with relatively volatile cash flow streams. These assets may be first loss pieces covered by excess spread from several structured finance products such as CMBS and RMBS. As first loss pieces, their ability to provide cash flow is highly susceptible to voluntary and involuntary prepayments of the underlying collateral. These securities are typically limited to 5% of the collateral pool in conventional corporate CDO transactions, and a “haircut” is applied in the modeling of cash flow.
A growing number of CDO structures are including “baskets” for assets with bivariate credit risk. These baskets can enhance yield, or expand the eligible collateral universe, especially later in the reinvestment period when a collateral manager’s asset maturity profile contracts. Bivariate risk arises when the probability of default on an asset is the combination of the probabilities of default of two obligors or counterparties. These “bivariate risk assets” include loan participations, credit-linked notes (CLNs) or credit derivatives, securities loans, and corporate debt from obligors domiciled in countries rated lower than ‘AA’. Standard & Poor’s does not limit bivariate exposure in transactions because it has the analytical tools to size such risks, typically resulting in a higher level of required credit support. The “basket” limitations are driven by the investors and bankers that want to constrain certain risks.
A payment default may occur on a participation if either the borrower, the lending bank selling the participation, or both default. A credit derivative, such as a CLN, in which a counterparty promises payment based on performance of an underlying reference obligor or security, can default if either or both parties default. Similarly, securities can default if the counterparty (cash borrower and collateral pledgor), the obligor on the underlying collateral securities held by the lender, or both default. Finally, emerging market debt denominated in a foreign currency (for example, U.S. dollar-denominated assets from corporate obligors domiciled outside the U.S.) may default if the corporate obligor defaults, if the sovereign government actions adversely affect the ability of the obligor to make timely payment on its obligations, or both the sovereign and the obligor default.
Not only is the risk of default higher on such assets, but it is also more difficult to assess. In addition, transparent, consistent pricing of such assets and secondary market liquidity are often not available for these assets. As a result, default recovery, and therefore loss levels are more difficult to estimate.
In order to help protect CDO noteholders from this incremental risk, bivariate default risk exposure is either generally limited or sized into the credit support. If total bivariate risk exposure is substantial, then the portfolio will be analyzed using Standard & Poor’s multi-jurisdictional default model, which assesses the incremental default risk these assets introduce. This typically results in higher default estimates and credit enhancement levels. (Sec “Emerging Market CDO Criteria” in the “Special Topics” section for a more detailed explanation of bivariate risk.)
Corporate debt from countries rated as high as the most senior rating in the transaction at closing, or above ‘AA’, would not be analyzed as bivariate risk (for example, countries with foreign currency ratings of ‘BBB’ in a ‘BBB’ rated CDO). However, there should always be disclosure to investors of the presence of multiple jurisdictions and the potential impact of subsequent downgrade of a country.
CDOs continue to expand the collateral universe that is eligible for inclusion in CDO transactions, such as other CDOs or more traditional asset-backed securities (ABS). In traditional corporate CDOs, limited provisions have been permitted for including ABS and other rated CDO tranches. CDOs art increasingly investing in generally the rated tranches of other CDOs and even considering market value CDO debt tranches, as well as equity tranches of other CDOs. Managers have an appetite not only for senior tranches, but also for mezzanine pieces in senior-subordinated transactions, typically rated in the range of ‘BBB’ to ‘BB’. Although these investments give the seller an additional distribution channel, and a liquidity or funding source for its CDO, the CDO transaction investing in other CDOs may face certain additional risks such as industry over concentrations that need to be addressed. Because of this, CDOs that repackage other CDOs or ABS art analyzed differently, from an asset default correlation standpoint, than are CDOs collateralized with corporate credits.
As structured, the credit quality of ABS, in CDO transactions, is generally strong, with a large portion carrying investment-grade ratings. Often, ABS comprises the highest-rated collateral in a portfolio, especially for arbitrage transactions. However, there art other considerations in looking at ABS transactions as assets in CDO transactions. Although highly rated secured financings, the secondary ABS market is not as mature or deep as the unsecured corporate debt market. Default and recovery history is limited for ABS, and investors that invest in traditional corporate CDOs may not be comfortable with investing in CDOs of ABS. As such, basket provisions are appropriate in corporate CDOs. Generally, asset managers should not “cross-invest” in their transactions by purchasing their own CDO tranches in other CDOs under their management. Investors in such CDO-backed CDOs may face the risk of highly correlated defaults if managers encounter problems.
II. SYNTHETIC CDOS’ COLLATERAL DEBT SECURITIES/ELIGIBILITY CRITERIA
Since synthetic CDOs take on credit risk through the derivatives market, the same issues that prevail in cash CDOs are applicable, but must be viewed slightly differently. A synthetic CDO is in a sense a CDO with a 100% synthetic bucket. As such, counterparty risk, which has traditionally been referred to as bivariate risk, is a primary focus of concern. Currently, this risk is addressed structurally rather than being explicitly modeled into the synthetic CDO.
A synthetic CDO transaction takes on credit risk by entering into one or more credit derivative contracts with one or more counterparties, as opposed to acquiring the physical assets. The credit derivative swap contract will list the reference asset. Typically however, as opposed to a cash CDO where a portfolio manager will purchase a specific bond, the credit derivative simply lists the name of the company as the reference entity. Typically, the obligation category selected in such transactions is “borrowed money”. Thus, default of any bond, loan, deposit obligation or reimbursement obligation by the reference entity constitutes grounds for exercising what amounts to a default option the CDO manager has sold to the counterparty on the reference entity.
When the physical settlement option is selected, upon default the synthetic CDO replicates the cash CDO most closely, but not exactly. As noted above, the cash CDOs have extensive thought given to the nature of the collateral debt securities and the characteristics of the pool. In the synthetic CDO, the sources of credit risk are explicitly not acquired assets hut rather sourced as a derivative. Thus, as is commonplace in the credit derivatives market, only the name of the company is of concern, and the eligibility issues in regard to the cash flow characteristics of the assets are not an issue.
The cash flow the synthetic CDO receives is the spread associated with the credit risk of that particular obligor. It is at the time of contract not a specific security that would require eligibility scrutiny. This cash flow, or spread income, if unstructured is subject to two risks, default of the reference entity or default of the counterparty that has entered into the credit derivative contract with the CDO.
A. Counterparty Risks
Standard & Poor’s has required that mitigation of the counterparty risk be addressed by eligible counterparty ratings. Thus a highly rated ‘A-1+’ counterparty is deemed to be of sufficient credit quality to warrant no further adjustment. A counterparty rated ‘A-1’ may be required to post some amount of the cash flow (the swap premium referred to in the credit derivatives definitions as the fixed-rate payment) in advance. Typically, this is simply one periodic payment that must be made in advance, and thus the net effect is to have the premium payment made at the beginning of the period as opposed to the conventional end-of-period payment. Counterparties rated ‘A-2’ are deemed insufficient to contract in a ‘AAA’ rated synthetic CDO transaction without posting the present value of all future periodic payments up-front. This posting requirement mitigates the risk that cash flows, that have been modeled and relied upon as credit support in the transaction are terminated for reasons other than default of the underlying reference entity.
The other risk that the counterparty presents in synthetic CDOs is termination risk. As opposed to a cash CDO, the synthetic CDO faces not only the risk of default of the underlying bond-the reference entity-but also the possibility that a counterparty will cause termination of the credit derivative contract. This opens up the unsized and unanticipated risk of not only loss of the premium, or cash flow, which was previously addressed, but also the reality that swap mechanics demand a mark-to-market (MTM) on the swap contract at the time of termination.
In a scenario where the associated credit spread with the reference entity or entities in the credit derivative have widened in the traded market relative to when the contract was initiated, it is quite likely that the credit derivative protection the CDO sold to the counterparty could be repriced at an MTM that is “out of the money” from the CDO. In other words, the CDO has an unanticipated cash payment due through no fault of its own and only because the counterparty defaulted. This payment could cause default of the CDO on its rated obligations to investors and to other counterparties. Typically, solutions include subordinating the termination in the waterfall to the rated noteholders, or eliminating the responsibility to make such a payment by rendering Section 6(e) of the swap master agreement “Not Applicable” at the outset of the transaction.
Having addressed the counterparty risk and the nature of how the synthetic CDO takes on credit risk, it becomes clear that in typical synthetic CDOs, as in cash flow CDOs, the primary focus is the credit risk of the reference entity and the premium spreads (cash) being paid to the CDO. The collateral debt security is actually defined by its characteristics in the credit derivative contract. These characteristics help relate the credit derivative contract to the actual collateral debt securities that would be purchased by a typical cash flow CDO, The following are some of the typical characteristics of the International Swap Dealers Association Inc.’s (ISDA) credit derivative contract that Standard & Poor’s requires in order to establish the nature of the credit risk.
B. Reference Price
A reference price of 100% of par is selected in the vast majority of transactions. If a reference price lower than 100% is selected, the discount, represented by a cash payment to the CDO, must be retained in the structure. It is common to limit the discount to no more than 2% of the market “price” as represented in the spread.
C. Obligation Category
The broad concept of “borrowed money” is acceptable, but typically the general concept of bonds or loans is referenced. Loan is typically elected in synthetic balance sheet transactions. This election is possible because the bank seeking regulatory relief has a specific loan already on the books and is seeking regulatory capital relief on that specific loan. This is advantageous because, if a workout consistent with Standard & Poor’s assumptions is allowed, recovery assumptions may be higher for these “loan”-only reference pools (see Synthetic Recoveries).
D. Obligation Characteristics
For this, “None Specified” is acceptable. “None Specified” means that the standard characteristics found in the ISDA 1999 document are applicable.
E. Settlement Terms
Either cash or physical settlement is acceptable. As noted earlier, recovery assumptions will be lower for cash settlement relative to physical settlement. Similarly, recovery assumptions may be lower for physical settlement than for a traditional cash CDO. This focuses on the relevant eligibility criteria under the settlement terms present in the synthetic. Most often, transactors do not want to pre-define what the settlement obligation will be but rather give a wide range of obligations that are pari passu. This is quite different from a cash flow CDO that has eligibility criteria because of cash flow concerns.
Thus the credit derivative is really a credit default put option that is sold by the investor to a transaction’s counterparty to be exercised upon a credit event of the referenced entity. The investors are thus considered sellers of credit protection and the counterparty the buyer. The counterparty has, for a premium, gained the ability, in theory, to deliver an eligible instrument to the CDO upon default of the underlying reference entity. What security will be delivered is generally not known prior to default. A cash CDO knows exactly what security it owns since it has purchased it already. In the synthetic CDO, typically this security is not pre-specified and thus the manager does not know what security will either be delivered or priced depending upon whether physical or cash settlement is elected.
This put option on the asset held by the counterparty is recognized as inferior to the manager’s ability to have sourced a specific obligation and manage it through the default process. But such difference can be minimized or mitigated as follows:
* Defining the deliverable obligation or settlement asset by utilizing the eligibility criteria typically found in a cash flow CDO. This makes the credit derivative slightly less desirable to the counterparty since the flexibility to deliver the cheapest possible asset may be compromised. However, it makes the credit derivative more consistent with what cash flow CDOs would have acquired to begin with.
* Eliminating contingent obligations and limiting the newly defined “Not Contingent” deliverable obligations. The “Not Contingent” definition now includes zero-coupon, convertible, and exchangeable bonds. These exposures would typically be limited in cash flow CDO portfolio eligibility criteria, and lower recoveries are currently assumed by Standard & Poor’s for these assets with either out-of-the-money options or options that have questionable value at the point of default of the reference entity.
* In all cases, the option must he held by the holder and not the issuer of the security, and this is standard in the new ISDA 99 definitions.
* Limiting the maximum maturity of the deliverable or settlement obligation to that consistent with maturity of collateral debt securities criteria applicable to a cash flow CDO. This limitation is less relevant given the maturity restriction limitation in the new ISDA 99 definitions.
If the characteristics of the physically delivered settlement obligations are likened to those which a CDO manager would have purchased under typical eligibility criteria described previously, then the recoveries identical to those the managers would qualify for in cash CDO are applicable. In all other cases, lower recoveries will be assumed. The deliverable characteristics mad recovery mechanism in the synthetic CDO affect recovery values similar to how these parameters affect recovery values in cash flow CDOs.
In synthetic CDOs that repack ABS or other CDOs, specific reference obligations are mandatory, as there is no applicable concept of default of a reference entity for structured financings that could be equated to a corporate entity. For example, if a subordinate bond of a corporate issuer defaults, it is generally assumed that the modern bond, loan, and reimbursement documentation contains cross-default language such that the entire capital structure will have the ability to declare a default event. Capital structure for the corporate entity is considered to be most important to the recovery assumptions, but not probability of default. This is completely inconsistent with structured finance obligations where the probability of default is totally tied to the place in the capital structure. Thus, specific reference obligations must be referenced in a synthetic CDO that repackages ABS or CDOs.
For inclusion in synthetic CDOs, reference entities are rendered eligible if they have a public, private, or implied issuer credit rating (ICR) by Standard & Poor’s. Notional amounts and tenor are characteristics in regards to the specific credit, but are not typically covered eligibility criteria for the transaction, other than to limit obligor and industry concentrations.
Upon an event of default in a synthetic CDO, the settlement obligation characteristics typically have:
* Precluded indirect and direct loan participations,
* Accepted the assignable loan or consent required loan characteristic, typically with language that the ability to assign or transfer the loan has been secured, and
* Specified a currency that is usually the currency of the synthetic CDO issuer.
However, it is possible to not require the specified currency of the CDO issuer, given one of two solutions to the currency risk:
* The cash settlement price is calculated on a percentage basis and then translated into the issuer’s currency, thus eliminating additional loss to the investor that could have been reflected in the currency loss; and
* The physical settlement recovery assumption is haircut to reflect the additional loss possible due to currency conversion-rate loss. These currency stress haircut assumptions are derived from Standard & Poor’s Foreign Exchange Extreme Value tables.
The contingent ability of a manager to enter into a currency hedge upon physical delivery of a defaulted asset is not generally accepted, as it is hard to determine the cost in advance to reserve in the capital structure to address such cost and at the time of default it is hard to determine precisely what the recovery will be. Thus the CDO will be under- or over-hedged, which introduces new risk to the synthetic CDO investor.
Traditionally, the portfolios of a synthetic CDO has been investment-grade corporate names due to the fact that those are the names that are relatively liquid in the credit derivatives market. The derivative market for high-yield companies and instruments is currently still in the nascent stage, and while such instruments and companies are eligible for inclusions in synthetic CDOs, some further refinements and haircuts in recovery values for cash settlement options are appropriate, given the liquidity of the market.
Standard & Poor’s takes into consideration items such as the experience of the collateral manager, financial institution, or calculation agent, along with the asset types and the credit spectrum, when considering recovery assumptions in synthetic CDOs.
III. RAMP-UP PERIOD
A CDO transaction may involve an initial period of time post transaction closing during which the manager acquires the underlying collateral from the proceeds of the rated securities. This is most prevalent in cash flow transactions, since in synthetic CDOs the portfolio is typically fully identified. The period during which the portfolio assets are purchased in the market or are originated is called the “ramp-up” period. Typically, in cash flow arbitrage transactions, 50% to 70% of the assets are accumulated by the closing date, with the balance acquired during the ramp-up period which generally ranges from three to six months.
The ramp-up period gives the manager more flexibility to identify assets that will add diversity and solid credit standing to the portfolio. The manager is able to choose from a larger universe of assets as new issuances are brought to market. This is particularly important during times of market upheaval such as those experienced during the Asian financial crisis and Russia’s default in the late 1990s. Absent the ramp-up period, a CDO closing at a time of constricted debt issuance or in a stressed interest rate environment would experience difficulty sourcing acceptable collateral and might be forced into purchasing assets with less desirable credit or payment characteristics.
There are, however, several risks associated with long ramp-up periods. The most prevalent risks during ramp-up, when bulk purchases of collateral are made over uncertain market conditions and time horizons, include the following:
* Negative carry between short-term earnings on undeployed cash proceeds and the already issued note liabilities;
* Liquidity risks due to accrued interest flows and payment date differences;
* “Origination risk” due to unavailability of the bonds and loans the manager intended to buy; adverse credit spread or price movements, which increase the cost of purchased assets;
* Interest rate movements or “spikes,” which increase the interest cost on any floating-rate liabilities; and
* Concentration risk in the portfolio prior to full ramp-up. Concentration risk can arise despite portfolio diversification guidelines because the investment may initially be concentrated in a small number of obligors, few industries, or relatively weaker credits compared with the portfolio’s intended composition at the end of the ramp-up period. Though the transaction is under-leveraged during ramp-up based on the “injection” of equity and mezzanine debt proceeds at closing, these risks are present, especially when interest rates, or credit spreads for corporate debt over applicable risk-free rates, become volatile or when corporate debt market liquidity diminishes.
Arbitrage CDOs have designed numerous solutions to mitigate these risks. Many structures have incorporated a “phased” ramp-up, for example, a nine-month ramp-up period divided into three three-month periods, during which notes are redeemed if collateral purchase targets have not been met at the end of each of the three-month periods. Another protective feature is to fix the interest rate on floating-rate note liabilities during the ramp-up period, which usually differs in length from a regular interest accrual period. Standard & Poor’s rates the transactions based on the anticipated effective date portfolio, and expects to affirm its rating on the fully ramped-up portfolio on the designated effective date or on the date that marks the end of the ramp-up period.
While the ramp-up risks in the transaction are real, the vast majority of CDOs closed to date have not had a problem with ramp-up. The primary and secondary debt markets have been fairly liquid, and collateral managers have been able to purchase assets that met the overall transaction requirements. In certain cases, collateral managers have turned to synthetic securities to craft certain asset characteristics that were needed for the CDO, but perhaps were not available in the market. Such strategies do work to a certain extent; however, most cash flow CDOs have limitations on how much synthetic collateral may be contained in the asset pool, and such synthetic collateral is typically less liquid.
IV. EFFECTIVE DATE
At the end of the ramp-up period most transactions have an effective date. This date occurs after the last day of the ramp-up period, or earlier if the required amount of collateral has been purchased. Typically, for the transaction to become effective the ratings of the transaction must be affirmed. For this to occur, Standard & Poor’s requires the manager to provide information on the composition of the portfolio and to verify that the portfolio default rate is lower than the break-even default rate shown by the cash flow analyses prior to closing. In addition, the portfolio collateral eligibility and coverage test should be met.
If the transaction does not meet all of its tests, Standard & Poor’s will generally rerun the cash flow analyses and assess if the ratings can be maintained. In rerunning the cash flows, Standard & Poor’s may modify some of the original assumptions used prior to closing to better reflect the actual composition of the collateral. For example, even if the default rate of the ramp-up portfolio is greater than the break-even default rate, the actual collateral pool may have a weighted average coupon or spread significantly above the minimum at which the transaction was initially modeled. Thus the transaction can still perform at the respective rating level.
If the ratings of the transaction are not affirmed, most transactions require a paydown of the rated notes to bring themselves back in compliance.
V. PORTFOLIO COMPOSITION AND ASSET ADDITIONS
The sponsor or collateral manager may choose to use the CDO Monitor, also known as the Trading Model (see the “CDO Evaluator & Portfolio Benchmarks” section for a complete description), as a surveillance tool in managing the portfolio during the revolving period. (Note: Any reference in this section to the CDO Monitor can apply to the single-jurisdictional or multi-jurisdictional version.) Alternatively, the sponsor or manager may choose not to use the model, but to manage the portfolio within “stressed” eligibility criteria. Each of these management choices has important ramifications for the relationship between the portfolio assumptions used in sizing credit enhancement and the actual portfolio composition as it changes over the life of the transaction.
Credit enhancement may be analyzed based on a closing portfolio if regular ongoing tests are performed, including running the CDO Monitor upon substitution and reinvestment. Notification to Standard & Poor’s should occur when limits are reached, or when the potential default rate exceeds the threshold established at closing. In this application, reliance on the manager may increase, particularly if the manager changes strategy or is replaced. The portfolio may evolve differently from the assumptions in the original rating, and the transaction may be subject to a rating change. Sponsors and investors alike should be aware of the trade-offs between the level of credit support and potential rating volatility of the transaction, and carefully consider them in structuring a transaction and setting up management guidelines.
Credit enhancement also may be analyzed based on a “stressed” eligible portfolio. Based on transaction investment parameters, the assumed portfolio will be constructed by filling the rating, concentration, and maturity buckets with the riskiest assets. In this application, the manager does not regularly run the CDO Monitor during the reinvestment period.
For example, consider portfolio eligibility guidelines that permit up to 10% ‘CCC’ rated assets, 80% ‘B’, and 40% ‘BB’; 100 obligors with a 1% obligor limit; and a maturity distribution of 20% in 10-year, 20% in seven-year, and 60% in five-year assets. Given these transaction parameters, Standard & Poor’s analysts would expect an assumed stressed eligible portfolio, and fill the buckets as follows: The 20% maximum 10-year maturity bucket would comprise the lowest rated ‘CCC’ assets totaling 10%, with the remaining 10% comprising the next lowest rated ‘B’ assets. The next longest seven-year maturity bucket would comprise another 20% of ‘B’ assets. The remaining 20% of ‘B’ assets would be placed in the five-year maturity bucket, along with the remaining 40% of ‘BB’ assets. No more than 100 obligors and assets would be assumed, as this would fill the 1% obligor limit.
The highest-risk, lowest-rated assets are distributed in the buckets to maximize credit exposure assuming the manager exercises his full flexibility to the limits of the eligibility criteria. As a result, the credit enhancement level will be higher to cover this “stressed case.” Under these assumptions, the manager does not use the CDO Monitor, and can trade to eligibility criteria. The benefit is the simplicity in managing to eligibility guidelines for which initial credit enhancement has been sized. All else equal, a change in manager or strategy may not adversely affect the CDO rating, as long as the manager does not breach eligibility criteria.
While the “stress case” gives the manager more flexibility per se, since he/she can manage to only the eligibility requirements without running the model, in most cases the default numbers are more onerous than when the transaction is structured using a representative portfolio and the CDO Monitor. As such, the arrangers structure most transactions with the CDO Monitor. Most collateral managers also like the concept that they are not tied to hard bucket limitations or weighted-average rating concepts.
In synthetic CDOs, as with cash flow CDOs, the sponsor or collateral manager may choose to use the CDO Monitor as described above. The synthetic CDO considerations revolve around the structure. In a synthetic CDO with no trading gains or loss but with substitution, the CDO Monitor will simply reflect the changed credit quality of the portfolio based upon the deletion of one reference entity and the associated Standard & Poor’s rating compared with the new credit risk associated with the new reference entity’s rating. In a synthetic CDO with trading gains and losses, the identical procedure as described in the cash CDO Monitor section is applicable.
VI. REVOLVING CREDIT FACILITY RISKS
CDOs are increasingly tapping into revolving credit facility assets and offering to investors revolving liabilities. Revolvers introduce payment, liquidity, and portfolio concentration risks in exchange for the flexibility they provide. Revolving credit facilities are more prevalent in bank balance sheet CDOs than in arbitrage CDOs (for a fuller discussion, see the section on “Master Trust CDO Structures”). In arbitrage transactions, revolvers generally comprise a small portion of the portfolio, and their purchase and funding is often done through the SPE. Below is a general discussion of revolving credit facility risks, and key analytical issues, including those germane to funding via the SPE.
The main financial risks that must be covered are:
* The ability of the CDO sponsor SPE as lender to make unfunded commitments, in full and on time, to its borrowers on the asset side of the CDO;
* The ability of the CDO sponsor or SPE as borrower to make payments on its funded commitments, in full and on time, to its lenders on the liability side of the CDO; and
* The sufficiency of credit enhancement to withstand default and interest rate stresses in cash flow tests under various revolver origination and funding scenarios.
On the asset side, revolvers affect the portfolio and the transaction cash flows because they affect the relative balance of the pool. For example, if 50% of revolver assets with higher-rated obligors are not fully funded, the resulting portfolio may be smaller, lower in credit quality, and more highly concentrated per obligor. The weakness, however, is partially offset by the higher spread from the higher margins on the loans of weaker borrowers. In general, these risks should be covered by credit enhancement as demonstrated in the cash flow analysis, by reserves, or by liquidity or support agreements from providers rated as high as the senior tranche.
Revolving credit facilities on the asset side of a CDO transaction impact portfolio composition, based on varying drawn and undrawn amounts from different borrowers of different credit quality. In a difficult economic environment, it will be likely to see lower-credit quality borrowers making more use of the funding sources at their disposal, even with a weakened lending institution. In other situations or for higher credit quality borrowers, however, some assumption of portfolio payment or purchase rates may be warranted. In order to assess the many asset portfolios and cash flow risks that can arise, revolver stress scenarios are analyzed by generally varying the asset portfolio in terms of size, drawn versus undrawn percentages, credit quality, obligor/industry concentrations, and interest rate spread. CDO criteria focus on the impact of revolving credit facility assets and liabilities on the transaction’s cash flows, liquidity, and portfolio composition, which are summarized below:
* Cash flow analysis. Changes in the amount outstanding under revolving facilities impact transaction liquidity and cash flow. Analysts will request that cash flows be stressed using a default frequency assumption at several drawdown levels on revolving assets and liabilities.
* Reserves. If the SPE is obligated to fund revolving assets, it may set up a cash reserve to fund its draws. Credit enhancement must be sufficient to cover the resulting negative carry between the earnings on reserve fund-eligible investments and the transaction’s interest cost.
* Liquidity or support agreements. If the SPE is obligated to fund revolving assets, it may also fund draws by purchasing liquidity lines or standby commitments from providers rated as high as the senior-most tranche. Eligible providers should be rated as high as the senior-most tranche. Alternatively, an ‘A-1+’ rated entity may participate in an ‘AAA’ CDO with appropriate replacement provisions upon downgrade. To cover negative carry, the commitment fees earned on the unused revolving credit facility assets should be higher than the commitment fees charged on the unused revolving credit facility liability. These liquidity agreements can also be put in place to support revolving rated liabilities issued by the SPE.
Revolving loans also introduce additional legal risks to the transaction. These should be adequately addressed (see “Legal Considerations”).
VII. REINVESTMENT PERIOD
A. Cash Flow Transaction
Although cash flow and synthetic CDOs do not rely on collateral market value to pay debt service, they can be impacted by changes in market value. The reason is that, although limited, some trading and secondary market sales are allowed. The period during which assets may be traded under specified conditions is called the “revolving” or “reinvestment” period. During this time in cash flow transactions, asset cash flows can be reinvested or used to purchase eligible assets as long as certain tests are met, mainly coverage, collateral quality and portfolio profile tests. After the revolving period, collateral principal proceeds are typically used to pay down senior notes until they are retired, even if the coverage tests are passed. In synthetic CDOs, the collateral manager may also have the option of selling securities and entering into new arrangements.
Issuers prefer the option of trading CDO portfolio assets throughout the term of the transaction. Credit enhancement in CDOs is sized to account for losses on defaulted assets, but not on performing assets. As a result, trading and portfolio turnover is limited, either by reinvestment criteria during the revolving period or by specific trading rules.
Typically the revolving period ranges from two to six years. Reinvestment of collateral cash receipts during this time has several advantages. Reinvestment can be used to maintain collateral quality and portfolio diversification, as rating changes, or as maturities, amortization, prepayments, or defaults reconfigure the pool. In addition, if prepayments during the revolving period are reinvested in eligible collateral, they may preserve yield for investors and excess spread for the transaction. The revolving period also enables a transaction to profit purely from limited trading activities, that is, buying and selling of collateral.
Replacing collateral, however, instead of paying down notes, can add credit and market risk to any transaction. Failure of some or all of the coverage, collateral quality, or portfolio diversification tests may trigger delevering or paydown of the rated notes in order of seniority. These tests, and their remedies upon failure, are very important to the integrity of the structure. That is, maintaining a particular rating level depends directly on meeting, on an ongoing basis, the fundamental requirements of that rating.
The majority of rated CDO transactions provide that the collateral manager may trade assets during the reinvestment period via four collateral sales mechanisms:
* Credit-risk security sales,
* Credit-improved security sales,
* Defaulted asset sales, and
* Discretionary sales.
Assets judged to be credit-risk (or “credit-impaired’) securities can be sold to avert default losses, while credit-improved (or “credit-appreciated”) securities can be sold to improve collateral quality and boost returns to equity investors. The intention of such trading should be to protect against default by selling credit-risk assets with a deteriorating credit profile. The intention of such trading should not be to exercise greater discretion and flexibility in asset management, particularly to proffer gains for the manager or other equity holders at the expense of rated noteholders.
There are two aspects of constraining the trading of these assets in order to protect the portfolio from high turnover and undue exposure to price erosion: designation, and application of proceeds. The designation or definition of credit-risk and credit-improved securities controls how often the sale occurs, and should be specific. The application of proceeds controls uses of the sales proceeds, reinvestment in new assets, and payment of all or part of the sales proceeds to investors according to the priority of payments, or “waterfall.” These guidelines should protect senior noteholders from the release of cash should the transaction be underperforming.
There are many variations in terms of the definition of credit-risk and credit-improved securities. However, there are at least two elements important to carving out these assets. First, the concept of a significant change in credit standing should be clear. Second, the manager’s responsibility to judge that an asset fits the applicable definition should be clear.
The manager should certify to the trustee in writing his opinion that the asset should be so designated and sold, and that any replacement asset meets applicable reinvestment criteria. Standard & Poor’s believes that the manager’s judgment and responsibility are paramount in making these decisions, and therefore does not impose price or other hurdles before the manager may consider something credit-improved or credit-impaired.
The application of sales proceeds is more complicated. General reinvestment criteria should apply, as well as additional guidelines as follows to fulfill the purpose of the trade:
Credit-risk security-If the manager deems a security to be a credit-risk security, the manager should be able to take appropriate action to avert a likely default in the future. The problem that arises is that, unless the manager is way ahead of the market sentiment, the sale price of such security is at a considerable discount to par. Requiring the manager to satisfy, or if not currently satisfying the coverage test or CDO Monitor test, to maintain or improve the test, would de facto force the manager to buy another deeply discounted security.
In Standard & Poor’s opinion, this would not benefit the transaction. Standard & Poor’s thus believes the manager should use all the sale proceeds to buy a new security without the requirement to maintain or improve the par coverage test and the Standard & Poor’s CDO Monitor test. This gives the manager the flexibility to buy a good credit and not focus on replacing par with another “credit-risk” security. The interest coverage test and the other quality tests must still be maintained or improved. Also, the manager and the transaction might be better served if the proceeds from the sale of a credit risk security were used to pay-down the notes. Many indentures allow this if the collateral manager cannot find a suitable reinvestment option or deems that pay down is the best course of action.
Credit-improved security-If the credit view on the security has improved, it is likely that the market value of the security has improved relative to where it was purchased. After selling a credit-improved security, Standard & Poor’s requires that the manager replace the par of the credit-improved security with an asset the par value of which is equal to or greater than the credit-improved security sold. The manager must also satisfy the collateral quality tests and the Standard & Poor’s CDO Monitor tests, or if they were not satisfied prior to the sale of the credit-improved security, to maintain or improve the results of the test with the purchase. If the tests are not satisfied prior to the sale of the credit-improved security, Standard & Poor’s prefers that capital gains be used to purchase new par value securities and such gains not paid out as interest to junior noteholders or equity holders.
Some transactions track par loss and require all gains to be reinvested until the par loss is made up. A structure that continues to reinvest premiums and capital gains in a par replacement of collateral during the revolving period is stronger from an overcollateralization perspective. For example, if a collateral debt security (CDS) with a par amount of $100 was originally purchased for $80, but sold for $90 (for example, as a credit-improved security), a $10 capital gain is realized upon sale. If the collateral manager reinvests the entire $90 sale proceeds to replace the $100 par amount sold, the new $100 CDS will maintain the overcollateralization test and remain in the transaction for the benefit of the rated noteholders.
However, if the collateral manager “bifurcated” the $90 sales proceeds by releasing the $10 capital gain as excess interest through the interest waterfall, he would be left with $80 to reinvest as principal. Even if the structure had a par replacement provision, the manager is at a disadvantage, having a more limited investment universe since he could not buy anything costing more than $80. To maintain credit quality, it is more likely that the replacement collateral would have a par amount significantly lower than $100. From the point of view of the rated noteholders, the first structure, which reinvests the capital gain, is stronger from an overcollateralization perspective than the second structure, which “flows out” the capital gain to enhance the return of equity holders.
Defaulted security-Defaulted securities may be sold at any time or worked out to recovery. In general, most transactions use such recoveries to pay down the rated notes should the overcollateralization (O/C) or interest coverage (I/C) tests be breached. If the coverage tests are not satisfied, the sale proceeds or “recoveries” from the defaulted security must be held in the collection account and used to pay down the liabilities on the next payment date. Some transactions allow reinvestment of these sales, as long at the coverage tests are maintained or improved. For these transactions, Standard & Poor’s models the cash flows assuming that recoveries on defaults are never used to pay down the notes during the reinvestment period, regardless of whether the coverage tests are met or not.
The risk of price depreciation and liquidity diminution in the secondary market, particularly in defaulted asset sales for recovery, is important in cash flow transactions. The loss of expected interest proceeds from defaulted assets stresses the interest coverage ratio and the transaction’s ability to make timely payments on its interest obligations. Defaulted assets are also treated at recovery assumptions that reflect substantial price depreciation in the par coverage ratio. Through sales of defaulted securities, the manager frees up cash to reinvest in performing assets or pay down the senior-most notes. However, there is a trade-off between current market value and ultimate recovery. In a majority of cases defaulted securities trade at much lower prices than the ultimate recovery that they would achieve. Part of this is due to the carrying cost over the recovery period, and part is associated to the uncertainty as to what the ultimate recovery will be. The collateral manager must evaluate this in conjunction with the current status of the transaction and make a decision if it is better to hold or sell such defaulted securities. Defaulted securities can be sold both during and after the reinvestment period.
Discretionary trading-In addition to credit-risk, credit-improved and defaulted asset trades, CDOs often allow discretionary trades during the revolving period, subject to coverage tests and reinvestment criteria. In general, these trades are limited to a small basket (typically 10% to 20%) which caps the principal amount purchased in a calendar year or one-year period to a percent of the pool principal balance. The concerns cited above regarding release of premiums and capital gains to equity holders prior to the repayment of rated notes also apply to discretionary trades. Recent deals seek to alleviate such concerns with the inclusion of provisions that shut off the manager’s access to discretionary trading should the transaction have migrated significantly from its coverage or/and collateral quality tests. Standard & Poor’s requires that the manager replace the par of the discretionary security traded with an asset whose par value is equal to or greater than the discretionary security sold. The manager must also satisfy the collateral quality tests and the Standard & Poor’s CDO Monitor tests, or if they were not satisfied prior to the sale of the discretionary security, to maintain or improve the results of the test with the purchase.
Equity Securities-Equity securities get no benefit in any test in the indenture. Such equity is either acquired through a debt conversion or as recoveries on defaulted obligations. In general cash flow and synthetic CDOs are not allowed to purchase equities. Equity securities may be sold at any time. If the equities are acquired through a debt conversion, the collateral manager is typically required to maintain or improve all coverage tests after the conversion. If the equity is acquired as recoveries, then any sale proceeds from such equities must also be deemed recoveries and must be applied similar to any other recovery. The collateral manager may also hold onto equity securities obtained as recoveries if he/ she believes that such securities will improve in price over time.
To monitor the quality of the portfolio during the reinvestment period for Standard & Poor’s, the majority of transactions are structured with the use of Standard & Poor’s CDO Monitor (see “CDO Monitor” in the “Sizing Defaults” section for a complete explanation). The Monitor looks at the total dollar amount of losses that the transaction can sustain as established by the initial cash flows for each rating, and compares that with the default potential of the current portfolio plus par loses to date. For other than credit risk sales, the collateral manager runs the Monitor before and after the proposed reinvestment and sees if the results are maintained or improved. Most managers view this as a useful tool in maintaining portfolio quality and stipulate in the transaction documents that they will only reinvest if they can maintain or improve the results. If the transaction falls the Monitor test, the collateral manager must notify Standard & Poor’s of such failure in order to reevaluate the transaction
A certain number of CDOs aim to combine the benefits of arbitrage with those of off-balance sheet treatment. Under FASB 125 in the U.S., the collateral manager must relinquish control over his ability to trade the transferred assets, and trade only credit-risk securities, which are defined based on “objective” criteria. The investor should note that some interpretations of FASB 125 can translate into automatic sale of broadly defined credit-risk securities. For example, such transactions can have provisions that if the rating of the asset migrates to below ‘B’ then such asset must be sold out of the collateral pool. In these situations, there could be higher asset turnover because not only defaulted assets would impact the transaction, but also assets with negative credit migration. In such cases Standard & Poor’s has to size how many assets would transition from B directly to default and how many would be downgraded to below B and sold. This analysis is more complex but feasible. In addition assets that must be sold increase exposure to market value risk, thereby warranting a more price-based analysis of credit enhancement.
Overall, the trading flexibility discussed above represents an additional level of risk to the investor, who is exposed to the collateral manager’s decisions, As a result, there is a greater risk in CDOs (versus more traditional asset-backed paper in which assets rend to be homogeneous) that the rating on a prospective CDO can change over time as the composition of the asset pool deteriorates. These changes can be a result of long revolving periods, credit upgrades or downgrades in the underlying assets, and active management. Transactions permitting portfolio turnover, whether through discretionary trading, or the trading of credit-risk or credit-improved assets, should adequately disclose that the ultimate rating of the respective transaction may be affected by the changing composition of the asset pool and the manager’s skill in trading such assets.
B. Synthetic Transactions
In a synthetic CDO, the typical transaction has been a five-year bullet with the potential for up to one year of extension risk to give time for recoveries to be established on defaults that occur in the fifth year. These transactions typically have reinvestment periods that can extend all the way to days prior to the swap contract maturity date. More recently, the investment bankers who are more familiar with cash CDOs have structured synthetic CDOs with five-year reinvestment periods and 12-year legal final maturities. As the credit derivative contract is totally flexible, it renders irrelevant the concern that the collateral manager may not find debt securities with the appropriate maturity. Physical collateral is not being sourced; thus the contract can reference the desired maturity up to transaction maturity date. The one caveat is that the credit derivative market is currently not liquid beyond the five-year point and thus provides a market-driven maturity limit.
In synthetic CDOs, the portfolio is typically modeled to five years, the bullet maturity of the transaction. Weighted average life and actual maturity profiles of a portfolio of underlying credit default swaps may alternatively be considered if these are factored in the notionals of the contracts.
In a synthetic CDO, the concept of trading is also slightly different from that in cash CDOs. One way to effect a trade occurs when the manager entices the counterparty to accept unwind of the swap contract. Unfortunately this can be non-economic relative to selling a cash bond because the counterparty must agree to the unwind and thus holds some leverage over the CDO. This leverage can be assumed to cost something, most easily coming from the spread income. To date there has been relatively little trading in the synthetic CDOs that absorb trading gains and losses. Alternatively, a CDO could book an offsetting trade which could be assumed to render the position “flat” from a credit perspective, and thus the gain or loss is the difference between the two spreads, the premium received in connection with a particular reference entity on which the CDO sold protection and the spread payment due out to a counterparty. In fact, this risk may not be flat the credit. The CDO has hedged the credit risk of the reference entity, but has taken on the new risk of the counterparty’s ability to perform. One way to think about it is as an insured bond. The underlying may have a natural rating of “BBB”, but the “wrapped” rating is “AAA”. It is NOT however, risk-free. It is risky to the extent the insurer does not perform. So too is the new, opposite credit derivative trade risky to the extent the counterparty performs. This risk is typically treated at the new assumed risk of “AAA” on the “package” as long as the counterparty is rated A-1+. To count as a totally offsetting trade, the two contracts must have identical counterparties, reference obligations, reference entities and terms. Furthermore offsetting trades are included in the discretionary trading bucket to prevent large exposures.
As with cash arbitrage CDOs, so too have managers of synthetic CDOs tried to pick up the language of credit-risk security sales, credit-improved security sales, defaulted asset sales and discretionary sales. However, one must think, again, in terms of spread. These credit-risk securities are defined as those for which the mark has widened by 100 basis points. Credit-improved securities are generally assumed to be credits whose mark to market spread has tightened by 20 basis points. Both definitions have included the manager’s discretion provisions typical of traditional cash CDOs. Defaulted exposures are either cash settled or physically settled. Managers retain the ability to make discretionary trades with a limit of between 10%-20% established either for the lifetime or per annum. That differentiation is made based upon the strategy and background of the manager.
VIII. REINVESTMENT AFTER THE REINVESTMENT PERIOD
A. Cash Flow Transactions
Traditionally, the end of reinvestment period in a CDO transaction means principal proceeds, with the exception of principal prepayment, thereafter will be used to pay down liabilities. As such, noteholders can expect winding-down of their investment based on the priority of the notes they hold in the capital structure of the transaction. From a credit point of view, the amortization of the asset pools brings some interesting consideration. All else being equal, the credit protection provided by the equity position in the transaction increases as a percentage of the transaction (the structure is “de-levering”). At the same time the maturity of the assets is getting shorter and thus most likely the probability of default is getting smaller. At the same time, adverse ratings migration and greater collateral lumpiness can be increasing the portfolio default rate. The sequential paydown structure, coupled with the shorter maturities, affords the senior tranches sufficient protection while they pay down.
More recently, however, Standard & Poor’s has seen a marked increase in structures that permit reinvesting principal proceeds after the reinvestment period. Specifically, some structures permit collateral managers to reinvest sale proceeds from credit-risk, credit-improved, and even discretionary trading after the end of reinvestment period. While this trend reflects issuers’ desire to keep assets under management for as large and as long as possible, Standard & Poor’s views this development as presenting additional risk factors. Primary among them are:
Back-Ended Default: Standard & Poor’s adjusts its cash-flow stress tests based on the weighted average life of the collateral pool. This limitation sterns from the fact that imposing a certain level of defaults based on the original balance of the asset pool cannot be achieved and may be onerous once the pool balance declines past a certain point. If, however, the transaction has the option of maintaining pool balance due to added reinvestment alternatives, Standard & Poor’s will likely impose additional stress tests that extend into the reinvestment period to test for the robustness of the structure. If the collateral manager can take a transaction with an eight years average life and turn it into a 12-year bullet pay structure, then that transaction will be analyzed as such.
Credit Quality Monitoring: At present, Standard & Poor’s monitors the credit quality of the collateral asset pool via the Standard & Poor’s CDO Monitor. The CDO Monitor measures total dollar of loss potential and is most meaningful during the reinvestment period. Added trading flexibility while the asset pool is amortizing requires additional tests and ongoing credit quality monitoring.
Interest Rate Hedges: A transaction typically structures its interest rate hedge to the original balance of the pool. This strategy is probably the most efficient and rational one. However, the structure may face more interest rate risk if the original pool is kept for longer than anticipated beyond the reinvestment period. This problem may be especially acute if the structure allows for a mix of fixed- and floating-paying assets. Additional cash-flow stress tests may be called for to examine the impact of longer asset life on the adequacy of interest rate hedges.
Because of these additional risk factors associated with trading activities after the reinvestment period, Standard & Poor’s may require additional cash flow stress tests and collateral tests if the transaction proposes reinvestment during the amortization period, depending on the nature and extent of proposed trading activities.
Reinvestment of principal prepayment only: This provision does not require any additional testing if the documents require that the replacement asset should have an equal or better rating and an equal or shorter maturity than the asset it prepays. Alternatively, the indenture can require that Standard & Poor’s CDO Evaluator be run, and the scenario default rate has to be maintained or improved, and the collateral manager has to test the hedging structure for adequate coverage. Furthermore, all other reinvestment criteria concerning collateral quality tests and concentration limitation have to be met.
Sale of credit-risk assets: Proceeds must be used to pay down the liabilities or reinvest in the most par possible with equal or shorter maturity; otherwise additional stresses will be tested in the transaction.
Credit-improved and discretionary trade: In the case of sale of credit-improved and discretionary sales, the indenture has to require that sale proceeds be equal to or greater than the principal balance of assets sold. Additional cash-flow stress tests may apply to back-ended default if reinvestment is permitted without the equal or shorter maturity test. The indenture has to require that replacement assets should have an equal or better rating and an equal or shorter maturity than the asset that is traded out. Alternatively, the indenture can require that Standard & Poor’s CDO Evaluator be run and the scenario default rate has to be maintained or improved, and the collateral manager test the hedging structure for adequate coverage. Furthermore, all other reinvestment criteria concerning collateral quality tests and concentration limitation have to be met.
B. Synthetic Transactions
In a synthetic CDO, reinvestment after a reinvestment period is a slightly different concept due to the traditional short bullet structure. If principal returns are contemplated in a five-year structure, consideration must be given to what “de-levering” means. In a traditional synthetic CDO, the funded “AAA” noteholders have a synthetic or “super senior” swap counterparty. The presence of this counterparty leaves the open question of what de-levering means. It can mean the reduction of the notional exposures the super senior swap counterparty takes on. But it must be remembered that the super senior swap counterparty is a contingent participant. It did not put any cash into the deal. Thus, this counterparty is not due a principal distribution. If actual principal return to the AAA noteholder is contemplated, the super senior swap counterparty traditionally opposes such an action because it reduces the subordination protection it would likely be called upon to provide. Thus, the AAA noteholders, who would typically have a shorter expected life than legal final maturity, do not have such an assumption as appropriate in the synthetic CDO. Some transactions require a pro-rata reduction of the unfunded and funded senior-most risk positions, but that is not a rating requirement of Standard & Poor’s.
Interest Rate Hedges: The partially funded synthetic CDO structure typically locks in the floating-rate component of the income due to the noteholders by investing in a GIC or locking in a repo rate of return. The credit derivative spread premium income represents fixed spead income and is used to pay the spread over LIBOR/EURIBOR that is required to service the noteholders. Thus, interest-rate hedges are not typically required. Standard & Poor’s cash flow runs that pick up the fixed-floating risk in a typical cash CDO are generally not required in the synthetic CDO.
Sale of credit-risk assets: Proceeds must be used to pay down the liabilities or retained in the structure as credit support against which new credit derivative risk could be written pending the passing of the model dun. The CDO Evaluator is typically run for trading eligibility purposes in synthetic CDOs. Certain older structures depend upon limit structures, the bucket approach that seeks to limit risk by limiting the initial portfolio to “ratings” buckets, and substitutions are required to be of the same then-current rating of the exposure being removed or of a higher rating.
IX. COVERAGE TESTS
A. Cash Flow Transactions
The coverage tests-overcollateralization (O/C) or par coverage ratio, and the interest coverage ratio (I/C)-are the main financial ratios that drive the manager’s decision to “reinvest” cash in new collateral or pay down noteholders during the revolving period.
The par coverage ratio is essentially the ratio of CDO asset par to CDO rated tranche par. This test ensures that there are adequate assets to cover the liabilities, as measured on a par basis.
The typical O/C ratio for senior securities is calculated as follows:
* Total dollar par of assets in collateral pool
+ Defaulted securities at lower of market or expected recovery rate
* Divided by
+ Total amount of senior securities presently outstanding.
In general most transactions have an O/C test for each class of securities issues. Thus there would be a class A O/C test, a class B O/C test, a class C O/C test, etc. Each of the tests below the senior-most security test would also include all the senior securities in the denominator. Thus the denominator of the class B O/C test would be made up of the class A securities and class B securities. Since the numerator of the O/C test is the same regardless of the class, the class B and C O/C tests are lower than the class A test.
With the notable exception of defaulted assets and some special securities, which are given credit for the lower of an assumed recovery rate and market value, the par coverage test does not take into consideration the market values of assets. Furthermore, this coverage test typically makes no adjustments based on asset credit ratings. Recently however, some transactions have started to haircut the par value of certain low rated securities to the extent such securities exceed certain limits which are higher than the original composition of the asset portfolio. For example, “CCC” securities that exceed 10% of the total asset pool must be included at 75% of the par value. This is done in order to trip the O/C test faster and start delevering the transaction in order to compensate for the added credit volatility associated with a large concentration of low rated securities.
In addition, certain assets with unique cash flow characteristics are afforded special treatment in the O/C test. For example, zero-coupon bonds are treated at their accreted value, and I/O securities and equity receive no credit. Securities that are deferring interest are also accorded special treatment.
The interest coverage ratio (I/C test) is essentially the ratio of interest collected in a given period net of transaction expenses, divided by the interest payable on a respective tranche of the CDO in that period. If the transaction has multiple tranches there will likely be one I/C test per tranche. The I/C test is a liquidity test that ensures that there is adequate interest generated by the assets to cover the interest payment obligations of the liabilities plus a certain cushion. The I/C test is generally set higher than the minimum needed to pay interest on the tranche. If the I/C test failed, the transaction will trap interest and principal collections and pay down the senior notes. The I/C test is both a cash and an accrued interest test. On any determination date the numerator should be given credit only to interest actually received in that period, while on any measurement date within the period, the numerator includes interest collected and interest expected to be received, in the reasonable judgement of the collateral manager. Thus, any interest payable by defaulted securities should always be excluded.
The typical I/C ratio for a senior security on determination date is calculated as follows:
* Interest received during period
Expense payable above interest payments
+ or – Net swap payments
* Divided by
Total amount of interest payable on the senior securities.
At this point the money actually received during the period, net of expenses or hedge income or costs, should cover interest payable on the senior securities more than 100%. In general most transactions have an I/C test for each different class of rated notes. Some transactions, however, combine some of the tranches. For example, the senior test might include the class A and B of the securities.
The investor should be aware of subtleties in the definitions of these ratios that might not properly reflect transaction interest cash flow and can distort or overstate interest coverage. An example of such is how hedge receipts or payments are reflected in either the numerator or the denominator. Such differences in treatment make direct comparison of such ratios across transactions difficult and misleading.
The investor should be aware that there are very important subtleties in how coverage tests are managed. Some structures require that the issuer “maintain compliance at all times” and trigger a special redemption whenever a coverage test is failed and not brought back into compliance with the original minimum ratio. If one or more of the coverage tests is not met, principal proceeds should not be allowed to be reinvested unless the coverage tests are brought in compliance as a result of the reinvestment or trade. This early amortization trigger works to return available cash to rated noteholders sequentially, thereby converting risk into a prepayment.
Other structures have the provision to “maintain compliance or improve” and may permit intra-period noncompliance and collateral substitution. This allows the manager to bring himself closer to compliance after a trade. In such “maintain or improve” structures, there may not be cash available to redeem liabilities sequentially and restore compliance on the next payment date. The investor in a “maintain or improve” structure is buying a CDO that gives the collateral manager more flexibility than a “maintain at all times” structure. One noteworthy “carve-out” in many CDO structures is for credit-risk sales proceeds, which may be reinvested under limited circumstances in order to protect noteholders from credit losses, even if compliance is not immediately restored.
The timing and frequency of test performance is also an important aspect of the effectiveness of reinvestment criteria. In addition to regular monthly and due period measurement dates, any date on which there is a proposed collateral purchase or change in the portfolio (for example, downgrade, default, maturity, or redemption) should trigger recalculation of the coverage tests.
While the coverage tests are designed to buffer rated noteholders from declining portfolio performance through the early paydown of senior notes, such tests are susceptible to collateral manager actions that can delay the paydown at the risk of more severe future losses. Noteholders should scrutinize the manager’s reinvestment of sales proceeds to ensure that proceeds are re-deployed in solid credit positions. Take for example a scenario where the par coverage ratio falls below the set threshold between payment dates due to the default of an asset. At this point, the par credit assigned to the defaulted asset is the lower of market value or assumed recovery rate. Let’s say it’s $40. The collateral manager is able to bring the coverage test back into compliance by selling the defaulted asset for $40 and purchasing a performing asset at par of $100 with the sales proceeds. Let’s also assume that the interest rate on this asset is at the current market rate. The credit for the new asset of $100 par brings the test back into compliance. The manager averts early pay down of the senior notes, thus allowing the interest and principal proceeds to flow down the waterfall at the next payment date. Both the noteholders and equity investors receive payments and the manager has built par back into the deal. Unfortunately, the scenario likely doesn’t end here. By purchasing the replacement asset at $100 par with $40, the manager acquired the asset at a heavy discount that the market deems highly likely to default. Should this asset subsequently default, the transaction is back to the earlier predicament but some proceeds have already been passed on to the equity investors. In such a situation, the noteholders would have been better served had the manager purchased $40 par of an asset with solid credit fundamentals. The par coverage test failure would trigger early partial redemption of the senior notes, but the portfolio would have a stronger credit base.
It is also possible that the collateral manager arbitrages the test through discretionary sales. Assume that a transaction is failing its coverage tests and a collateral instrument is scheduled to pay down the day before the period end and the determination day. Thus the money would be available to delever the transaction on the payment date. To avoid paying down, the collateral manager could simply sell the security as part of discretionary sales, and then reinvest the proceeds in new collateral that has a maturity date later in the future. For these reasons, Standard & Poor’s requires that the transactions be modeled assuming that no scheduled principal is available for paying down on O/C or IC test failures during the reinvestment period. Generally only recoveries on defaulted securities and excess spread are used to pay down during the reinvestment period.
B. Synthetic Transactions
Synthetic CDOs also have coverage tests as seen in cash flow CDOs, the overcollateralization ratio (O/C), and the interest coverage ratio (I/C). There is much discussion about eliminating the I/C test in a synthetic CDO as the total spread income coming into the portfolio, due to the leverage, usually dwarfs the real risk of having interest coverage shortfalls. But, not surprisingly, Standard & Poor’s has seen portfolios where loss of one, two, or three of the highest-spread derivatives exposures could lead to the payment-in-kind (PIK) of the lowest-rated security. As a result, Standard & Poor’s does usually require an I/C test. In certain structures, enough comfort can be drawn from a minimum spread test that the I/C test could be eliminated.
Because a large portion of a synthetic CDO is supported by an unfunded liability (typically a “super senior swap”) and therefore the leverage afforded off funded notes, these coverage ratios are primarily used to trap cash, not to pay down noteholders but to divert cash into the collateral account to build subordination. But there are exceptions. In “hybrid” transactions where there are characteristics of both cash flow and synthetic CDOs and in some of the more recently structured synthetic CDOs, there are instances where the tripping of O/C and I/C tests leads to amortization from “super senior swap” on down the different classes. Additionally, in synthetic CDOs where all excess spreads are trapped to build subordination, there are obviously no O/C or I/C tests.
How the O/C is defined in a synthetic structure is driven by whom the O/C is aiming to protect. If the funded noteholders are those that are to be protected, the likely O/ C ratio is defined as the ratio of funded note proceeds par to tranche par. Funded note proceeds are typically deposited into a guaranteed investment contract (GIC), a reverse repurchase (repo) agreement using appropriate collateral, or purchase of very high quality corporate paper with market risk removed, for example, through a par put agreement. All of the counterparties involved, whether it is the GIC provider, the reverse repo counterparty or the put provider, are subject to rating downgrade trigger to ensure the availability of resources to pay for credit protection upon credit events, The typical O/C ratio for senior securities is calculated as follows:
* Undrawn amount of funded note proceeds
+ Defaulted securities at lower of market or expected recovery rate
* Divided by
Total amount of senior securities presently outstanding.
Most transactions have an O/C test collectively for the senior class securities and the junior class securities. For example, there would be a class A, B, and C O/C test. Each of the tests below the senior-most security test would also include all the senior securities in the denominator.
While there are structural provisions to minimize the market risk in funded note proceeds, some of the more recent synthetic CDOs have adopted similar haircut to the par amount of the high-grade collateral, itself a contra-liability, depending on the credit quality of the assets. For example, if the notional amount of credit default swaps written referencing B+ or lower rated obligors exceeds 1% of the portfolio, for the computation of the par amount of the collateral, it is haircut by 20% of this excess. Thus the O/C will trip sooner and cash will be diverted more quickly into the collateral account.
Since trapped cash in synthetic structures is often relevered through the synthetic CDO writing more credit default swaps, how much credit exposure can be written is ultimately governed by a synthetic exposure to synthetic coverage ratio. This ratio is aimed at protecting the unfunded and funded investors as well as credit default swap counterparties. It is calculated as follows:
* Total amount of credit default swaps written
– defaulted or credit event credit default swaps
– hedged credit default swaps
* Divided by
Undrawn “super senior swap”
+ funded note proceeds in the collateral account
– net undelivered defaulted credit default swaps
The ratio has to be less than or equal to 1, so that synthetic coverage is always enough to cover synthetic exposure.
In structures where the protection of the super senior swap provider takes on priority, we will likely see the super senior swap notional in both the numerator and denominator, so that the senior O/C is now calculated as:
* Undrawn amount of funded note proceeds
+ Defaulted securities at lower of market or expected recovery rate
+ “super senior swap”
* Divided by
Total amount of senior securities presently outstanding
+ “super senior swap”
The I/C ratio is calculated as follows:
* Premium received from credit default swap written
+ interest income from funded note proceeds in a given period
* Divided by
Insurance premium payable to an unfunded tranche or tranches
+ interest payable to a funded tranche or tranches of the CDO in that period.
The I/C test is set higher than the minimum needed to pay interest and insurance on the tranches. But again the same distinction from cash flow CDOs holds. If the I/C test fails, cash trapped will only go into the collateral account to build subordination but notes will not be amortized.
Similar to cash flow CDOs, on top of regular monthly and due period measurement dates, any date on which there is a trading, hedging, or changes in the existing portfolio such as downgrade, default or maturity should trigger recalculation of the coverage tests.
X. COLLATERAL QUALITY TESTS/PORTFOLIO PROFILE TESTS
In addition to coverage tests, collateral quality tests serve as a “blueprint” for eligible collateral and for portfolio parameters during the revolving period. For example, an arbitrage transaction may allow collateral debt securities that are U.S. dollar denominated from U.S. issuers with a minimum issuer credit rating of ‘B-‘, and no more than 8% total principal balance of collateral debt securities may be from the same industry. Such limitations are not imposed by Standard & Poor’s, but generally by the investors, since Standard & Poor’s uses the CDO Evaluator (see the “Sizing Defaults” section) to size default risk and the Evaluator uses correlation between assets in the same industry and can handle assets with any issuer rating.
Other trading and reinvestment criteria may include par replacement criteria (for example, the principal amount of the purchased collateral debt security at least equals 100% of the principal amount of the sold or paid down collateral debt security). In contrast to coverage tests, many of these reinvestment and trading criteria are qualitative and dependent on availability of desired collateral in the market. Consequently, some structures give the issuer the flexibility to reinvest cash to be closer to compliance if a failure occurs.
Covenants to maintain the portfolio at or above a minimum weighted-average coupon (WAC) for fixed-rate assets and minimum weighted-average spread (WAS) for floating-rate assets are common portfolio profile tests. Such measures are necessary to facilitate the modeling of the cash flows in transactions that have revolving collateral pools. An alternative to these tests is a covenant to replace interest with interest for each trade.
One particular collateral quality test that deserves mention is designed to limit individual asset and/or portfolio maturity. Typically, collateral eligibility definitions include individual or discrete maturity restrictions (for example, all collateral debt securities must mature prior to the stated maturity of the notes). Pool parameters may include a weighted average maturity (WAM) limit on the portfolio.
Any number of portfolios could satisfy these guidelines, including the following three sample portfolios: a portfolio of all short-term securities maturing within one year and then having to be reinvested; a bar-belled portfolio of short- and long-term securities; or a portfolio with equal amounts of principal maturing in every year of the transaction.
As much as it would simplify the analysis and management of collateral, the portfolio with equally sized, evenly distributed maturities is not typical in CDOs given the nature of the corporate debt markets. In fact, a “barbell” distribution with a portfolio concentrated in the short- and long-term ends of the maturity spectrum can occur, given that the cash flow characteristics of the assets differ, and that the portfolio changes over time. Such a skewed portfolio may be permissible under collateral stated maturity limits or a portfolio WAM requirement. For “barbell” or at least “lumpy” CDO portfolios, investors should be aware that sole reliance on arithmetic weighting, averaging or aggregation of maturities may not effectively measure the risk or effect a prudent reinvestment decision. For this reason, Standard & Poor’s used the CDO Evaluator and CDO Monitor to factor in the characteristics of the porfolio into the default estimation.
Analysts review the issuer-provided reinvestment or trading guidelines-the collateral quality and portfolio parameters discussed above-to determine that each new asset meets certain eligibility requirements before it replaces an asset. As mentioned, the manager may choose to run the CDO Monitor, in addition to checking coverage ratios and collateral quality tests, to assess the portfolio and the impact of reinvestment on an ongoing basis. Such regular testing gives the manager access to “updated” portfolio information for his consideration in the decision to reinvest cash.
If the manager chooses to use the CDO Monitor for a replacement test, analysts will request copies of the results. If the default rate of the pool after replacement is less than or equal to the default rate of the pool before replacement, the replacement can occur without causing deterioration in the pool credit quality or significantly increasing expected defaults over time. The manager may run the CDO Monitor to see the default rates on the pool with and without replacement, compare the results with the “break-even” default rate and portfolio assumptions applied in the transaction, and make his decision. A rating action may be taken if, upon replacement, the portfolio quality deteriorates.
Alternatively, if the manager is not using the default model, he need only check that both the “before” and “after” positions are within the collateral eligibility criteria. In this latter case, the original credit enhancement level is based on “stressed” eligible portfolio composition with maximum allowable asset credit risk. Therefore, in general, the original credit support should still cover this risk as long as the portfolio quality remains within these assumed stressed collateral quality parameters, and the manager tests and maintains compliance with coverage tests. Standard & Poor’s requests that the issuer provide pool information monthly and immediately notify us of any CDO Monitor failure.
XI. PRIORITY OF PAYMENTS
The principal and interest “waterfalls” drive the transaction’s allocation or distribution of cash flow down the capital structure. Even synthetic CDOs have cash waterfalls that dictate how premiums, interest, and cash from the collateral accounts will be distributed. These distributions may occur periodically in cash flow transactions, at the end of the transaction in synthetics, or sooner should a transaction unwind due to a transaction event of default.
As one would expect, in senior/subordinated structures, the most senior, highly rated tranche should have priority in the principal and interest waterfalls. Subordinated tranches are in place to provide credit support, which, for example, may translate into deferring interest receipts while the transaction tries to build back its O/C tests, junior investors, however, have their own return hurdles. Usually, the investor will invest in a single rated or unrated tranche position in the capital structure. When several tranches are rated, however, the “tradeoffs” across classes and waterfall mechanics can become quite complex, as differing interests compete for the same collateral cash flow.
In most transactions, the ongoing hedge payments (if hedges are used in the deal) are senior to the senior-most class. Ongoing is the exchange of periodic interest. Hedge termination payments may or may not be above the senior-most class, but are situated after the capped transaction expenses. Under Standard & Poor’s CDO criteria, since future hedge termination payments are very difficult to accurately size, any termination payment due from the SPE to any hedge counterparty must be subordinated to the investment-grade noteholders, if such payment is due because the counterparty defaulted on its obligations. If the payment is due to the SPE defaulting, then it may be senior in the waterfall.
The majority of transactions to date use separate priorities of payment for interest and principal and consequently bifurcate all cash receipt into interest proceeds and principal proceeds. Standard & Poor’s looks closely at these two “buckets” to ensure that principal receipts are not inadvertently passed down the interest waterfall to the equity investor. Similarly, the analyst checks that all sources of payment are covered within these definitions. The inclusion of catch-all language in the principal proceeds definition to cover any unanticipated items is preferred.
From the perspective of the investors in the rated notes, stronger deal structures will include trapping trading gains in principal proceeds which allows the manager to increase overcollateralization to support the notes. Conversely, investors should note that some transactions divert a portion of the unused proceeds to the interest waterfall after the end of the ramp-up period. To the extent unused proceeds result from purchases of assets at significant discounts, the manager is potentially exposing the noteholders to additional credit risk while flowing the proceeds to the equity holders. Careful attention to the definitions of principal proceeds and interest proceeds is therefore warranted. As a general rule Standard & Poor’s considers all money recovered on defaulted securities, either through sale or work-out, up to the par of the security to be principal proceeds.
The priority of payments will also differ from transaction to transaction. Following the breach of a coverage test, most CDOs use interest proceeds for paydown of senior notes and will utilize principal proceeds only to the extent of a shortfall, but some deals start delevering with principal proceeds. Most cash flow transactions will also delever sequentially beginning with the senior-most outstanding tranche. However, under certain conditions, some waterfalls might pay pro-rata or divert the paydown to a subordinated tranche. In general, the analyst looks closely at what is released through both the principal and interest waterfalls to junior debt holders and equity holders while senior debt is outstanding and will apply additional stresses to the cash flow modeling to ensure adequate subordination protection to the senior tranche.
Some of the additional features the analyst will look at in the priority of payments include the following:
* A cap to the payment of administrative expenses and fees to various participants such as the trustee and paying agent senior in priority to payments on the notes. Otherwise, it is difficult to adequately model the cash flow.
* The senior collateral management fee should be adequate to entice a replacement collateral manager should such substitution become necessary. If the fee is too low, Standard & Poor’s will stress cash flows at an appropriate fee.
* Triggers that can switch payments back and forth among different waterfalls. Such triggers are very difficult to model because specific transition paths must be modeled. Because of this difficulty such triggers are not common.
* As mentioned, termination payments to the hedge counterparty triggered by hedge counterparty default or termination event should be subordinated to the payment of rated notes.
Some CDO transactions will combine the payment of both interest and principal into one waterfall. The same concerns cited above apply, and the analyst needs to carefully scrutinize the definition of principal distribution amount to identify any potential leakages to equity.
XII. DEFINITION OF DEFAULTS
A. Cash Flow CDOs
The two most important factors in Standard & Poor’s assessment of required credit enhancement for rated notes are the frequency of defaults and the loss severity stemming from defaults. The events of default for the underlying assets need to be clearly defined and consistent with those applicable to Standard & Poor’s default study, which is used as the basis of the CDO Evaluator. Standard & Poor’s considers the following to be events of default for an asset:
* Failure to pay interest or principal in whole when due;
* Designation by Standard & Poor’s of ‘D’ or ‘SD’;
* Initiation of bankruptcy, insolvency, or receivership proceedings.
In addition to these items, the judgment of the collateral manager to deem an asset as defaulted based on reasonable belief of pending default should be included. This allows the collateral manager to protect the noteholders since more defaults will trigger the par coverage rest and cause early partial redemption of the senior notes.
Absent properly defined events of default, the intent of the par coverage test to limit credit exposure to the senior notes is weakened. A collateral manager who manages to equity would be able to treat such severely distressed assets at par for purposes to the par coverage test to avoid delevering the deal and pass the proceeds to the equity investors.
Standard & Poor’s allows two carve-outs where obligations of an issuer with an ICR of ‘D’ or ‘SD’ are deemed performing. These carve-outs are debtor-in-possession (DIP) facilities and certain current pay instruments.
B. Synthetic CDOs
The CDO Evaluator measures the probability of default on an underlying instrument. The default matrix used is based on Standard & Poor’s Corporate Default history, but altered slightly to account for certain mathematical abnormalities and to yield consistent results. In order to put a credit estimate on a synthetic, the definition of default on the synthetic must be consistent with the definition of default used in the default study. In concept, the acceptable default definitions are as follows:
* Payment default on the reference obligation,
* Bankruptcy of the reference obligor,
* Material cross-default with another debt instrument (‘SD’), and
* Downgrade to ‘D’, or withdrawal, of the Standard & Poor’s rating.
Synthetic CDOs typically are transacted under the 1999 ISDA, which was designed explicitly for credit derivatives. The following “Credit Events” with regard to the reference obligation, sometimes referred to as “Big O”, are currently accepted by Standard & Poor’s in synthetic CDOs. They are broader than what is accepted for small baskets, which are typically weak-linked ratings. This difference is based on how dependant upon timing considerations the CDOs, the credit-linked notes (CLN), or single-name credit derivatives arc. An example is to say a company accelerates its debt due to a covenant violation. If obligation acceleration were to be called a credit event in a small basket CLN, the investor would automatically lose money at that moment. The synthetic CDO builds in the luxury of time in which we can wait to see if the acceleration was rescinded, or whether the debt was paid in full. If it was, the synthetic CDO investor suffers no loss. This is a simple but crucial example of why credit events may work for one but not the other structures.
It should not be misunderstood; the simplest and best credit derivative is the one that contains only bankruptcy and failure to pay. Each of the other credit events creates more fuzziness around the definition of default. However, the other credit events are largely captured in Standard & Poor’s default study. Some, however, are not as, for example, restructuring with regard to the unrated nonpublic loan market for which banks have not been able to supply Standard & Poor’s with default data and restructuring with regard to certain cases in which the restructuring constituted a downgraded but not default rating. Standard & Poor’s believes that the modification made to the Restructuring credit event goes a long way to solving some of the problems and thus accepts it as a credit event. Non-modified restructuring requires a probability adjustment to reflect the increased probability of experiencing a defaulted Reference Entity.
For corporate credit exposures, Standard & Poor’s allows the following credit event:
* Failure to pay, with the standard payment thresholds, and
* Obligation acceleration.
Obligation acceleration is accepted using the following logic: A trustee may declare an event of default for myriad reasons, but will initiate acceleration only if it is determined that fiduciary duty mandates action of that severity. Once a declaration of acceleration is made, it only qualifies as a “credit event” under the 1999 ISDA if knowledge of this acceleration is available via “Publicly Available Information” [WSJ, Bloomberg, etc.].
Such knowledge, it is assumed, will lead to massive action by lawyers to protect clients’ interests by initiating acceleration on all liabilities of the obligor in question. Thus, all obligations will immanently either be paid or defaulted upon. If default occurs, it is picked up in the default study. If all obligations are paid, the credit event ostensibly leads to settlement at par as long as you either have physical delivery or cash settlement outside of the window required for this to play out (45 business days or 60 calendar days has been deemed sufficient).
* Repudiation/moratorium: the sovereign rating captures the likelihood of moratorium. The rating of a corporate obligor is typically constrained by the sovereign’s rating.
* Restructuring is accepted with the potential probability adjustment noted above. Alternatively, further modifications to the language may be accepted so as to mitigate the added risk of the restructuring credit event. Restructuring only qualifies as a “credit event” if the publicly available sources requirement is retained in the ISDA.
Standard & Poor’s explicitly does not accept “Obligation Default”, as this includes all technical defaults such as interest coverage ratio violations, which are decidedly not equal to default as defined by Standard & Poor’s in the default study.
For structured finance obligations in synthetic CDOs, Standard & Poor’s limits the acceptable definition of default to:
* Bankruptcy of the SPE,
* Failure to pay within the stated payment terms, and
* Downgrade to ‘D’, or withdrawal, of the Standard & Poor’s rating. The other credit events are not consistent with structured finance structures, where the subordinated tranches are there to provide credit protection and may only receive distributions at the legal final maturity of the transaction.
Standard & Poor’s
Standard & Poor’s
NIK KHAKEE is a Director in Standard and Poor’s Structured Finance Group and serves as Global Co-Head of Derivative Ratings. He is also the Co-Head of CDO criteria and is primarily responsible for development and implementation of credit derivatives ratings criteria. Nik is also the senior analyst regarding credit enhanced Derivative Product Companies, Structured Investment Vehicles, Synthetic CDO’s, Credit Derivative Operating Vehicles and Quasi Operating Entities.
Nik joined Standard & Poor’s Financial Institutions Division in June 1996. Nik joined the Structured Finance Division’s Derivative Ratings Group in 1998. Prior to joining Standard & Poor’s, he worked in money management with a mutual fund family, a hedge fund and a business management firm. Nik received his Masters in Public and Private Management degree from Yale University’s School of Management in May 1996. His areas of concentration were Strategy and Finance. Nik received an academic letter of commendation from Yale. Nik was also selected by Yale to be a Strategy Case Series Writer and is the author of “Chase–The Strategic Plan for Recovery & Merger”. He received his Bachelor of Arts flora New York University where he graduated with honors.
ELWYN WONG is a Director in Standard and Poor’s CDO Group. He is an analyst responsible for credit enhanced Derivative Product Companies, Structured Investment Vehicles, Synthetic CDO’s, Credit Derivative Operating Vehicles and Quasi Operating Entities.
Prior to joining Standard and Poor’s, Elwyn was a Director in the Structured Finance Group of Prudential Securities, responsible for structuring, repackaging and hedging strategies associated with securitization across asset classes. He has extensive experience in the derivatives market managing fixed income and municipal derivative trading for a predecessor of Sumitomo Mitsui Banking Corporation Capital Markets. He was also involved in investment grade fixed income origination for Prudential Securities and Daiwa Securities. Elwyn began his career with Bankers Trust in their Asset Liability Management Division. He gradated with an M.B.A. in finance from Columbia Business School and a M.A. and B.A. in economics from Cambridge University.
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