FIAG Primer

Fixed Income Products and Analytics

Helix Advisors Pvt. Ltd.

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Primer – Bonds and Rates

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Contents (i) Overview (ii) Bond Characteristics

a. Issuer b. Priority c. Coupon Rate d. Redemption Features e. Day-Count Basis

(iii) Risks associated with investing in bonds (iv) Yield Curve

a. Treasury Yield Curve b. Spot Curve c. Forward Curve d. Libor Curve e. Swap Curve

(v) Bond Yield Measures a. Current Yield b. Yield to Maturity c. Yield to Call d. Yield to Worst

(vi) Interest Rate risk a. Duration b. Convexity

(vii) Discount Margin (viii) WAL of a bond (ix) Price of a bond – components (x) References

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Fixed income securities, historically, were promises to pay a stream of semiannual payments for a given number of years and then repay the loan amount at the maturity date. The contract between the borrower and the lender (the indenture) can really be designed to have any payment stream or pattern that the parties agree to. For example, if you borrow money and have to pay interest once a month, you have issued a fixed-income security. When a company does this, it is often called a bond or corporate bank debt The contract that specifies all the rights and obligations of the issuer and the owners of a fixed income security is called the bond indenture. The indenture defines the obligations of and restrictions on the borrower and forms the basis for all future transactions between the bondholder and the issuer. A "straight" (option-free) bond is the simplest case. Consider a Treasury bond that has a 6% coupon and matures five years from today in the amount of $ 1,000. This bond is a promise by the issuer (the U.S. Treasury) to pay 6% of the $ 1,000 par value (i.e., $60) each year for five years and to repay the $ 1,000 five years from today. With Treasury bonds and almost all U.S. corporate bonds, the annual interest is paid in two semiannual installments. Therefore, this bond will make nine coupon payments (one every six months) of $30 and a final payment of $1,030 (the par value plus the final coupon payment) at the end of five years. This stream of payments is fixed when the bonds are issued and does not change over the life of the bond. Note that each semiannual coupon is one-half the coupon rate (which is always expressed as an annual rate) times the par value. An 8% Treasury note with a face value of $ 100,000 will make a coupon payment of $4,000 every six months and a final payment of $ 104,000 at maturity. A U.S. Treasury bond is denominated (of course) in U.S. dollars. Bonds can be issued in other currencies as well. Before getting to the all-important subject of bond pricing, we must first understand the many different characteristics bonds can have. The classification of a bond depends on its type of issuer, priority, coupon rate and redemption features.

• Bond Issuers As the major determiner of a bond's credit quality, the issuer is one of the most important characteristics of a bond. There are significant differences between bonds issued by corporations and those issued by a state government/municipality or national government. In general, securities issued by the federal government have the lowest risk of default while corporate bonds are considered to be riskier ventures. Of course there are always exceptions to the rule. In rare instances, a very large and stable company could have a bond rating that is better than that of a municipality. It is important to point out, however, that like corporate bonds, government bonds carry various levels of risk; because all national governments are different, so are the bonds they issue.

o Treasury Bonds – Marketable securities from (example) the US Government. All debt issued by US is regarded as extremely safe, as is the debt of any stable country. The debt of many developing countries, however, does carry substantial risk. Like companies, countries can default on payments (read RUSSIAN FINANCIAL CRISIS, 1998).

o Municipal bonds - known as "munis", are the next progression in terms of risk.

Cities don't go bankrupt that often, but it can happen (Read ORANGE COUNTY bankruptcy, CALIFORNIA). The major advantage to munis is that the returns are free from federal tax. Furthermore, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely

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tax free. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond.

o Corporate Bonds - A company can issue bonds just as it can issue stock. Large

corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years. Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives.

o Mortgage Bonds - A bond secured by a mortgage on a property. Mortgage

bonds are backed by real estate or physical equipment that can be liquidated. The cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.

o International bonds (government or corporate) are complicated by different

currencies. That is, these types of bonds are issued within a market that is foreign to the issuer's home market, but some international bonds are issued in the currency of the foreign market and others are denominated in another currency. Here are some types of international bonds:

� The definition of the eurobond market can be confusing because of its name. Although the euro is the currency used by participating European Union countries, eurobonds refer neither to the European currency nor to a European bond market. A eurobond instead refers to any bond that is denominated in a currency other than that of the country in which it is issued. Bonds in the eurobond market are categorized according to the currency in which they are denominated. As an example, a eurobond denominated in Japanese yen but issued in the U.S. would be classified as a euroyen bond.

� Foreign bonds are denominated in the currency of the country in which a foreign entity issues the bond. An example of such a bond is the samurai bond, which is a yen-denominated bond issued in Japan by an American company. Other popular foreign bonds include bulldog and yankee bonds.

� Global bonds are structured so that they can be offered in both foreign and eurobond markets. Essentially, global bonds are similar to eurobonds but can be offered within the country whose currency is used to denominate the bond. As an example, a global bond denominated in yen could be sold to Japan or any other country throughout the Eurobond market.

• Priority In addition to the credit quality of the issuer, the priority of the bond is a determiner of the probability that the issuer will pay you back your money. The priority indicates your place in line should the company default on payments. If you hold an unsubordinated (senior) security and the company defaults, you will be first in line to receive payment from the liquidation of its assets. On the other hand, if you own a subordinated (junior) debt security, you will get paid out only after the senior debt holders have received their share.

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• Coupon Rate Bond issuers may choose from a variety of types of coupons, or interest payments.

o Straight, plain vanilla or fixed-rate bonds pay an absolute coupon rate over a specified period of time. Upon maturity, the last coupon payment is made along with the par value of the bond.

o Floating rate debt instruments or floaters pay a coupon rate that varies according to the movement of the underlying benchmark. These types of coupons could, however, be set to be a fixed percentage above, below, or equal to the benchmark itself. Floaters typically follow benchmarks such as the three, six or nine-month T-bill rate or LIBOR. For example, if market interest rates are moving up, the coupons on straight floaters will rise as well. In essence, these bonds have coupons that are reset periodically (normally every 3, 6, or 12 months) based on prevailing market interest rates. The most common procedure for setting the coupon rates on floating-rate securities is one which starts with a reference rate (such as the rate on certain U.S. Treasury securities or the London Interbank Offered Rate LIBOR)) and then adds or subtracts a stated margin to or from that reference rate. The quoted margin may also vary over time according to a schedule that is stated in the indenture. The schedule is often referred to as the coupon formula. Thus, to find the new coupon rate, you would use the following coupon formula: new coupon rate = reference rate +/- quoted margin .Just as with a fixed-coupon bond, a semiannual coupon payment will be one-half the (annual) coupon rate.

� Caps and floors. The parties to the bond contract can limit their exposure to extreme fluctuations in the reference rate by placing upper and lower limits on the coupon rate. The upper limit, which is called a cap, puts a maximum on the interest rate paid by the borrower/ issuer. The lower limit, called a floor, puts a minimum on the periodic coupon interest payments received by the lender/ security owner. When both limits are present simultaneously, the combination is called a collar. Consider a floating-rate security (floater) with a coupon rate at issuance of 5%, a 7% cap, and a 3% floor. If the coupon rate (reference rate plus the margin) rises above 7% , the borrower will pay (lender will receive ) only 7%

o Inverse floaters pay a variable coupon rate that changes in direction opposite to that of short-term interest rates. An inverse floater subtracts the benchmark from a set coupon rate. For example, an inverse floater that uses LIBOR as the underlying benchmark might pay a coupon rate of a certain percentage; say 6%, minus LIBOR.

o Zero coupon, or accrual bonds do not pay a coupon. Instead, these types of bonds are issued at a deep discount and pay the full face value at maturity.

o Accrual bonds are similar to zero-coupon bonds in that they make no periodic interest payments prior to maturity, but different in that they are sold originally at (or close to) par value. There is a stated coupon rate, but the coupon interest accrues (builds up) at a compound rate until maturity. At maturity, the par value, plus all of the interest that has accrued over the life of the bond, is paid.

o Step-up notes have coupon rates that increase over time at a specified rate. The increase may take place once or more during the life of the issue.

o Deferred-coupon bonds carry coupons, but the initial coupon payments are deferred for some period. The coupon payments accrue, at a compound rate, over the deferral period and are paid as a lump sum at the end of that period. After the initial deferment period has passed, these bonds pay regular coupon interest for the rest of the life of the issue (to maturity).

• Redemption Features

Both investors and issuers are exposed to interest rate risk because they are locked into

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either receiving or paying a set coupon rate over a specified period of time. For this reason, some bonds offer additional benefits to investors or more flexibility for issuers:

o Callable, or a redeemable bond features gives a bond issuer the right, but not the obligation, to redeem his issue of bonds before the bond's maturity. The issuer, however, must pay the bond holders a premium. There are two subcategories of these types of bonds: American callable bonds and European callable bonds. American callable bonds can be called by the issuer any time after the call protection period while European callable bonds can be called by the issuer only on pre-specified dates. The optimal time for issuers to call their bonds is when the prevailing interest rate is lower than the coupon rate they are paying on the bonds. After calling its bonds, the company could refinance its debt by reissuing bonds at a lower coupon rate.

o Convertible bonds give bondholders the right but not the obligation to convert their bonds into a predetermined number of shares at predetermined dates prior to the bond's maturity. Of course, this only applies to corporate bonds.

o Puttable bonds give bondholders the right but not the obligation to sell their bonds back to the issuer at a predetermined price and date. These bonds generally protect investors from interest rate risk. If prevailing bond prices are lower than the exercise par of the bond, resulting from interest rates being higher than the bond's coupon rate, it is optimal for investors to sell their bonds back to the issuer and reinvest their money at a higher interest rate.

• DCB (Day Count Convention) A system used to determine the number of days between two coupon dates, which is important in calculating accrued interest and present value when the next coupon payment is less than a full coupon period away. Each bond market has its own day-count convention. There are several different types of day-count conventions. For example, a 30/360 day-count convention assumes there are 30 days in a month and 360 days in a year. An actual/actual day-count convention uses the actual number of days in the month and year for a given interest period. This concept might sound illogical. After all, regardless of the particular bond market there will always be 365 days in a year! Nevertheless, these conventions are standards that have developed over time and help to ensure that everybody is on an even playing field when a bond is sold between coupon dates.

o 30 / 360

The 30/360 day-count method is used in the U.S. for most corporate, agency, and municipal bonds and for mortgage-backed securities. It is sometimes used for floating-rate notes and short-term CDs.

To find the size of an interest period, use this formula:

360(Y2-Y1)+30(M2-M1)+(D2-D1) where Yn is the year, Mn is the month, and Dn is the number of days. However, if D1=31, set D1=30. If D2 is 31 and D1 is 30 or 31, change D2 to 30; otherwise, leave at 31.

For example, there are 29 days between May 1 and May 30 and 30 days between May 1 and May 31.

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To calculate the number of days in a normal coupon period, multiply the number of calendar months in the period by 30.

o 30E / 360

The 30E/360 day-count method is used for Eurobonds and many foreign government bonds.

To find the size of an interest period, use this formula:

360(Y2-Y1)+30(M2-M1)+(D2-D1) where Yn is the year, Mn is the month, and Dn is the number of days. However,if Dn=31, set Dn=30.

For example, there are 29 days between May 1 and May 30, and 29 days between May 1 and May 31, since D2 was changed to 30.

To calculate the number of days in a normal coupon period, multiply the number of calendar months in the period by 30.

o Actual / Actual

The actual/actual day-count method is used primarily to calculate U.S. government notes and bonds, but may also be used to calculate foreign government bonds and floating-rate notes.

When calculating a fraction of the normal coupon period, the actual number of calendar days in the interest period is used as the number of days for which interest is paid, and the actual number of calendar days in the normal coupon period is used as the denominator.

o Actual / 365

The actual/365 day-count method is used primarily to calculate Treasury bond equivalent yields for U.S. Treasury bills, but may also be used to calculate foreign government bonds and floating-rate notes.

When calculating a fraction of the normal coupon period, the actual number of calendar days in the interest period is used as the number of days for which interest is paid, and 365 is used as the denominator.

o Actual / 360

The actual/360 day-count method is used mainly for money-market securities: medium-term CDs, short-term CDs, and floating-rate notes. The U.S. Treasury bill dollar discount is also calculated using this method.

When calculating a fraction of the normal coupon period, the actual number of calendar days in the interest period is used as the number of days for which interest is paid. The denominator is 360 (12 months of 30 days each).

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Risks Associated With Investing In Bonds

Interest rate risk refers to the effect of changes in the prevailing market rate of interest on bond values. When interest rates rise, bond values fall. This is the source of interest rate risk which is approximated by a measure called duration.

o Recall that floating-rate securities have a coupon rate that "floats," in that it is periodically reset based on a market-determined reference rate. The objective of the resetting mechanism is to bring the coupon rate in line with the current market yield so the bond sells at or near its par value. This will make the price of a floating-rate security much less sensitive to changes in market yields than a fixed-coupon bond of equal maturity. That's the point of a floating-rate security: less interest rate risk. Between coupon dates, there is a time lag between any change in market yield and a change in the coupon rate (which happens on the reset date). The longer the time period between the two dates, the greater the amount of potential bond price fluctuation. In general, we can say that the longer (shorter) the reset period, the greater (less) the interest rate risk of a floating-rate security at any reset date. The presence of a cap (maximum coupon rate) can increase the interest rate risk of a floating-rate security. If the reference rate increases enough that the cap rate is reached, further increases in market yields will decrease the floater's price. When the market yield is above its capped coupon rate, a floating-rate security will trade at a discount. To the extent that the cap fixes the coupon rate on the floater, its price sensitivity to changes in market yield will be increased. This is sometimes referred to as cap risk. A floater's price can also differ from par due to the fact that the margin is fixed at issuance. Consider a firm that has issued floating-rate debt with a coupon formula of LIBOR + 2%. This 2% margin should reflect the credit risk and liquidity risk of the security. If the firm's creditworthiness improves, the floater is less risky and will trade at a premium to par. Even if the firm's creditworthiness remains constant, a change in the market's required yield premium for the firm's risk level will cause the value of the floater to differ from par.

Yield curve risk arises from the possibility of changes in the shape of the yield curve (which shows the relation between bond yields and maturity). While duration is a useful measure of interest rate risk for equal changes in yield at every maturity (parallel changes in the yield curve), changes in the shape of the yield curve mean that yields change by different amounts for bonds with different maturities. Call risk arises from the fact that when interest rates fall, a callable bond investor's principal may be returned and must be reinvested at the new lower rates. Certainly bonds that are not callable have no call risk, and call protection reduces call risk. When interest rates are more volatile, callable bonds have relatively more call risk because of an increased probability of yields falling to a level where the bonds will be called. Prepayment risk is similar to call risk. Prepayments are principal repayments in excess of those required on amortizing loans, such as residential mortgages. If rates fall, causing prepayments to increase, an investor must reinvest these prepayments at the new lower rate. Just as with call risk, an increase in interest rate volatility increases prepayment risk. Reinvestment risk refers to the fact that when market rates fall, the cash flows (both interest and principal) from fixed-income securities must be reinvested at lower rates, reducing the returns an investor will earn. Note that reinvestment risk is related to call risk and prepayment risk. In both of these cases, it is the reinvestment of principal cash flows at lower rates than were expected that negatively impacts the investor. Coupon bonds that contain neither call nor prepayment provisions will also be subject to reinvestment risk, since the coupon interest payments must be reinvested as they are received.

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Note that investors can be faced with a choice between reinvestment risk and price risk. A non-callable zero-coupon bond has no reinvestment risk over its life since there are no cash flows to reinvest, but a zero coupon bond has more interest rate risk than a coupon bond of the same maturity. Therefore, the coupon bond will have more reinvestment risk and less price risk. Credit risk is the risk that the creditworthiness of a fixed -income security's issuer will deteriorate, increasing the required return and decreasing the security's value. Liquidity risk has to do with the risk that the sale of a fixed -income security must be made at a price less than fair market value because of a lack of liquidity for a particular issue. Treasury bonds have excellent liquidity, so selling a few million dollars worth at the prevailing market price can be easily and quickly accomplished. At the other end of the liquidity spectrum, a valuable painting, collectible antique automobile, or unique and expensive home may be quite difficult to sell quickly at fair-market value. Since investors prefer more liquidity to less, a decrease in a security's liquidity will decrease its price, as the required yield will be higher. Exchange-rate risk arises from the uncertainty about the value of foreign currency cash flows to an investor in terms of his home-country currency. While a U. S. Treasury bill (T- bill) may be considered quite low risk or even risk-free to a U.S.-based investor, the value of the T-bill to a European investor will be reduced by a depreciation of the U.S. dollar's value relative to the euro. Inflation risk might be better described as unexpected inflation risk and even more descriptively as purchasing power risk. While a $ 10,000 zero-coupon Treasury bond can provide a payment of $ 10,000 in the future with (almost) certainty, there is uncertainty about the amount of goods and services that $ 10,000 will buy at the future date. This uncertainty about the amount of goods and services that a security's cash flows will purchase is referred to here as inflation risk. Volatility risk is present for fixed-income securities that have embedded options, such as call options, prepayment options, or put options. Changes in interest rate volatility affect the value of these options and thus affect the values of securities with embedded options. Event risk encompasses the risks outside the risks of financial markets, such as the risks posed by natural disasters and corporate takeovers. Sovereign risk refers to changes in governmental attitudes and policies toward the repayment and servicing of debt. Governments may impose restrictions on the outflows of foreign exchange to service debt even by private borrowers. Foreign municipalities may adopt different payment policies due to varying political priorities. A change in government may lead to a refusal to repay debt incurred by a prior regime. Remember, the quality of a debt obligation depends not only on the borrower's ability to repay but also on the borrower's desire or willingness to repay. This is true of sovereign debt as well, and we can think of sovereign risk as having two components: a change in a government's willingness to repay and a change in a country's ability to repay. The second component has been the important one in most defaults and downgrades of sovereign debt. Relationships among a bond's coupon rate, the yield required by the market, and the bond's price relative to par value When the coupon rate on a bond is equal to its market yield, the bond will trade at its par value. When issued, the coupon rate on bonds is typically set at or near the prevailing market yield on similar bonds so that the bonds trade initially at or near their par value. If the yield required in the market for the bond subsequently rises, the price of the bond will fall and it will trade at a discount to (below) its par value. Conversely, if the required yield falls, the bond price will increase and the bond will trade at a premium to (above) its par value.

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Yield Curve A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity.

There are four general shapes that we use to describe yield curves: • Normal or upward sloping. • Inverted or downward sloping. • Flat. • Humped.

However, Yield curves can take on just about any shape

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The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates. (see, US Treasuries on http://www.bloomberg.com/markets/rates/index.html)

The appropriate discount rates for the promised payments from a Treasury bond at different times in the future are called Treasury spot rates. The spot rates for different time periods that correctly value (produce a value equal to market price) a Treasury bond are called arbitrage-free Treasury spot rates, or the theoretical Treasury spot rate curve. Conceptually, spot rates are the discount rates for (yields on) zero-coupon bonds, securities that have only a single cash flow at a future date Let’s do this again, a spot interest rate for maturity m is an interest rate payable on a spot loan of maturity m that accumulates interest to maturity. Spot rates are sometimes called zero-coupon rates because they are the rates of interest payable on obligations that accumulate all interest to maturity. Libor [The London Interbank Offered Rate, a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market)] rates for maturities of a week or more are spot rates (GBP Libor is an exception). Table below indicates USD Libor rates for monthly maturities as of different dates in March, 2008.

USD 3-Mar 4-Mar 5-Mar 6-Mar 7-Mar 10-Mar

s/n-o/n 3.153% 3.160% 3.153% 3.116% 3.094% 3.096%

1w 3.136% 3.134% 3.134% 3.128% 3.107% 3.080%

2w 3.133% 3.125% 3.121% 3.111% 3.062% 3.003%

1m 3.086% 3.080% 3.075% 3.058% 3.000% 2.935%

2m 3.043% 3.042% 3.039% 3.029% 2.981% 2.920%

3m 3.014% 3.008% 3.000% 2.990% 2.939% 2.901%

4m 2.966% 2.964% 2.960% 2.960% 2.886% 2.862%

5m 2.913% 2.920% 2.925% 2.929% 2.836% 2.821%

6m 2.863% 2.877% 2.893% 2.893% 2.784% 2.781%7m 2.810% 2.830% 2.845% 2.845% 2.739% 2.735%

8m 2.756% 2.782% 2.796% 2.798% 2.687% 2.690%

9m 2.706% 2.735% 2.746% 2.754% 2.636% 2.644%

10m 2.678% 2.706% 2.716% 2.729% 2.616% 2.626%

11m 2.651% 2.679% 2.690% 2.707% 2.599% 2.606%12m 2.626% 2.658% 2.668% 2.686% 2.575% 2.589%

Source BBA

See: http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=141&a=627 http://www.bankrate.com/brm/ratewatch/other-indices.asp

A spot curve (or zero-coupon curve) is a graph of spot rates as a function of maturity.

A forward rate is a borrowing/lending rate for a loan to be made at some future date. Alternatively, the amount that it will cost to deliver a currency, commodity, or some other asset some time in the future.

The notation used must identify both the length of the lending/borrowing period and when in the future the money will be loaned/ borrowed. Thus 1f1 is the rate for a 1-year loan one year from now and 1f2 is the rate for a 1-year loan to be made two years from now, etc. Rather than introduce a separate notation, we can represent the current 1-year rate(1 year spot) as 1f0. To get the present values of a bond's expected cash flows, we need to discount each cash flow by the forward rates for each of the periods until it is received.

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The idea here is that borrowing for three years at the 3-year rate or borrowing for 1 -year periods, three years in succession, should have the same cost. This relation is illustrated as (1+S3)^3 = (1 + 1f0)(1+ 1f1) (1+ 1f2 ) where S3 is the 3 year spot rate. In the image below, USD Libor Forward curves as of 15

th April 08 are given

Period LIBOR 1M LIBOR 3M LIBOR 6M LIBOR 1YR

0 2.51% 2.72% 2.94% 3.17%

1 2.76% 2.89% 3.05% 3.25%

2 2.88% 3.00% 3.13% 3.30%

3 3.00% 3.14% 3.21% 3.35%

4 3.11% 3.20% 3.27% 3.40%

5 3.27% 3.24% 3.33% 3.43%

6 3.18% 3.26% 3.35% 3.46%

7 3.24% 3.32% 3.39% 3.49%

8 3.32% 3.38% 3.42% 3.52%9 3.37% 3.41% 3.44% 3.55%

10 3.43% 3.42% 3.46% 3.59%

11 3.40% 3.43% 3.48% 3.62%

12 3.41% 3.45% 3.51% 3.65%

13 3.44% 3.47% 3.54% 3.70%

14 3.46% 3.50% 3.57% 3.75%

15 3.49% 3.53% 3.60% 3.80%

16 3.52% 3.57% 3.64% 3.85%

17 3.55% 3.60% 3.69% 3.91%

18 3.59% 3.64% 3.74% 3.97%

19 3.63% 3.69% 3.79% 4.04%

20 3.67% 3.74% 3.86% 4.10%

21 3.73% 3.80% 3.92% 4.16%

22 3.78% 3.86% 3.99% 4.23%23 3.85% 3.94% 4.06% 4.29%

The Swap Curve The fixed rates on vanilla swaps(a cash-settled OTC derivative under which two counterparties exchange two streams of cash flows. It is called an interest rate swap if both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations) are called swap rates. The swap curve is a yield curve comprising swap rates for different maturities of swap. Due to high liquidity in the USD swap market, the swap curve has emerged as an alternative to Treasuries as a benchmark for USD interest rates at maturities exceeding a year. So, how is a Libor Curve different from a Swap Curve? For one, Swap Curve is a coupon bearing curve while Libor is a zero coupon curve. Two, Swap rates are quoted on a BEY basis while Libor is quoted on monthly*12 basis.

Bond Yield Measures The income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value. Current yield is the simplest of all return measures, but it offers limited information. This measure looks at just one source of return: a bond's annual interest income-it does not consider capital gains/losses or reinvestment income. The formula for the current yield is:

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current yield = annual cash coupon payment / current bond price

Yield to maturity (YTM) is an annualized internal rate of return, based on a bond's price and its promised cash flows. For a bond with semiannual coupon payments, the yield to maturity is stated as two times the semiannual internal rate of return implied by the bond's price. The formula that relates bond price and YTM for a semiannual coupon bond is: Bond price = CPN1/(1+ YTM/2) + CPN2/[(1+ YTM/2)^2] + ….+ (CPN2n + Par)/[(1+ YTM/2)^2n] Where CPNt = the (semiannual) coupon payment received after t semiannual periods n = number of years to maturity YTM = yield to maturity

YTM and price contain the same information. That is, given the YTM, you can calculate the price and given the price, you can calculate the YTM. We cannot easily solve for YTM from the bond price. Given a bond price and the coupon payment amount, we could solve it by trial and error, trying different values of YTM until the present value of the expected cash flows is equal to price. The yield to maturity used in the previous equation (2 X the semiannual discount rate) is referred to as a bond equivalent yield (BEY), because most bonds issued in US pay semi-annual coupon and thus cash flows are compounded semi-annually. Similarly, Mortgage Equivalent Yield (MEY) can be described, where the compounding has to be done monthly because typical mortgages and mortgage back securities pay monthly. The yield to call is used to calculate the yield on callable bonds that are selling at a premium to par. For bonds trading at a premium to par, the yield to call may be less than the yield to maturity. This can be the case when the call price is below the current market price. The yield to worst is the worst yield outcome of any that are possible given the call provisions of the bond.

Interest Rate Risk….again The duration /convexity approach provides an approximation of the actual interest rate sensitivity of a bond or bond portfolio. Its main advantage is its simplicity. Limiting our scenarios to parallel yield curve shifts and "settling" for an estimate of interest rate risk allows us to use the summary measures, duration, and convexity. This greatly simplifies the process of estimating the value impact of overall changes in yield. The relation between price and yield for a straight coupon bond is negative. An increase in yield (discount rate) leads to a decrease in the value of a bond. The precise nature of this relationship for an option-free, 8%, 20-year bond is illustrated in the figure below.

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First, note that the price-yield relationship is negatively sloped, so the price falls as the yield rises. Second, note that the relation follows a curve, not a straight line. Since the curve is convex (toward the origin) we say that an option-free bond has positive convexity. Because of convexity, the price of an option-free bond increases more when yields fall than it decreases when yields rises. Convexity is a good thing for a bond owner: for a given volatility of yields, price increases are larger than price decreases. The convexity property is often expressed by saying, "a bond's price falls at a decreasing rate as yields rise." For the price-yield relationship to be convex, the slope (rate of decrease) of the curve must be decreasing as we move from left to right [i.e., towards higher yields). Note that the duration (interest rate sensitivity) of a bond at any yield is the (absolute value of) the slope of the price-yield function at that yield. The convexity of the price-yield relation for an option-free bond can help you remember a result presented earlier, that the duration of a bond is less at higher market yields. With a callable or pre-payable debt, the upside price appreciation in response to decreasing yields is limited (sometimes called price compression). Consider the case of a bond that is currently callable at 102. The fact that the issuer can call the bond at any time for $ 1,020 per $ 1,000 of face value puts an effective upper limit on the value of the bond. As the figure below illustrates, as yields fall and the price approaches $ 1,020, the price-yield curve rises more slowly than that of an identical but non-callable bond. When the price begins to rise at a decreasing rate in response to further decreases in yield, the price-yield curve "bends over" to the left and exhibits negative convexity. Thus, in the figure below, so long as yields remain below level y', callable bonds will exhibit negative convexity; however, at yields above level y', those same callable bonds will exhibit positive convexity. In other words, at higher yields the value of the call options becomes very small so that a callable bond will act very much like a non-callable bond. It is only at lower yields that the callable bond will exhibit negative convexity.

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In terms of price sensitivity to interest rate changes, the slope of the price-yield curve at any particular yield tells the story. Note that as yields fall, the slope of the price-yield curve for the callable bond decreases, becoming almost zero (flat) at very low yields. This tells us how a call feature affects price sensitivity to changes in yield. At higher yields, the interest rate risk of a callable bond is very close or identical to that of a similar option-free bond. At lower yields, the price volatility of the callable bond will be much lower than that of an identical but noncallable bond. The effect of a prepayment option is quite similar to that of a call; at low yields it will lead to negative convexity and reduce the price volatility (interest rate risk) of the security. Note that when yields are low and callable and prepayable securities exhibit less interest rate risk, reinvestment risk rises. At lower yields the probability of a call and the prepayment rate both rise, increasing the risk of having to reinvest principal repayments at the lower rates. Duration is described as the ratio of the percentage change in price to change in yield. We know that the price change in response to rising rates is smaller than the price change in response to falling rates for option-free bonds. The formula used for calculating the effective duration of a bond uses the average of the price changes in response to equal increases and decreases in yield to account for this fact. The formula for calculating the effective duration of a bond is:

Effective duration = (bond price when yields fall – bond price when yields rise) / (2 * initial price * change in yield in decimal form) =(V_ - V+) / (2 * Vo * ∆y) Where V_ = bond value if the yield decreases by ∆y V+ = bond value if the yield increases by ∆y Vo = intial bond price ∆y = Change in yield used to get to V_ and V+, expressed in decimal form

So, percentage change in bond price = - effective duration x change in yield in percent

- 17 -

Macaulay duration is an estimate of a bond's interest rat e sensitivity based on the time, in years, until promised cash flows will arrive. Since a 5-year zero -coupon bond has only one cash flow five years from today, its Macaulay duration is five. The change in value in response to a 1% change in yield for a 5-year zero -coupon bond is approximately 5%. A 5-year coupon bond has some cash flows that arrive earlier than five years from today (the coupons), so its Macaulay duration is less than five. This is consistent with what was stated earlier: the higher the coupon, the less the price sensitivity (duration) of a bond. Macaulay duration is the earliest measure of duration, and because it was based on the time, duration is often stated as years. Because Macaulay duration is based on the expected cash flows for an option-free bond, it is not an appropriate estimate of the price sensitivity of bonds with embedded options. Modified duration is derived from Macaulay duration and offers a slight improvement over Macaulay duration in that it takes the current YTM into account. Like Macaulay duration, and for the same reasons, modified duration is not an appropriate measure of interest rate sensitivity for bonds with embedded options. For option-free bonds, however, effective duration (based on small changes in YTM) and modified duration will be very similar. Modified Duration = Macaulay Duration / (1 + periodic Market Yield) Interpreting Duration We can interpret duration in three different ways. First, duration is the slope of the price-yield curve at the bond's current YTM. Mathematically, the slope of the price-yield curve is the first derivative of the price-yield curve with respect to yield. A second interpretation of duration, as originally developed by Macaulay, is a weighted average of the time (in years) until each cash flow will be received. The weights are the proportions of the total bond value that each cash flow represents. The answer, again, comes in years. A third interpretation of duration is the approximate percentage change in price for a 1% change in yield. This interpretation, price sensitivity in response to a change in yield, is the preferred, and most intuitive, interpretation of duration. Convexity is a measure of the curvature of the price-yield curve. The more curved the price-yield relation is, the greater the convexity. A straight line has a convexity of zero. If the price-yield curve were, in fact, a straight line, the convexity would be zero. The reason we care about convexity is that the more curved the price-yield relation is, the worse our duration-based estimates of bond price changes in response to changes in yield are. As an example, consider an 8%, 20-year Treasury bond priced at $908 so that it has a yield to maturity of 9%. Calculated effective duration at 9% yield of this bond is 9.42. Figure below illustrates the differences between actual bond price changes and duration-based estimates of price changes at different yield levels.

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Based on a value of 9.42 for duration, we would estimate the new prices after 1% changes in yield (to 8% and to 10 %) as 1.0942 X 908 = $993.53 and (1 - 0 .0942) X 908 = $822.47, respectively. These price estimates are shown in the Figure along the straight line tangent to the actual price-yield curve. The actual price of the 8% bond at a YTM of 8% is, of course, par value ($ 1,000). Based on a YTM of 10 %, the actual price of the bond is $828.41, about $6 higher than our duration based estimate of $822.47. Note that price estimates based on duration are less than the actual prices for both a 1% increase and a 1% decrease in yield. The Figure illustrates why convexity is important and why estimates of price changes based solely on duration are inaccurate. If the price-yield relation were a straight line (i.e., if convexity were zero), duration alone would provide good estimates of bond price changes for changes in yield of any magnitude. The greater the convexity, the greater the error in price estimates based solely on duration. A method of incorporating convexity into our estimates of bond price changes in response to yield changes is the subject of the next LOS. A Bond's Approximate Percentage Price Change Based on Duration and Convexity By combining duration and convexity we can obtain a more accurate estimate of the percentage change in price of a bond, especially for relatively large changes in yield. The formula for estimating a bond's percentage price change based on its convexity and duration is: Percentage change in price = duration effect +convexity effect = {[-duration * (∆y) ] + [ convexity * (∆y)2 ]} * 100 With ∆y entered as a decimal, the "* 100" is necessary to get an answer in percent

There are a few points worth noting here. First, the convexity adjustment is always positive when convexity is positive because (∆y)2 is always positive. This goes along with the illustration in the Figure above, which shows that the duration-only based estimate of a bond's price change suffered from being an underestimate of the percentage in crease in the bond price when yields fell, and an overestimate of the percentage decrease in the bond price when yields rose. Recall, that for a callable bond, convexity can be negative at low yields. When convexity is negative, the convexity adjustment to the duration-only based estimate of the percentage price change will be negative for both yield increases and yield decreases. Effective convexity takes into account changes in cash flows due to embedded options, while modified convexity does not. The difference between modified convexity and effective convexity mirrors the difference between modified duration and effective duration. Recall that modified duration is calculated without any adjustment to a bond's cash flows for embedded options. Also

- 19 -

recall that effective duration was appropriate for bonds with embedded options because the inputs (prices) were calculated under the assumption that the cash flows could vary at different yields because of the embedded options in the securities. Clearly, effective convexity is the appropriate measure to use for bonds with embedded options, since it is based on bond values that incorporate the effect of embedded options on the bond's cash flows.

Discount Margin (DM) The return earned in addition to the index underlying the floating rate security. The size of the discount margin depends on the price of the floating rate security. There are three basic situations: 1. If the price of a floater is equal to par, the investor's discount margin would be equal to the reset margin. 2. Due to the tendency for bond prices to converge to par as the bond reaches maturity, the investor can make an additional return over the reset margin if the floating rate bond was priced at a discount. The additional return plus the reset margin equals the discount margin. 3. Should the floating rate bond be priced above par, the discount margin would equal the reference rate less the reduced earnings. The DM is the spread that, when added to the bond's current reference rate, will equate the bond's cash flows to its current price.

Weighted Average Life (WAL) The Weighted-Average Life (WAL) of an amortizing loan or amortizing bond is the weighted average of the times of the principal repayments: it's the average time until a dollar of principal is repaid. The time weightings are based on the principal pay downs - the higher the dollar amount, the more weight that corresponding time period will have. For example, if the majority of the repayment amount is in 10 years the WAL will be closer to 10 years. Let's say there's an outstanding bond with five years of $1,000 annual payments. The weighted average life would be three years, assuming payment is made at the end of each year. WAL is a measure of credit risk in an amortizing loan, bearing in mind that the main credit risk of a loan is the risk of loss of principal. WAL should not be used to calculate interest rate risk, as it only includes the principal payments, omitting interest payments. Instead, one should use bond duration, which takes the average of all cash flows.

Pricing a bond Like any other fixed income security, bonds are valued by calculating the present value of each cash flow(coupon + maturity payment) from the bond. There really are just two aspects to pricing a bond: (1) Estimating the cash flows from the bond and (2) Using the correct discount rates to calculate the PVs of every cash flow. Estimating the cash flow from a bond can vary from being very straight-forward (like for Treasury bonds) to very difficult (like mortgage backed bonds) and very uncertain (risky corporate bonds). So, this can be similar to just some basic formulas in MS Excel to a little sophisticated with probabilities of default being accounted for and more complex like MBS which have rule based and trigger-dependent payment of principal and interest.

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Another important aspect is to arrive at the discount rates to be used – Which spread to use over which curve or point on curve. Here are some benchmarks that exist in the market w.r.t pricing

• High-Yield Bonds: High-yield bonds are usually priced at a nominal yield spread to a specific on-the-run U.S. Treasury bond. However, sometimes when the credit rating and outlook of a high-yield bond deteriorates, the bond will start to trade at an actual dollar price. For example, such a bond trades at $75.875 as opposed to 500 basis points over the 10-year Treasury.

• Corporate Bonds: A corporate bond is usually priced at a nominal yield spread to a specific on-the-run U.S. Treasury bond that matches its maturity. For example, 10-year corporate bonds are priced to the 10-year Treasury.

• Mortgage-Backed Securities: There are many different types of MBS. Many of them trade at a nominal yield spread at their weighted average life to the U.S. Treasury I-curve(the interpolated Yield Curve). Some adjustable-rate MBS trade at a DM, others trade at a Z-spread. Some CMOs trade at a nominal yield spread to a specific Treasury. For example, a 10-year planned amortization class bond might trade at a nominal yield spread to the on-the-run 10-year Treasury, or Z-bond might trade at a nominal yield spread to the on-the-run 30-year Treasury. Because MBS have embedded call options (borrowers have the free option of prepaying their mortgages), they are frequently evaluated using an OAS.

• Asset-Backed Securities: ABS frequently trade at a nominal yield spread at their weighted average life to the swap curve.

• Collateralized Debt Obligations: Like the MBS and ABS that frequently back CDOs, there are many different pricing benchmarks and yield measures used to price CDOs. The Eurodollar(early half of a swap curve, for more see “Swap Curve Construction”) curve is sometimes used as a benchmark. Discount margins are used on floating rate tranches. OAS calculations are made for relative value analysis.

• Municipal Bonds: Because of the tax advantages of municipal bonds (usually not taxable), their yields are not as highly correlated with U.S. Treasury yields as other bonds. Therefore, munis frequently trade on an outright yield to maturity or even a dollar price. However, a muni's yield as a ratio to a benchmark Treasury yield is sometimes used as a relative value measure.

References Glossary http://www.pimco.com/LeftNav/BondResources/Glossary/A.htm http://www.ejv.com/bp/html/glossary3.html Labs http://www.cba.ua.edu/~rpascala/bond/BondForm.php Gyaan Temples http://www.riskglossary.com http://www.investopedia.com http://www.yieldcurve.com http://seekingalpha.com

Structured Finance


Contents (i) Introduction (ii) Motivation behind development of SF industry

a. Originator b. Investor c. National Economy

(iii) Evolution of Market a. US b. Europe c. India

(iv) Securitization Process (v) Credit Enhancement

a. Internal b. External

(vi) Market Participants (vii) What can be securitized (viii) Introduction: CMBS, RMBS, CDO. (ix) Structure: Credit card ABS. (x) Liability Structure

a. Z-Bonds b. PAC & TAC Bonds c. Companion bonds d. Stripped Mortgage Backed Security e. Floating rate bonds.

Introduction

A service offered by many large financial institutions for companies with very unique financing needs which does not match conventional financial products such as a loan. These tailor-made securities go beyond "standard" securities like conventional loans, debentures, debt, and equity. The essence of structured finance is that it takes pools of undifferentiated risks and parcels them out into debt instruments with different risk profiles. The efficiency in this process is that it allows different investors with different interests and risk appetites to purchase exactly the risks they want.

Motivation behind Structured Finance Industry:

Originator:

• Assets are removed from balance sheet increasing the scope for borrowing, servicing.

• Reduced financing cost by structuring a security of higher credit quality. • Means of raising public debt without disclosure of information. • Improved asset liability management by transferring of funding mismatch

risk. • Credit Worthiness of borrower is not a problem.(If a bank wants to

borrow it can securitize its assets and in such case the creditworthiness of the bank is not a problem as it is the cash flow from the collateral).

Investors:

• Superior Spread vis-à-vis debt of similar rating. • Opportunity to diversify portfolio by participating in different asset

classes. • Mitigation of event risk as high rated ABS are immune from event risk.

National Economy:

• Capital market development due to addition of high quality securities. to the fixed income market.

• Source of funds for rapidly growing capital constrained banks, finance and industrial companies

Evolution of Market

US Market:

• The growth of US Structured Finance Industry stems in large part due to active role of government agencies like Fannie Mae, Ginnie Mae, and Freddie Mac.

• Ginnie Mae and Fannie Mae have emerged as major operators in the secondary market and they together purchase roughly half of the residential Mortgage debt originated in US every year.

European Market: • Dates back to mid 1980’s with the issuance of MBS IN the UK market. • Driven by Centralized Mortgage lenders with mortgage capabilities far in

excess of what they could book in their balance sheet. • Enabling laws and regulations in France, Italy, Spain and Belgium have

been the leading factors in growth of proprietary securitization since early 1990’s.

• One of the most significant regulatory change was in Mat 1998 when German banks were given authorization to securitize their own loans.

Current Market Size $5 Trillion as of June 30 2006.(Source: Credit Market Ratings Fitch).

India:

• Although a new concept in India it is gaining ground rapidly. • Issuance volume in Indian Structured Finance Market was Rs. 269 billion

during 2007. • ABS is the dominant instrument in the Indian market with issuance of Rs.

234 billion accounting for 64% of the issuance in the first half of this year, thus remaining the largest product class, while securitization of single corporate loans, that accounted for 29% also propped up the volume

Issuance Volume in Indian SF Market

0

100

200

300

400

FY03 FY04 FY05 FY06 FY07

Valu

e (

Rs.

bil

lio

n)

Value(Rs.

billion)Number oftransactions

*Source: ICRA Estimates

Year 2003 2004 2005 2006 2007

Issuance 77.7 139.2 308.8 256.5 256.5

Securitization Process Securitization is a process where financial assets are pooled and packaged into securities which is further sold to investors.

The Process:

• Pooling and transfer of assets: A portfolio of asset is pooled and sold to the SPV generally without any recourse to the issuer. By transferring the assets we delink the credit risk of the collateral asset pool from the credit risk of the originator. SPV is a special purpose entity formed for specific purpose of funding the assets and is bankruptcy remote.

� Issuance: The issuer now sells/issues tradable securities to investors. The proceeds from the sale are used to pay the Originator.

� Tranching: Liabilities are sliced based on different risk levels, consequently producing different returns. Together all the tranches make up the deal’s liability structure.

� Credit Enhancement: Unlike corporate debt the liabilities in a securitized structure are credit enhanced and the rating of the bonds can surpass the rating of the originator or the underlying asset pool by creation of a structure that allows it to

There are mainly 2 types of credit enhancement available: Internal and external.

Internal credit enhancement

o Excess Spread:

Excess spread is the difference between the interest rate received on the collateral and the coupon paid on the issued security after reducing servicing and other fees. So if the coupon paid on the bond is 4% whereas we are receiving 4.5% from the collateral 0.5% is the excess interest. This will be the first line of defense against losses as the extra spread will be used to cover losses. Let us continue with the previous example and assume there were losses of 0.25 million.

Losses 0.25

Collateral balance 100

Certificate Balance 100

Coupon received 4.49

Coupon to be paid 4

Excess spread 0.49

*All figures are in million We see that losses of 0.49 million can be covered with excess spread.

o Subordination:

Senior/subordinated (or A/B) structure is a popular type of internal credit support .It is characterized by a senior (or A) class of securities and one or more subordinated (B, C, etc.) classes that function as the protective layers for the A tranche. The senior classes have first claim on the cash received by the SPV and in case of default the subordinate classes will be first hit. The senior tranches remain unaffected till the losses wipe out the entire subordinate class. This structure of priority of payment is referred as cash flow waterfall and is deal specific.Also to specify there are certain triggers in the deal which can disrupt or change the priority.

Example:

Certificates Rating Balance (in mn) Subordination

Class 1-A Aaa 7.5 25%

Class 1-B Aa+ 1.5 10%

Class M-1 Aa 0.5 5%

Class M-2 Aa- 0.25 3%

Class M-3 A+ 0.25 0%

The subordination level in this structure is 25% and the subordinate tranches will absorb losses up to 2.5 million (25% of 10 mn).Class M-3 is the first loss piece.

Exercise:

Certificates Rating Balance(in

mn) Subordination?

Class IA-1 AAA 423,670,000

Class IIA-1 AAA 61,000,000



Class M-1 Aa1 27,654,000

Class M-2 Aa2 25,679,000

Class M-3 Aa3 14,617,000

Class M-4 A1 13,432,000

Class M-5 A2 10,667,000

Class M-6 A3 9,877,000

Class M-7 Baa1 10,667,000

Class M-8 Baa2 7,901,000

Class M-9 Baa3 9,877,000

o Overcollateralization With this support structure, the face value of the underlying collateral is larger than the security it backs. Therefore the assets are more than the liability and this excess acts as a cushion for tranches against the losses.

Total Certificate Balance

Collateral balance OC Amount

400 mn 410 mn 10 mn

500 mn 460 mn 40 mn

o Reserve funds: Reserve funds are created to provide credit support to the structure. They come in two forms: Cash reserve funds and Excess spread. Cash reserve funds are deposits of cash generated from issuance proceeds. Excess spread accounts will have monthly deposits of excess spread after payment of net coupon, servicing fees and all other expenses.

Example

WAC for mortgage pool 7.75%

Net WAC of bond classes 7.25%

Servicing fee 0.25%

Monthly deposit into reserve account 0.25%

As we have read earlier that excess spread is the first line of credit support this form of credit enhancement relies on the assumption that losses are low in the initial years of the deal. The amount accumulating in the excess spread account can be used to pay for future losses in the deal. In case the losses are low, the accumulating excess spread can be deployed in following ways:-

� Pay additional Principal to the bonds. � “Excess spread” can be a part of equity and will be released

to the owner of residual tranche.

Mechanism: The reserve fund has a target level which is defined as percentage of the outstanding balance. Excess spread will be deposited monthly till the target level is reached. The required target level will reduce with time as the bonds pay off. Amounts in excess of target level will be released each month till the floor is reached. ”Floor” is the minimum level which will be maintained in the account for the life of the deal. Example

Floor (in millions) 0.75

Target level 2%

Current Reserve 1.50%

Collateral balance 100

Certificate balance 90

WAC-Collateral 5%

WAC-Bond 4.50%

Servicing fee 0.25%

Excess Spread 0.25%

In this example the current level of reserve is 0.5% short of the target and the excess spread of 0.25% will be used to fill the reach the target. As the outstanding balance reduces the excess in the reserve will be disposed as mentioned above till the reserve reaches 0.75mn after which it will be frozen for the rest of the deal

External Credit Enhancement

o Letter of Credit

A bank letter of credit is a financial guarantee wherein the issuing bank will reimburse credit losses up to predetermined amount in return for a fees. Letters of credit are becoming less common forms of credit enhancement, as much of their appeal was lost when the rating agencies downgraded the long-term debt of several LOC-provider banks in the Fixed Income Sectors: Asset-Backed Securities—6 early 1990s.

o Bond Insurance

It is a guarantee from a monoline insurance company for the timely payment of principal and interest. They are basically insurance policies which will reimburse ABS of losses.

o Pool Insurance Bond insurance cover losses resulting from defaults and foreclosures therefore additional insurance must be obtained to cover losses from bankruptcy, fraud and special hazards.

o Interest Rate Swap/Hedge Contracts To mitigate interest rate mismatch risk, the Trust would use interest rate swaps, caps, and/or other hedging arrangements. Depending on the nature of the hedging arrangement and the importance of hedging to the overall structure, minimum rating requirements of Hedge Counterparties for different acquisitions of Assets may apply. Appropriate credit quality minimums are enforced for all hedging arrangements. Interest rate hedge or swap contracts are entered in to protect the pool structure from fluctuations in interest rates. For example if the assets in the pool are floating and the liabilities fixed, a plain vanilla swap would help in hedging against any increase in interest rate.

Key Market Participants

Roles and Responsibilities Originator

Lends money to borrower secured by a first priority lien, enters into a mortgage loan purchase agreement to sell the loan to the securitization depositor.

Depositor

An entity set up by the investment bank sponsoring the securitization purchases commercial mortgage and immediately sells loans to a trust.

Originator

Depositor

Investors

SPV

Rating Agency

Servicer

(i)Primary

(ii)Master

(iii)Special

Trustee

Senior

Mezz.

Junior

Financial

Guarantor

Issuer

The trust is the record owner of the commercial mortgage loans, formed by depositor pursuant to PSA.

Investors

Different investors with varying risk appetites purchase certificates with different ratings.

Trustee

Responsible for administering the trust on behalf of and making payments to the investors.

Primary Servicer

Responsible for collecting the P&I for a fess generally around .5% in return. Maybe the originating mortgage bank, They are in actual conversation with the borrower and are a lot of times the originators.

Master Servicer

Responsible for making sure that the P&I is collected and payments made to the investors. Also provides liquidity support.

Special Servicer

Comes in picture if the assets defaults or becomes delinquent.

Rating agency

Rating Agencies evaluate credit risk and deal structure, assess third parties, interact with investors, and issue ratings. The provision of a structured finance rating by a rating agency can help to mitigate asymmetric information problems arising in the creation of a structured finance instrument, for example in assessing the rules governing the prioritization of cash flows to the tranches. The rating agencies also collect and assess information on the performance of the servicer and of other third parties involved in the transaction. In rating Structured Finance deals, all three major agencies follow a two-step process, which applies equally to CDOs as well as traditional ABSs. First, analytical models are used to assess pool credit risk, followed by a detailed structural analysis as the second step. The latter will crucially depend on deal specifics, as laid out in the transaction’s documentation, and includes detailed cash flow modeling based on the results of the credit risk analysis, legal assessments and evaluations of collateral asset managers and other third parties involved in the deal.

What can be Securitized Any asset class with a stable stream of cash flow can in principle be included in the reference portfolio and securitized. Asset type determines the type and classification of the ABS structure - ABS, MBS, CDO, etc Underlying pools can include the following:

1. Aircraft/auto/equipment leases 2. Corporate debt 3. Credit cards 4. Gov't related payments 5. Loans (consumer, home equity, project, student) 6. Project finance/operating income 7. Trade receivables

RMBS,CMBS and CDO structures will be covered in the next sections. Now we will look at credit card securitizations. Will briefly look at each of these transactions:-

• CMBS Commercial mortgage-backed securities (CMBS) are a type of bond commonly issued in US security markets. They are a type of mortgage-backed security backed by mortgages on commercial real estate. CMBS issues are usually structured as multiple tranches, similar to CMOs, rather than typical residential "passthroughs." In a CMBS transaction, many single mortgage loans of varying size, property type and location are pooled and transferred to a trust. The trust issues a series of bonds that may vary in yield, duration and payment priority. Nationally recognized rating agencies then assign credit ratings to the various bond classes ranging from investment grade (AAA/Aaa through BBB-/Baa3) to below investment grade (BB+/Ba1 through B-/B3) and an unrated class which is subordinate to the lowest rated bond class. Investors choose which CMBS bonds to purchase based on the level of credit risk/yield/duration that they seek. Each month the interest received from all of the pooled loans is paid to the investors, starting with those investors holding the highest rated bonds, until all accrued interest on those bonds is paid. Then interest is paid to the holders of the next highest rated bonds and so on. The same thing occurs with principal as payments are received. If there is a shortfall in contractual loan payments from the Borrowers or if loan collateral is liquidated and does not generate sufficient proceeds to meet payments on all bond classes, the investors in the most subordinate bond class will incur a loss with further losses impacting more senior classes in reverse order of priority.

• RMBS Residential mortgage-backed securities (RMBS) are a type of bond commonly issued in US security market. It is a type of security whose cash flows come from residential debt such as mortgages, home-equity loans and subprime mortgages. This is a type of mortgage-backed securities that focuses on residential instead of commercial debt. Holders of an RMBS receive interest and principal payments that come from the holders of the residential debt.

• CDO Collateralized debt obligations (CDOs) are a type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). One important distinction is that between static and managed deals. With the former, collateral is fixed through the life of the CDO. With a managed CDO, a portfolio manager is appointed to actively manage the collateral of the CDO. The life of a managed deal can be divided into three phases:

o Ramp-up lasts about a year, during which the portfolio manager initially invests the proceeds from sales of the CDO's securities.

o The reinvestment or revolver period lasts five or more years. The manager actively manages the CDO's collateral, reinvesting cash flows as well as buying and selling assets.

o In the final period, collateral matures or is sold. Investors are paid off. CDO is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follows:

o Source of funds -- cash flow vs. market value Cash flow CDOs pay interest and principal to tranche holders using the

cash flows produced by the CDO's assets. Cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio.

Market value CDOs attempt to enhance investor returns through the

more frequent trading and profitable sale of collateral assets. The CDO asset manager seeks to realize capital gains on the assets in the CDO's portfolio. There is greater focus on the changes in market value of the CDO's assets. Market value CDOs are longer-established, but less common than cash flow CDOs.

o Motivation -- arbitrage vs. balance sheet

Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. The majority, 86%, of CDOs are arbitrage-motivated.

Balance sheet transactions, by contrast, are primarily motivated by the

issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A bank may wish to offload the credit risk in order to reduce its balance sheet's credit risk.

o Funding -- cash vs. synthetic

Cash CDOs involve a portfolio of cash assets, such as loans, corporate

bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the SPV issuing the CDO's tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006.

Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swaps, a derivatives instrument.

Credit Card ABS: Structure The typical setup has three different cash flow periods: revolving, controlled amortization (in some cases, accumulation), and early amortization. This structure is designed to mimic a traditional bond, in which interest payments are made every month and principal is paid in a single “bullet” payment on the maturity date. In addition to issuing investor securities, every seller is required to maintain an ownership interest in the trust. This participation performs several critical functions.

• It acts as a buffer to absorb seasonal fluctuations in credit card receivables balance,

• is allocated all dilutions (balances canceled due to returned goods)and fraudulently generated receivables that have been transferred to the trust,

• and ensures that the seller will maintain the credit quality of the pool since the seller owns a portion of it.

Regardless of whether the trust is a stand-alone or a master trust, the same general structure is used for every deal. The typical setup has three different cash flow periods: revolving, controlled amortization (in some cases, controlled accumulation), and early amortization. Each period performs a different function and allocates cash flows differently. This structure is designed to mimic a traditional bond, in which interest payments are made every month and principal is paid in a single “bullet” payment on the maturity date. All collections on the receivables are split into finance charge income and principal payments. Finance charges are used to pay the investor coupon and servicing expenses fees, as well as to cover any receivables that have been charged off in the month. Any income remaining after paying these is usually called excess spread and is released to the seller.

o Revolving Period During the revolving period, monthly principal collections are used to purchase new receivables generated in the designated accounts or to purchase a portion of the seller’s participation if there are no new receivables. If there are not enough new receivables to reinvest in, an early amortization will be triggered because the seller’s participation has fallen below the required minimum, or, in some cases, the excess principal collections will be deposited in an excess funding account and held until the seller can generate more credit card receivables

o Controlled Amortization/Accumulation In the case of controlled amortization), which typically runs for 12 months, principal collections are no longer reinvested but are paid to investors in 12 equal controlled amortization payments.

o Controlled accumulation It follows a similar procedure, except that the controlled payments are deposited into a trust account, or principal funding account (PFA), every month and held until the expected maturity date on which the investors will be paid the full amount.

o Early Amortization Severe asset deterioration, problems with the seller or servicer, or certain legal troubles can trigger early amortization at any point in the deal, whether it is revolving, amortizing, or accumulating.

• Common amortization triggers are: Seller/Servicer 1. Failure or inability to make required deposits or payments. 2. Failure or inability to transfer receivables to the trust when necessary. 3. False representations or warranties that remains un-remedied. 4. Certain events of default, bankruptcy, insolvency, or receivership of seller or servicer. Legal 1.Trust becomes classified as an “investment company” under the Investment Company Act of 1940. Performance 1. Three -month average of excess spread falls below zero. 2. Seller’s participation falls below the required level. 3. Portfolio principal balance falls below the invested amount.

Liability Structure

• Z Bonds- Z tranches (also known as Accretion Bonds or Accrual Bonds) are structured so that they pay no interest until the lockout period ends and they begin to pay principal. Instead, a Z-tranche is credited "accrued interest" and the face amount of the bond is increased at the stated coupon rate on each payment date. During the accrual period the principal amount outstanding increases at a compounded rate and the investor does not face the risk of reinvesting at lower rates if market yields decline. Typical Z-tranches are structured as the last tranche in a series of sequential or PAC mad companion tranches and have average lives of 18 to 22 years. However, Z-tranches can be structured with intermediate-term average lives as well. After the earlier bonds in the series have been retired, the Z-tranche holders start receiving cash payments that include both principal and interest.

• PAC & TAC Bonds-

o They are type of CMO bonds. o PAC Bonds are designed to eliminate prepayment risk by

transferring the risk to other bonds in CMO. o They offer fixed principal redemption as long as prepayments on

the underlying collateral remains under fixed PSA. o The bonds to which the risk is transferred is called support or

companion bond.

PAC Bond Redemption Schedule

Exhibit 2

o PSA Public Securities Association Convention accounts for ageing or seasoning pattern observed in MBS (New loans have lesser prepayment rates which increases with the age of the loan) A pool is said to have 100% PSA if its CPR starts at 0 and increases by 0.2% each month until it reaches 6% in month 30. It is a constant 6% after that. A PSA of 50% indicates CPRs that are half those of 100% PSA. A PSA of 150% indicates CPRs that are one-and-a-half those of 100% PSA.

PSA Illustrated

Exhibit 1

TAC Bonds-They are same as they the PAC Bonds except that they offer one sided protection and shield investors from higher interest rates up to a specified PSA.

•••• Floating Rate bonds- o Floating CMO Bonds are bonds whose coupon is reset monthly

at a spread above the index. o To ensure that the coupon income from collateral is sufficient to

make collateral payments floater is combined with an inverse floater.

o A floater is a fixed income instrument whose coupon fluctuates with some designated reference rate whereas for Inverse floater coupon rates move inversely with the index.

•••• Stripped Mortgage Backed Security- o Created by dividing cash flow from different mortgage security

and allocating specified percentages of principal and Interest to specified strips.

o Most common examples are IO and PO STRIPS.

•••• Companion Tranches- Every, CMO that has PAC or TAC tranches in it will also have companion tranches (sometimes called support bonds), which absorb the prepayment variability that is removed from the PAC and TAC tranches. Once the principal is paid to the active PAC and TAC tranches according to the schedule, the remaining excess or shortfall is reflected in payments to the active companion tranche. The average life of a companion tranche may vary widely, increasing when interest rates rise and decreasing when rates fall. To compensate for this variability, companion tranches offer the potential for higher expected yields when prepayments remain close to the rate assumed at purchase.

Prepayments: Prepayments are the primary feature that differentiates the MBS market from other fixed income sectors. A prepayment is the early repayment of mortgage principal that results from the sale of a home, or the refinancing or partial principal pay down (curtailment) of an existing mortgage.

Prepayment Convention

o Single Month Mortality (SMM): This refers to the prepayment rate for a month and forms the basis for all prepayment calculations. The SMM is the fraction of the beginning month balance that prepays during the month. By convention the scheduled principal is subtracted from balance before calculating the prepayment rate.

o Conditional Prepayment Rate is the annualized version of the SMM.It is the cumulative prepayment rate over 12 months given the same SMM each month.

SMM= 1- (1-CPR) ^12

o PSA Public Securities Association Convention accounts for ageing or seasoning pattern observed in MBS (New loans have lesser prepayment rates which increases with the age of the loan) A pool is said to have 100% PSA if its CPR starts at 0 and increases by 0.2% each month until it reaches 6% in month 30. It is a constant 6% after that. A PSA of 50% indicates CPR’s that are half those of 100% PSA. A PSA of 150% indicates CPR’s that are one-and-a-half those of 100% PSA.

PSA Illustrated

Exhibit 1

Factors affecting Prepayment: Two major factors affecting prepayments are Housing Turnover and Refinancing

• Housing Turnover: Sale of a home typically lead to an attached mortgage being paid off. Therefore turnover rate of existing home will n will determine Housing Turnover in effect depends on a number of factors.

o Overall Turnover Rate Overall Turnover rate is the total number of houses sold. It is important for us to know the number of existing houses sold which are not assumable and are mortgaged.

o Seasonal Variation in Home Sales: Seasonal highs occur in summers and lows in winters.

o Relative Mobility-Overall Turnover rate depends upon the type of

loan. Balloon discounts prepay faster than conventional discounts. o Seasoning: Seasoning refers to gradual increase in prepayment

speeds on a pool of new mortgages till it reaches a steady level.

• Refinancing

Refinancing occurs when borrowers take out new mortgages (at lower rates) and pay off existing ones. Since most U. S. residential mortgages do not carry a prepayment penalty , refinancing decision primarily depends upon change in Interest rates. As mortgage rates decline, a homeowner may choose to refinance his existing mortgage with a lower rate mortgage. The size of the refinancing incentive, combined with the borrower's ability to be approved for a new mortgage (reflecting home price appreciation and the borrower's credit situation) affect the likelihood of prepayments from refinancing.

Risks associated with Prepayment:

o Contraction Risk: When mortgage rates decline, prepayments on a MBS will increase and can surpass the estimated levels. This will reduce the average life. The disadvantage to the investor is that the funds received from prepayments will have to be reinvested at lower rates. This reinvestment risk arising due to shortening of average life is referred to as contraction risk.

o Extension Risk- Now in case when interest rates rise, the prepayment

can slow down and fall below the expected levels. This will result in increase in average life of MBS. The investors are affected since their money is locked at lower interest rates for longer duration.

Due to prepayments at lower interest rates, bonds show negative convexity (price can tend to fall at lower yields) – this is akin to a callable bond – therefore MBS bonds are looked at option embedded bonds. This is one more reason that the OAS(Option adjusted spread) approach is used to price/compare bonds.

Residential Mortgage Backed Securities (RMBS)


Contents

(i) Overview (ii) Definition (iii) RMBS Structure

a. “I” Structure b. “Y” Structure c. “H” Structure

(iv) Cash Flow of RMBS (Waterfall) (v) Priorities of Payment

a. Interest Payment b. Principal Payment

(vi) Credit Enhancement Forms of Credit Enhancement

i. External ii. Internal

a. Excess Spread b. Overcollateralization c. Available Fund Cap d. Subordination/Credit Tranching

(vii) Step-down and Trigger Test (viii) Advantages of RMBS Structure

a. Advantages of Originator b. Principal Payment

(ix) Risk associated with RMBS a. Prepayment Risk b. Extension Risk

(x) Other Important features

Overview: From its inception in the early 1990s, the Home Equity Loan (HEL) market has experienced a dramatic evolution from a market predominantly representing second lien loans to prime borrowers to first line loans to credit impaired borrowers, including a wide variety of loan types, for example, fixed rate, hybrid adjustable rate and interest only loans. As lending practices evolved and investor acceptance of the product grew, the structure used to securitize loans in this sector also evolved. The earliest securitization employed financial guarantee from third-party Wrap providers. By the mid 1990s, the structure evolved to employ senior/subordinate tranching of credit risk, seller-paid mortgage insurance or deep mortgage insurance (MI) and Net Interest margin (NIM) transaction to monetize front end residuals. Recently, the advent of both single-name CDS and the ABX.HE credit index have increased notional trading volume and allowed investors to express directional opinions (long or short) regarding issuer originations and servicing practices, relative vintage performance and capital structure arbitrage.

RMBS Market Overview: The consumer asset –backed securities (ABS) market consists of securities backed by pool of assets such as credit card receivables, auto loans and leases, student loans and Home Equity Loans (HELs). The largest sector of the ABS market is the HEL market, which has evolved from securitizations of traditional second lien mortgages to prime borrowers in early 1990s to include several different types of mortgage products to credit impaired borrowers. The HEL sector has experienced outstanding growth, especially over the years till 2006. Growth in this sector was largely driven by following:

• The historically low mortgage rates that prevailed over the period; • Unprecedented home price appreciation; • Increased consumer leverage; • Greater investor acceptance of nontraditional mortgage products; and • Demand for mortgage credit exposure in the form of deeper subordination

Home Equity Issuance, 1996 through September 2006

The origins of the residential ABS market lie in the development of non-agency mortgage market in the mid- to late 1980s. Many of the mortgage loans made by lenders exceed the Agency (FNMA and FHLMC) underwriting guidelines, typically by either original loan balance or underwriting criteria. The non-conforming product encompassed Jumbo-A and Alternative- A (Alt-A loans to prime borrowers). The non-conforming market developed as a means to securitize these loans and generally made use of internal credit enhancement via senior/subordinate structure used in Residential ABS Market today.

Because the earliest residential ABS securitizations were collateralized by second lien loans to prime borrowers, the sector earned the name Home Equity Loan (HEL) ABS. During the early to mid – 1990s, monoline lenders extend the second lien lending practice to subprime and non-prime borrowers, assuming the first lien position when financing a subprime borrowers to his or her limit. Today, cash-out refinance loans still dominate the collateral backing of most residential ABS transactions. These loans allow borrowers to access the equity in their homes to consolidate debts, lower their monthly payments, finance home improvements, pay for education or purchase consumer durables. The loans may be fixed, adjustable rates (2/28, 3/27 or 5/25 hybrid ARMs) or interest-only loan structures.

RMBS Defined: According to investopedia.com: A type of security, whose cash flows come from residential debt such as mortgages, home-equity loans and subprime mortgages. This is a type of mortgage-backed securities that focuses on residential instead of commercial debt. According to “The Handbook of Fixed Income Securities” by Frank J. Fabozzi: A residential mortgage backed securities is an instrument whose cash flow depends on the cash flows of underlying pool of residential mortgages. In essence, The RMBS comprises a large amount of pooled residential mortgages. When you invest in a mortgage-backed security you are lending money to a homebuyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry if the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the homebuyer and the investment markets.

A Basic RMBS Structure:

MBS - The Unresolved Issues

Trustees

Seller &

ServicerSystem and Process Under-writing standardsPortfolio Performance(History)DocumentationStamp Cost on transferMIS / Accounting Standard

.

BorrowersWithholding taxes oninterest payments

Rating

Agency

Credit Enhancement

Role for Banks, Insurance companies,

Specialised Agency

SPVLimited Company(Pass Through Vehicle)Nature of Instrument

InvestorsDiversified Investors

Insurance Company

Banks

Trusts

Pension Funds

Mutual Funds

FII

Market

MakerRole for

specialised

agency

ListingRecognised

as security

Disclosure

Standards

Three Typical RMBS deal Structure type:

• “I” Simple and Straight Forward • “Y” Most Popular • “H” Like two “I” structure combined.

Illustration of “I” Structure (eg. Countrywide 2002-1)

o In this structure, all collateral together support senior and subordinate bonds.

Illustration of “Y” Structure (as in Ameriquest 2005-R5)

o Here senior bonds are backed by separate collateral groups, but the sub bonds are backed by all collaterals.

o Collateral groups could be separated by coupon type (Fixed/ARM) or loan size (conforming/non-conforming). To facilitate the purchase of senior bonds by GSEs (eg Fannie and Freddie), the second separation has become dominant in recent vintages.

o Most .Y. structures blend fixed and ARM loans. Typically ARM loans represent about 80% of total loans.

Illustration of “H” Structure (as in Countrywide 2005-4)

o Both senior and sub bonds are backed by separate collateral groups (mostly by fixed and

ARM). o Used to be fairly common, but less so today.

Typical Cash Flow Waterfall of RMBS Deal:

Priority of Payments explained:

• In order to understand home equity structures, it is important to understand the priority of payments across the various bonds in the capital structure.

• The two priorities of payment flavors can be referred to as Interest-Principal (IPIP) or Interest-interest or IIPP.

• In the IIPP structure, Interest is paid to all bonds before principal is paid to senior bonds. This IIPP structure is most common in subprime deals. This structural feature ensures that all bonds will receive timely payment of interest.

Interest Payment o Most home equity bonds are floaters. The bond coupon rate is the sum of index rate

(mostly 1-mo. LIBOR) and bond margin. Bond coupon rates are adjusted every month based on the corresponding change in the index rate.

o Actual bond interest payments may be lower than what we expect from bond coupon rate. In this scenario, there is an interest shortfall for this bond.

o Interest shortfall could be caused by two reasons: Credit Related: Credit related shortfalls result from high delinquencies. Due to large amount of excess spread and servicer advances, credit related shortfalls are extremely rare. Available Fund Cap (AFC): Bond payment is subject to the limit of collateral interest received (will be discussed in detail later).

o AFC interest shortfall can be repaid in future months when excess spread is available after paying collateral losses and building up overcollateralization to target. Interest rate swaps and caps also help reduce the cap risk.

o Servicer Advances: In nearly all home equity deals, servicers are required to advance delinquent principal and interest to the extent that such advance is recoverable. Servicers can recover advances from future collateral cash flow and therefore advances aren’t considered credit support, but rather act to improve deal liquidity.

Principal Payment o All collateral principal payments (scheduled or prepaid) will be allocated to senior

bonds until the step-down date. o After the step-down date, all bonds start receiving principals if collateral performance

based trigger tests are passed. o Principal can be allocated to a bond as long as the more senior bond has at least 2X

the original credit support. o Losses that exceed available credit support will result in a write down or reduction in

bond balance.

Credit Enhancement: An Important aspect of (‘R)MBS Transactions A common feature of all types of securitization transactions is the use of credit enhancement, i.e. a cushion put in place to protect investors against expected losses. The credit enhancement is sized to reflect an expected loss level determined under a series of adverse scenarios that could affect the asset pool during its life. The credit enhancement for a specific deal is usually a combination of several forms of credit enhancement mechanisms and is a reflection of the specific characteristics of the securitized assets, the goals of the securitization sponsor and the requirements of the rating agencies. Credit enhancement is normally sized by the rating agencies to help attain the desired ratings for the securitization notes. Senior asset-backed notes are usually assigned the highest rating (triple-A). Internal or external credit enhancement for asset-backed notes is typically complemented with structural investor protection built into the securitization transaction. The credit enhancement and the other structural enhancements should amongst them address most of the adverse eventualities that could affect the asset pool and the securitization bonds. Along with the legal protections they help create bonds which are fundamentally different and more resilient than other fixed income instruments.

Forms of Credit Enhancement (CE) Forms of Credit Enhancement

❏ External - provided by an outside party

➢ Bank letter of credit

➢ Insurance company surety bond

➢ Financial assurance company guarantee

➢ Subordinated loans from third party

❏ Internal - provided by originator or within the deal structure

➢ Reserve account/refunded or build up from excess

spread

➢ Originators guarantee

➢ Senior-subordinated structure

➢ Excess spread

➢ Overcollateralization

➢ Minimum required debt service coverage ratio (DSCR)

❏ Trigger events

One of the most essential elements in structuring an asset-backed security is establishing adequate credit enhancement levels. The role of credit enhancement is to bridge the credit quality of the assets, which may be B or BB, to the level of the desired rating of the asset-backed security, generally AAA. The credit enhancement is sized to absorb the expected losses that the pool could experience during the life of the asset-backed security, down to a residual level corresponding with the expected losses under the required rating level. The credit enhancement can be structured in a number of different ways.

External - Provided by an Outside Party

In the earlier stages of the development of the asset-backed market, the external credit enhancement prevailed. It is called external because it is provided by an outside party, a bank opening a letter of credit (LOC) or an insurance company and a monoline insurer providing a surety bond, or a company giving some other form of guarantee. It

would also take the form of a loan provided by a third party and subordinated to the senior asset-backed bonds sold to investors. However, it is important to remember that in the case of external credit enhancement, the rating of the security has a direct link with the rating of the credit enhancer, whether it is a bank providing an LOC or an insurance company providing a surety bond. Any rating downgrade, any bad news, any volatility in the quality or performance of the respective credit enhancer will have a direct impact on the performance or the rating of the insured securitization bond.

Internal - Provided by Originator or Within the Deal Structure

As the market developed, a new type of credit enhancement emerged. This credit support is provided within the structure by the originator or through mechanisms internal to the deal structure (subordination, overcollateralization, etc). The originator for instance, could provide some kind of a corporate guarantee for the asset-backed securities issued. Such a guarantee is typically attached to the most junior tranches of an asset-backed security for the purposes of improving their rating and improving their distribution in the market place.

Discussed below are some important and common tools to create Credit Enhancement in a transaction.

� Excess spread (XS) � Overcollateralization (OC) � Available Fund Cap (AFC) � Subordination/Credit tranching

Excess spread (XS) • Excess spread is the difference between collateral interest received and interest

payment to investors. • Excess spread is the first layer of credit enhancement. How is Excess Spread

Distributed?

• Given the relatively high collateral coupon in home equity deals, excess spread is

an important part of credit enhancement.

What Determines the Size of Excess Spread?

• Structural o ARM Percentage: The higher the percentage of ARM loans the lower the

risk of excess spread. This is due to the fact that a rise in interest rate will result in a higher coupon on both the collateral and the bond.

o Expenses: The higher the expenses of a transaction the lower the excess spread. Servicing fee is the biggest portion of expenses in most subprime home equity deals.

o Swaps/Caps: Swaps and caps have been used increasingly in recent years to reduce the basis risk associated with subprime deals (will discuss it later in details).

o Hybrid ARM Mix: Most subprime bonds reset monthly to 1 Mo Libor while most loans are fixed for 2 or 3 years and then become floating. During this initial fixed period, increases in Libor will reduce excess spread.

• Performance o Prepayments: The value of excess spread is a function of the

outstanding balance of the loans. So faster prepays will reduce the value of excess spread since the balance of the loans are reduced.

o Losses: The higher the amount of losses the lower the amount of excess spread. In addition, losses that occur earlier have more excess to offset losses. So both the magnitude and timing of losses impact the value of excess spread.

Overcollateralization (OC)

• Overcollateralization (OC) is the difference between collateral and bond balances.

• OC is the second layer of credit enhancement after excess spread.

• Each deal has specific OC target (about the 1.0%-4.0% of original loan balance at deal issuance).

• As with other subordinate bonds, after the stepdown date, the required OC amount can be reduced to 2x the original %. Eg if original target was 4% of original balance, after stepdown, the target OC will equal 8% of current balance.

OC in any deal can be created in two ways. Either it can be fully funded at the time of origination/closing or can be built over a period of time to the targeted amount. In the latter, OC is gradually built up as excess spread is used to pay off the senior bonds first before paying to the residual holders. Once the initial target ids reached, the future deficiency in OC will be covered by using available excess spread to pay of senior debts.

Available Fund Cap (AFC)

• Home equity bond interest payment is subject to the cap set by the collateral net WAC.

• Net WAC is equal to gross WAC minus servicing fee, trustee fee, MI premium and other expenses.

• Rating agencies don’t consider AFC risk as part of rating. In other words, rating agencies are rating the coupon up to capped rate.

• Several factors cause the AFC risk o Mismatch between deal assets and liabilities: fixed rate loans back floating

bonds o ARM loans have 2- to 3-yr initial fixed rate periods during which the loan

rates don’t change. o Even after entering into the floating rate period, ARM loans reset every six

months but bond coupon always change every month o Slight index mismatch: ARM loans use 6-mon LIBOR as index and bonds use

1-mon LIBOR o ARM coupon resets are subject to initial reset cap, periodic cap and lifetime

caps. • Cap shortfalls may be carried forward and paid to investors at a later time. • Swaps and cap derivates are often included in home equity deals and help

reduce AFC risk.

Subordination or ‘credit-tranching’, It means that the cash flows generated by the assets are allocated with different priority to the different classes of notes in order of their seniority. In case of subordination, the face value of the bonds is equal to the value of the assets. The subordinate structures are known as a senior/subordinated structure, or also as a senior/mezzanine/subordinated structure. In a simple senior/subordinated structure the senior tranche is usually rated AAA and it receives the cash flow generated by the assets first, for the purposes of interest and principal payment while the subordinated piece (also called equity piece), receives cash flows second and absorbs the losses first. The priority of the cash flow distribution comes from the top, waterfall like, while the distribution of the losses rises from the bottom.

Another form of internal credit enhancement is the requirement that the cash flows generated by the assets over a specified period of time exceed the debt service requirement of the bonds over the same period by a predetermined factor. The minimum required debt service coverage ratio (DSCR) it that factor. The revenue from the assets must exceed the debt service several times, thus allowing for monitoring performance and applying excess debt service to accelerate bond amortization in case of adverse events affecting the transaction.

Step-down and Trigger Test

• Step Down Date: The date after which subordinate bonds can receive principal payments.

• Deals are eligible to step down at the earlier of Month 37 or when all senior bonds are paid off

• But step-down can happen only when performance-based trigger tests are passed.

• All deals have delinquency trigger and recent vintages also have cumulative loss trigger.

• Both trigger tests must be passed for a deal to step down. • Trigger values could be dynamic, where the target values change as deals

season.

Cash Flow Impact of Trigger Test

o If a trigger fails, all principal goes to senior most bondholders. o Triggers are evaluated every month after the step down. Triggers may

initially pass the test and vice-versa. o If trigger tests pass and deals step down, a big portion of principal will be

distributed to the junior bonds and residual/OC holder. o If trigger tests fail, senior bonds receive all principal payments. o Failing triggers reduces average life of senior bonds and lengthens

subordinated bonds. o Failing triggers results in more credit enhancement being retained in the

deals. o Most home equity bonds are priced assuming triggers pass. o Recent triggers structures and strong deal performance has resulted in

most triggers passing for recent vintages.

Advantages of RMBS Structures The object of all transactions is

• The reduction of the credit risks connected with the assets, either through the disposal or guarantee of the assets,

• The virtual elimination of originator risk and • In the case of funded or "true sale" transactions an increase in liquidity in the near

term.

Advantages for the Originator

• Reduction in assets on balance sheet and improvement in key ratios such as ROE, potentially leading to improvements in credit rating / quality classifications

• Portfolio management tool based on the transfer of asset credit risk to an SPC or hrough risk coverage

• Possible lower borrowing costs versus conventional financings, especially if costs of capital can be saved

• Higher leverage using receivables for corporate financing purposes • Decreased reliance on the bank market and the general corporate debt capacity

through an additional financing source which can be used opportunistically • Diversification of the investor base, for example, away from shareholders and

corporate bond investors • Increased liquidity creating capacity for new business or investments • Anonymous market access available to the receivables originator through ABCP

multi-seller programmes • In Germany, (possibly) trade tax advantages in cases where the so-called

permanent debt problem can be avoided

Advantages for Investors

• Relative value pick-up compared to corporate bonds in same rating category • For rated paper, thorough review and ongoing surveillance from experienced

rating agencies • Especially in higher rated instruments, excellent and stable asset quality and

good reputation of the transaction participants • Higher yield potential for investors with tolerance for higher risk, innovative

structures or more exotic assets • High investor demand and improving secondary market liquidity • Possibility for indirect participation in targeted pools via a professional external

asset manager • Targeted construction of better risk diversification in own portfolio

Risks associated with RMBS:

Prepayment risk • Prepayment risk is the risk that homeowners will pay off more than their required

monthly mortgage payments. • Prepayment is usually precipitated by a decline in interest rates. • As prepayments occur, the amount of principal retained in the bond declines

faster than what otherwise may be expected-thereby shortening the average life of the bond by returning principal prematurely to the bondholder, potentially at a time when interest rates are low.

Extension risk

• Extension risk is the risk that homeowners will decide not to make prepayments on their mortgages to the extent initially expected-instead they make only the required monthly payment.

• Extension can be the result of an increase in interest rates-as rates rise, there is little incentive to refinance.

• As the prepayments that were expected do not materialize, the average length of term (average life) originally estimated begins to creep out further along the curve, resulting in a security that is lengthier in term.

Other Important Features of RMBS Deals:

• The heart of an RMBS structure is a “bankruptcy remote special purpose vehicle (SPV)” - usually a trust but may be a company

• An RMBS transaction involves the sale of residential mortgages to an SPV funded through an issue of rated and, occasionally, unrated bonds

• The capacity of an SPV to meet its obligations on the bonds relies heavily on the cash flows from the underlying residential mortgages

• Losses and late payments on the residential mortgages affect the ability of an SPV to meet its obligations on the bonds

• Credit enhancements, liquidity support, and other structural features are incorporated into RMBS transactions to cover income and cash flow shortfalls Credit enhancements cover losses on the underlying residential mortgages

• Liquidity support covers timing differences between cash flows on the residential mortgages and payment obligations on the bonds

• Interest rate swaps hedge the basis risk between the yield on fixed rate residential mortgages and the floating rate coupon on the bonds

• Currency swaps hedge the A$ cash flows on the residential mortgage loans and the payments on non-A$ denominated bonds

Commercial Mortgage Backed Securities

Contents

i. Introduction ii. Types of CMBS iii. CMBS market

a) Overview of Global Market

iv. Property Type of CMBS a) Residential and Non Residential Properties

v. CMBS transactions overview a) Deal structure in CMBS

vi. Credit Enhancement in CMBS a) External and internal CE b) Loss Position

vii. Structural Issues in CMBS viii. Waterfall Mechanism ix. Interest Type and tranche type in CMBS x. CMBS Investor Motivation & Issues xi. Some Definitions

Introduction of CMBS In very simple way we can define CMBS as 1. Commercial Mortgage Backed Securities (“CMBS”) are bonds, sold through the capital markets, the payments on which are backed by mortgage loans, which in turn are backed by cash flows from commercial properties 2. CMBS market allows participants to gain exposure to commercial property through the liquid capital markets 3. The bonds issued are usually split into separate tranches, each with its own risk profile 4. The tranches are typically rated by one or more credit rating agencies 5. CMBS are a segment of structured finance markets like RMBS, ABS, and CDOs etc.

Types of CMBS There are mainly five types of CMBS as mentioned below 1. Credit Tenant Lease Transactions 2. Single Borrower – Single Property 3. Single Borrower – Multiple Properties 4. Multiple Borrowers – Multiple Properties 5. Synthetic CMBS Transactions If we will look the Global network we have different types of CMBS like in Australia we have two types of CMBS 1. Small ticket multi-borrower 2. Large ticket single-borrower

CMBS Market Overview An Overview of world wide CMBS

US CMBS BREAKDOWN (Year to Date)

($Bil.) (%)

Fusion 7.3 84%

Single Borrower 1.4 16%

TOTAL 8.8 100% REIT Financings Year-to-date volume ($Bil.)

2008 2007

Unsec. Notes 0.0 3.6

MTN 0.0 0.2

TOTAL 0.0 3.8

Spread (Basis Points)

Fixed Rate Avg. Week 52-wk

(Conduit) Life 16-Apr Earlier Avg.

5 S+275 S+320 119

AAA 10 S+275 S+289 115

AA 10 S+800 S+825 274

A 10 S+1,000 S+1,100 375

BBB 10 T+1,571 T+1,565 687

BB 10 T+2,100 T+2,000 870

B 10 T+2,500 T+2,200 1,221

Floating Rate (Large-loan)

AAA 5 L+275 L+275 83

AA 5 L+400 L+400 136

A 5 L+500 L+500 191

BBB 5 L+650 L+650 299

CMBS total return Total Return (%)

Avg. Month Year Since

As of 4/16 Life To Date to Date 1/1/1997

Inv.-grade 6 -0.5 -4.3 100.3

AAA 5.9 -0.9 -3 102.8

AA 6.6 2.6 -14.1 81.7

A 6.7 4.7 -17.7 68.5

BBB 6.9 7.6 -21.7 49.6

*N.B: The above data has been taken from CMBS market statistics as of 24

th

April 2008.

Year-to-date volume ($Bil.)

2008 2007

US 8.8 65.9

Non-US 4.9 24.4

TOTAL 13.7 90.4

Property Type in CMBS Residential properties Residential properties are properties that provide residences for individuals or families. These include single houses and multifamily properties such as apartments, condominiums and co-ops. As hotels and motels provide temporary residences and thus are not categorized as residential properties.

Non-residential properties Non-residential properties are typically broken down into five major subcategories: 1. Commercial real estate includes both office building and retail space. Office properties range from major multitenant buildings to a single tenant building, often built with the needs of a specific tenant or tenants in mind. An example of the later would be a medical office building near the hospital. Retail properties vary from large regional shopping center containing over a million of square meter space to a small stores with single tenant found in every town. It is also common to find retail combined with office space, particularly on the first floor of office building in major cities. 2. Industrial real estate includes properties used for light or heavy manufacturing as well as associated warehouse space. 3. Hotels and motels vary considerably in size and facilities. Motels and smaller hotels are used primarily for business travelers and families to spend a night. 4. Recreational real estate includes uses of country clubs, marinas, sports complexes, and so on. 5. Institutional real estate is a general category for property that is used by special institutions such as government agency, a hospital or a university. All of these buildings outlined above have a potential to generate income which depends on its ability to attract tenants to rent space in the building as well as expenses associated with the operating the building. “The rents depend on many factors, including the outlook for national economy, the economic base of the area in which property is located, the demand for type of space provided by the property in the location being analyzed and the supply of similar competitive space”3. Commercial properties are typically leased to tenants for a specific period of time, which assign rights, duties and responsibilities between the lessor (owner) and lessee (tenant). The term of lease include legal considerations that are designed to protect the interest of both parties and specify how payments are to be made over the time period. In Commercial property market, the supply and demand for space interact to establish the market rent rate for a property. And in capital markets debt and equity funds are raised for investment and financing, and claims on these debt and equity instruments are traded. These claims include funds to acquire stocks, bonds, and other invest able assets including real estate income property investments At any time, the supply of real estate is fixed and claims on these assets are priced relative to all other capital assets. To attract investors, real estate must be expected to earn a competitive risk-adjusted rate of return. The capitalization rate implicitly considers the riskiness of the property and its future NOI net operating income. For a given capitalization rate, investors are obviously willing to pay a higher price for a greater amount of rental income.

CMBS transactions overview We will deal with following parameters like

1. Typical CMBS deal Structure : Security Package & Mortgage Security Package & P&I on Loan Collateral P&I on Notes

Rent Loan Amount Issuance proceeds

2. CMBS counterparties & their interrelation

How CMBS works 1. Lender originates commercial mortgage loan(s) to Borrower(s) 2. Borrower provides mortgage security to Lender 3. Arranger (investment bank) structures transaction and select loan pool for CMBS issuance 4. Rating Agencies provide and maintain ratings on CMBS notes. 5. CMBS Issuer sells notes to Investors 6. CMBS Issuer sells notes to Investors 7. Issuer uses notes proceeds to purchase loan (pool) from originator 8. Servicer collects principal & interest (“P&I”) on the loan pool and pays

P&I on the notes and provides reports to Investors 9. Security Trustee holds the security for the benefit of the note-holder and enforce a security in case of default. In above we have also showed the parties in bold letter for their involvements in CMBS transactions. So far we have seen the CMBS overviews and different participants’ involvement in different process. Now we will look into note structure for a typical CMBS. We have different tranches in CMBS starting from top rating (AAA) to Non rated tranche. We can visualize the loss effect in different notes in simple ways that is illustrated below

Credit enhancement is primarily derived through the subordination of note tranches, Funded reserves, Excess spread and trapping mechanism but it can be seen sometimes that Liquidity facility also play an important role in Credit support mechanism.

Credit Enhancements Credit enhancements protect investors when the cash flows from the underlying assets are insufficient to pay the interest and principal for a security in a timely manner. An issuer uses credit enhancements to improve a security’s credit rating, and, therefore, its pricing and marketability. Aside from the coupon rate paid to investors, the largest expense in structuring an asset-backed security is the cost of credit enhancements. Issuers constantly attempt to minimize the costs associated with providing credit protection to investors. Credit enhancements come in several different forms, although they can generally be divided into two main types: external (third party or seller’s guarantees) or internal (structural or cash flow driven). External/Third Party Credit Enhancements As a general rule, third party credit enhancers must have a credit rating at least as high as the rating sought for the security. Third party credit support is often provided through a letter of credit or surety bond from a highly rated bank or insurance company. Currently, there are only a few highly rated third party credit enhancers. Further, there is the possibility that the ratings assigned to a third party credit enhancer could be lowered. Although it rarely happens, such an event could cause the security itself to be downgraded. As a result, issuers are relying less and less on third party credit enhancements.

Third party letter of credit: For issuers with credit ratings below the level sought for the security issued, a third party may provide a letter of credit to cover a certain amount of loss or percentage of losses. Any draws on the letter of credit protection are often repaid (if possible) from subsequent excess cash flows from the securitized portfolio.

Surety bonds: Third party surety bond providers, usually triple-A rated mono-line insurance companies, generally provide a guarantee for 100 percent of the principal and interest payments. Internal Credit Enhancements Among internal enhancements, the securitized assets and transaction’s cash collateral accounts provide most of the credit support. These cash collateral accounts and separate junior classes of securities protect the senior class by absorbing losses before the cash flows from the senior certificate are interrupted. Senior/subordinate structures can be layered so that each position benefits from all the credit protection of the positions subordinate to it. The junior positions are subordinate in the payment of both principal and interest to the senior positions in the securities. A typical security structure may contain any of the following internal enhancements, which are presented in order from junior to senior, that is, from first to absorb losses to the last:

Excess spread: The excess spread is created from the monthly portfolio yield on the receivables supporting an asset-backed security. The excess spread is generally greater than the coupon’s servicing costs and expected losses for the issued securities. Any remaining finance charges after funding, servicing costs, and losses, is called excess spread. This residual amount may eventually revert to the institution/seller as additional profit. However, it is available for the trust to cover any losses that are greater than what is normally expected for the portfolio. Such losses may arrive from higher than projected charge-offs or servicing costs, or lower than projected revenues.

Cash collateral accounts: These are segregated trust accounts, fully or partially funded at the outset of the deal. They can be drawn on to cover shortfalls in interest, principal, or servicing expenses if excess spread is reduced to zero. The account can be funded by the issuer, but may be funded by a loan from a third party financial institution. This loan will be repaid from the proceeds of the trust assets, but only after all secured certificate holders have been paid in full.

Collateral invested amount (CIA): The CIA is a privately placed ownership interest in the trust assets, subordinate in payment rights to all investor certificates. It may be referred to as a residual interest in the trust or the “equity piece,” because a seller often creates and holds this interest to provide credit support for the issue. It may, however, be sold to an outsider. Like a layer of subordination, the CIA serves the same purpose as the cash collateral account. It makes up for shortfalls if excess spread is insufficient. If the CIA absorbs losses, it can be reimbursed from any available excess spread. The CIA is usually an un-certificated ownership interest. Subordinate security classes: Subordinate security classes are junior in claim to other debt. They are repayable only after other classes of the security with higher claims have been satisfied. Some securities may contain more than one class of subordinated debt, and one subordinated class may have a higher claim than other such positions.

Performance-based enhancement: Most securities contain performance related features designed to protect investors (and credit enhancers) against portfolio deterioration. Poor portfolio credit performance can trigger additional safeguards, such as an increase in the spread account available to absorb losses or the accelerated repayment of principal (early amortization). The earliest performance-based enhancement typically requires the capture of excess spread within the trust to provide additional credit protection when the portfolio begins to show signs of deterioration. If delinquencies and loss levels continue to deteriorate, early amortization may occur in revolving securitizations. Early amortization triggers are usually based on a three-month rolling average to ensure that amortization is accelerated only if the pool’s performance is consistently weak. However, you should criticize covenants that cite supervisory thresholds or adverse supervisory actions as triggers for early amortization events or the transfer of servicing as unsafe and unsound banking practices.

Illustration of Credit Enhancement/Loss Positions To illustrate the credit enhancement concept, losses in a hypothetical securitization would be absorbed as follows.

First loss tranche: Usually the residual interest is typically retained by the originator and is established at the normal expected rate of portfolio credit losses. The excess spread, which funds the residual interest, normally should absorb expected portfolio losses, so that the credit support provided by the originator’s investment provides an additional cushion against unexpected losses. Second loss tranche: Referred to as the cash collateral account, typically covers losses that exceeds the originators retained interest. This second level of exposure is usually capped at some multiple of the pool’s expected losses (customarily between three and five times these losses), depending on the desired credit ratings for the senior positions. A high grade, well capitalized credit enhancer that is able to diversify the risk often absorbs this risk.

Senior tranches: Investors that buy the asset backed securities themselves bear the lesser credit risk of the senior tranches. These are often divided into a senior tranche and a mezzanine tranche. Although these investors are exposed to other types of risk, such as prepayment or interest rate risk, senior level classes of asset-backed securities typically have less exposure to credit loss because of the credit support offered by the junior tranches as well as other credit enhancements.

Structural Issues in CMBS • Priority of Payment – Sequential Triggers • Available Funds Caps Release Premium in addition of Allocated Loan Balance in Event of Asset Sales • A/B Note Structure as compared to Mezz with Joint Creditor Agreement • Potential Conflicts between Servicer, Originator and B piece Holder Quality and Extent of Disclosure of Ongoing Reporting

Prioritization of Payments- Waterfall Mechanism

The highest-rated bonds are paid-off first in the CMBS structure. Any return of principal caused by amortization, prepayment, or default is used to repay the highest-rated tranche first and then the lower-rated bonds. Any interest received on outstanding principal is paid to all tranches. However, it is important to note that many deals vary from this simplistic prioritization assumption. For example, consider the GMAC 1999-C3 deal. The bonds that are rated AAA by Fitch (classes A-1-a, A-1-b, A-2 and X) are the Senior Certificates. Classes B through M are organized in a simple sequential structure. Principal and interest are distributed first to class B and last to class N. Unfortunately, the Senior Certificates are not as simple in their prioritization. The loans underlying the GMAC 1999-C3 are divided into two groups. Group 2 consists of the multifamily loans and Group 1 consists of the remaining loans (retail, office, warehouse, etc.). In terms of making distributions to the Senior Certificates, 61% of Group 1's distribution amount is transferred to Group 2’s distribution amount. Group 1’s distribution amount is used to pay: 1) Interest on bond classes A-1-a , A-1-b, and the portion of interest on the Class X on components A-1-a and A-1-b pro rata, and 2) Principal to the Class A-1-a and A-1-b in that order. Loan Group 2’s distribution amount is used to pay: 1) Interest on Class A-2 and the portion of interest on the Class X components from A-2 to N pro rata, and 2) Principal to the Class A-2; In the event where the balances of all the subordinated classes (Class B through Class M) have been reduced to zero because of the allocation of losses, the principal and interest will be distributed on a pro rata basis to Classes A-1-a, A-1-b and A-2.

Loan default adds an additional twist to the structuring. Any losses that arise from a loan defaults will be charged against the principal balance of the lowest rated CMBS bond tranche that is outstanding (also known as the “first loss piece”). For the GMAC 1999-C3 deal, losses are allocated in reverse sequential order from Cl N through Class B. After Class B is retired, classes A-1-a, A-1-b, and A-2 bear losses on a pro-rata basis. As a consequence, a localized market decline (such as a rapid decline in the Boston real estate market) can lead to the sudden termination of a bond tranche. Hence, issuers seek strategies that will minimize the likelihood of a microburst of defaults. As long as there is no delinquency, CMBS are well behaved. Unfortunately, delinquency triggers intervention by the servicer (whose role will be discussed later in the chapter). In the event of a delinquency, there may be insufficient cash to make all scheduled payments. When there are insufficient funds, the servicer is supposed to advance principal and interest on a continued basis, as long as both amounts can eventually be recovered.

Interest Types in CMBS We can classify the interest type into following main category listed below

Fixed: Rate has an interest rate that is fixed throughout the life of the class

Floating: Rate has an interest rate that resets periodically based upon a designated index and that varies directly with changes in the index.

Interest Only: Receives some or all of the interest payments made on the underlying securities or other assets of the series trust but little or no principal. Interest Only classes have either a notional or a nominal principal balance. A notional principal balance is the amount used as a reference to calculate the amount of interest due on an Interest Only class. A nominal principal balance represents actual principal that will be paid on the class. It is referred to as nominal since it is extremely small compared to other classes. Principal Only: Does not bear interest and is entitled to receive only payments of principal.

WAC: Coupon related to collateral interest rate has an interest rate that represents an effective weighted average interest rate that may change from period to period. A Weighted Average Coupon class may consist of components, some of which have different interest rates. WAC_IO: Excess interest receives the excess of the collateral interest over the amount of interest payable to all other bonds in the deal. Note that WAC IO bonds may also contain a component with a real principal balance, despite the IO tranche type. CAP: Fixed Rate, but capped to collateral net rate Bond has a fixed rate. However, this rate might be capped, generally at the collateral net rate

Tranche Type in CMBS We have different types of CMBS tranches

Junior: Junior tranche, generally with a sub-investment-grade rating Mezzanine: Mezzanine tranche, generally with an investment-grade rating (but not AAA) Super Senior: Super senior tranche, which receives credit support from other senior bonds

Senior: Senior tranche, generally with AAA rating Ratio Strip: Receives principal (and possibly interest) as a direct strip from collateral with net rates between particular bands (as with ratio-strip PO bonds in RMBS deals) Multifamily carve-out: The practice of "carving-out" a multifamily tranche started in approximately 1998, and still happens in selected deals today. The collateral is split into two groups, and an “AAA-rated” bond is created that is primarily backed by 100% multifamily loans.11 Freddie Mac and Fannie Mae are the only known buyers of this tranche, and the bond is created to conform to the investment rules specified in their charters. Because of its position on the capital structure, if there are defaults in the multifamily loans, generally the bond will get cash from other property types as well, so the name “multifamily carve-out” can be slightly misleading. Also, if other property types default, cash may be taken from the “multifamily carve-out” to help make other AAA-rated bonds whole. A small portion of all CMBS – consisting exclusively of deals backed by loans on multifamily properties (i.e., apartment buildings) – carry guarantees from the federal government or GSEs.

CMBS Investor Motivation & Issues

• Relative Yield Advantage to alternative investments • Allocation to property debt without need for origination & servicing • Portfolio diversification from other fixed income and

structured investment products • As market develops, risk & return characteristics of deals can be

benchmarked against each other We can see security packages in CMBS as well. We have mainly two types of security package one is secured loan from Lender to Borrower and another is secured notes issued by issuer.

We have different type of Lender security package like Registered Mortgage over property and others like

• Leases: 1. Registered mortgage 2. Assignment by way of security

• Security interest over borrower’s assets • Security interest over shares

Lender Security Package for secured creditors is from Lender and swap counterparties. Like Lender we have issuer security package for assignment of loans and security documents and security interest over all assets of the issuer. We can list down the security package for issuer in terms of secured creditors is

• Note holders • Trustee and receiver • Liquidity facility provider • Swap counterparty • Paying agent • Trust Manager • Servicer

Some Definitions Participation Loans Some CMBS transactions contain participation loans. These are whole loans that have been split into multiple pieces that may be owned separately. Each piece is known as a participation note. From the borrower's perspective, there is still only one mortgage loan, so prepayment and default behavior occur at the mortgage level. A common type of participation loan is the A/B loan. The loan is carved into a senior and junior portion (known as the A note and B note). The senior portion has first priority on any payments on the whole mortgage and will receive all cash it is due before the junior portion receives payments. In addition, the junior portion will take losses before the senior portion. Another common type of participation loan is the pari-passu split, where the loan is split into multiple pieces at the same level of priority. Often these two types are combined, with a loan split into an A note and a B note, and the A note then further split into two or more pari-passu notes.

Rake Bond A loan is split into an A note and a B note and each piece is included in the deal - the A note backing the main certificates issued by the deal and the B note backing one or more tranches that receive payments solely from that B note then B note is said to be Rake Bond. Trust Assets Where both A note and B notes are involved to form securities in this case, there would be a PNOTE line for both the A note and the B note. Both the A note and the B note would be considered "trust assets", meaning that they are owned by the trust and back certificates issued by the trust. If the B note does not back tranches issued by the deal, there will be no PNOTE line for the B note. Though the B note does exist in real life, it is not considered a "trust asset" for this particular deal because it does not back any certificates issued by that deal. Pool assets In continuation of the above for Trust assets, Both the A notes and B notes in such a case would be considered "trust assets", because both are owned by the trust, but only the A note would be considered a "pooled asset", because only the A note is pooled with other mortgages to back the main group of bonds in the deal. Call Protected IO Tranche Typical CMBS structures contain a WAC IO. The WAC IO generally gets excess interest. But in some deals, the WAC IO interest entitlements are further carved up. Examples include carving the WAC IO into a PAC IO and a new WAC IO (very typical of deals backed by conduit and fusion collateral) or carving the WAC IO into a Call Protected IO and a new WAC IO, and then sometimes further carving up the new WAC IO into smaller interest entitlements often based on loan originator, fixed strip rates, etc. (typical in deals backed by short-term floating rate collateral). Call Protected IOs are carved out of the amount of excess interest that would otherwise go to a single WAC IO based on the call protection end dates of the underlying loans. Basically, the call protected IO is structured to receive all WAC IO interest as if each underlying loan prepays on its respective call protection end date, if that interest amount is available, even if that isn't necessarily how the loans pay down. Whatever is not taken by the call protected IO is usually left for the non-call protected IO, or the new WAC IO. Defeasance Defeasance is a method of call protection used on some CMBS loans that protects the deal against prepayments (and, even better, defaults), while at the same time allowing the borrower to release a property from the lien of the mortgage.

Prepayment in CMBS

Defeasance and yield maintenance are used to define the prepayment terms of a CMBS loan before its maturity.

Yield Maintenance:

Yield maintenance is an actual payoff of the loan made up of two parts: the remaining principal balance on the loan and a prepayment penalty. The prepayment penalty applies because the borrower is paying off the loan prior to the maturity date; it allows the lender to attain the same yield as if the borrower had made all scheduled mortgage payments until maturity. The penalty is based on the difference between the interest rate on the loan and a specified reference rate (generally defined in the “NOTE”), and the remaining payments on the loan multiplied by this interest rate differential. The higher the borrower’s loan rate and the lower the current market rates, the greater the yield maintenance penalty. Unlike defeasance, there are no transaction costs associated with yield maintenance and the debt payments are paid off in cash instead of US Treasury securities.

Defeasance:

Defeasance is a method of call protection used on some CMBS loans that protects the deal against prepayments (and, even better, defaults), while at the same time allowing the borrower to release a property from the lien of the mortgage

Pre-payment penalty option:

This is really a CMBS-type analytic and not particularly relevant to HE (for example) deals. This option says don't prepay a particular asset if the resulting prepayment penalty is greater than X% of the amount that you would be prepaying.

It's a very common analytic for CMBS deals because that is often how developers decide if it makes good sense to refinance, sell a particular property or just keep going. For example, if I sell now but can only get 104% of my loan amount for the property then it doesn't make any sense if my YM penalty amount comes out to be 5% of what I have to prepay (assuming that amount is the entire remaining balance). With CMBS deals you are looking at things on more of a property to property basis but with HE deals prepayments are forecasted on more of a pool "statistical" level.

The more common approach to HE penalties is to use the "Prepay Penalty Haircut" option and just make an assumption that some % of the total penalty cash that comes in will not be collected (typically 10%, 15%, etc.). Note that there is no direct and intuitive correlation to any info on the Asset Detail page and how this will affect prepayment and penalty levels on normal amortizing residential collateral

Prepayment Calculation

1. For deals with loan level (or Agency pool level) collateral information, 1MO, 3MO, 6MO, 9MO, 12MO and LIFE average historical prepayments are calculated based on the PSA standard. The PSA standard methodology is to find which prepayment rate, when applied to each piece of the collateral (i.e. loan) over the specific average period, appropriately changes the aggregate collateral balance from the start of the specific averaging period to the aggregate collateral balance at the end of the specific averaging period.

For example, a deal which negatively amortizes over the specified period and experiences no prepayments on any loans will show a historical prepayment rate of 0, even though the collateral balance increased. If the collateral balance remained exactly the same, a Negam deal's historical prepayment rate would be positive, NOT 0.

For Option ARM loans, the minimum payment option is assumed to be the P&I payment for amortization and historical prepayment calculation purposes. For this reason if a borrower chose to pay the full interest payment, or the fully- amortizing P&I payment, this would show up as a positive historical prepayment.

If the actual decrease in the collateral balance is smaller than the decrease, then the historical CPR shown will be negative.

For deals with pooled (i.e. rep. lines, plug pools) collateral information, 1MO, 3MO, 6MO, 9MO, 12MO and LIFE average historical prepayments are also calculated based on the PSA standard method. However, in this case, the calculations are performed on the aggregate collateral plug pools since no individual loan/pool information is available.

Therefore, prepayment rates calculated with PSA standard for non-CMBS deals should be interpreted as the prepayment rate including the default effect.

Default in CMBS:

Default option in CMBS:

Determinants of Option Values

Now that we have defined the conditions that lead to the exercise of the options, we need to identify the determinants of the options’ values. The value of the embedded options depends upon many factors. The direct determinants are

1. Current balance of mortgage

2. Term to maturity of mortgage

3. Mortgage payments including interest and principal, and the amortization schedule

4. Prepayment terms and penalties

5. Net operating income from the collateral property

6. Volatility of net operating income

7. Terms of default and foreclosure costs

8. Interest rates

9. Volatility of interest rates

10. Correlation between interest rates and net operating income

The first four items specify the information necessary to calculate the promised cash flows of the underlying mortgage.

This information in conjunction with current and the potential future interest rates are necessary for calculating the value of the prepayment option. Items 5, 6, and 7 which relate to the property are essential for valuing the default option. The last three items are critical for valuing all assets, including the mortgage, the real estate, and the options.

Default, Liquidity and Losses:

It is customary to forecast by projecting future defaults, not future loss.

For example, it is common practice to assume a 12-month lag between default incident and loan/asset liquidation. (You can change this lag value to any number of months, including 0 months to indicate no lag.) So even if the default rate is 100 CDR (i.e. , 100% of the collateral defaults immediately), no losses will occur until 12 months have transpired. The amount actually written down as a loss is controlled by your severity (or 100 minus your recovery) percentage forecast assumption.

In addition, the cash flows are affected by your assumptions for servicer advancing on defaulted principal and interest. 100% advancing indicates that the servicer is making the payments, whereas 0% indicates no payments during the defaulted period.

The Combined Default and Prepayment: Since the call and put options are embedded in the mortgage debt, the call option and the put option cannot actually be separated. The incentive to prepay as we have discussed is linked not just to the general level of interest rates, but to the ever changing level of operating income of the property and the resulting available refinancing spread. Thus, the value of the prepayment option is related to factors that affect the value of the default option. Similarly the incentive to default is related to the level of interest rates which in turn affects the value of the prepayment option. Moreover, borrowers who either prepay or default terminate the contract of the mortgage. This results in the termination of both options. Our triggering conditions, thus, do not work independently, but need to be evaluated simultaneously.

Collateralized Debt Obligations (CDO)


Contents

(i) Introduction (ii) Structure of a CDO (iii) Life of a CDO

a. Ramp-up Phase b. Revolving Period c. Amortization Phase

(iv) Coverage Tests a. Overcollateralization Ratios b. Interest Coverage Ratios

(v) Cash flow CDO: Interest Waterfall Sample (vi) Cash flow CDO: Principal Waterfall Sample (vii) Sponsor’s Motivation

a. Economics of an Arbitrage Transaction

(viii) Arbitrage and Balance Sheet CDO a. Cash flow CDOs b. Market Value CDOs c. Arbitrage CDOs

i. Arbitrage market Value CDOs ii. Arbitrage cash flow CDOs iii. Arbitrage Cash flow CDOs

d. Balance sheet cash flows CDOs

(ix) Synthetic CDO a. Fully Funded Synthetic Transactions b. Partially Funded Synthetic Transactions

Introduction A Collateralized Debt Obligation (CDO) is an asset-backed security, backed by a diversified pool of one or more classes of debt (corporate and emerging market bonds, asset-backed and mortgage backed securities, real estate investment trusts, and bank debt). The list of asset types included in a CDO portfolio is continually expanding.

When the underlying pool of debt obligations consists of bond-type instruments, the CDO is referred to as a Collateralized Bond Obligation (CBO). When the underlying pool of debt obligations consists of only bank loans, the CDO is referred to as a Collateralized Loan Obligation (CLO). In a way, A CDO is similar to a regular mutual fund that buys bonds. However, unlike a mutual fund, most of the securities sold from a CDO are themselves bonds, rather than shares. In simplest terms, a CDO is an arrangement that raises money primarily by issuing its own bonds and then invests the proceeds in a portfolio of bonds, loans, or similar assets. Payments on the portfolio are the main source of funds for repaying the CDO's own securities.

The basic concept behind a CDO is the redistribution of risk - Some securities backed by a pool of assets in a CDO will be higher rated than the average rating of the portfolio and some will be lower rated.

Structure of a CDO In a CDO structure, there is an asset manager responsible for managing the portfolio of debt obligations. There are restrictions imposed (i.e., restrictive covenants) as to what the asset manager may do and certain tests that must be satisfied for the debt obligations in the CDO to maintain the credit rating assigned at the time of issuance.

The funds to purchase the underlying assets, referred to as the Collateral Assets, are

obtained from the issuance of debt obligations. These debt obligations are also referred to as tranches. The tranches are:

• Senior tranches • Mezzanine tranches • Subordinate/equity tranche

There will be a rating sought for all but the subordinate/ equity tranche. For the senior

tranches, at least an A rating is typically sought. For the mezzanine tranches, a rating of BBB but no less than B is sought. Since the subordinate/equity tranche receives the residual cash flow, no rating is sought for this tranche.

The order of priority of the payments of interest and principal to the CDO tranches is

specified in the prospectus. What is important to understand is that the payments are made in such a way as to provide the highest level of protection to the senior tranches in the structure. This is done by providing certain tests (Dealt in detail little later) that must be satisfied before any distribution of interest and principal may be distributed to the other tranches in the structure. If certain tests are failed, the senior tranches are then retired until the tests are passed. The ability of the asset manager to make the interest payments to the debt holders and repay principal to the debt holders depends on the performance of the collateral assets. The proceeds to meet the obligations to the CDO tranches (interest and principal repayment) can come from

• Coupon interest payments from the collateral assets • Maturity of collateral assets • Sale of collateral assets

Life of A CDO It is useful to view a CDO as having a lifecycle that consists of several phases.

• Ramp-up phase: The first phase is the ramp-up phase, when the manager uses the proceeds from issuing the CDO to purchase the initial portfolio. The CDO's governing documents generally specify parameters for the initial portfolio but not the exact composition. For example, the terms of the CDO might require that the initial portfolio have a minimum average rating, a minimum average yield, a maximum average maturity, and a minimum degree of diversification. During the ramp-up phase, the manger must select assets so that the portfolio satisfies all the parameters.5

• Revolving Period: The second phase is the revolving period during which, the

manager actively manages the portfolio and reinvests cash flow from the portfolio. The reinvestment phase allows a CDO to remain outstanding – without amortization of the CDO's own bonds – even though the assets in the underlying portfolio reach their maturity dates.

• Amortization Phase: The third period is the amortization phase. During the

amortization phase, the manager stops reinvesting cash flow from the portfolio. Instead, the manager must apply the cash flow toward repaying the CDO's debt securities.

A manager generally is required to follow certain rules in managing the portfolio. The

rules protect investors by somewhat limiting the manager's discretion. For example, one rule might require the manager to maintain the average yield or spread on the managed assets above a certain level. Another rule might require the manager to maintain the average maturity of the assets within a certain range.

Many CDO's include performance tests that can trigger the early start of the amortization

phase if the deal performs poorly. For example, many deals include an "overcollateralization" test based on the ratio of the portfolio balance to the balance of the CDO's debt securities. Likewise, many CDOs also include an interest coverage test, based on the ratio of interest cash flow on the portfolio to the interest that the CDO must pay on its own securities. If either ratio falls below a specified threshold, the deal would enter early amortization. The tests are designed to protect investors by triggering amortization if a deal's performance deteriorates. However, a CDO manager sometimes can manipulate the tests to avoid early amortization. In those cases, rating agencies are likely to downgrade the CDO's securities.

Coverage Tests In CDO, two coverage tests—overcollateralization and interest coverage tests—are designed to protect investors against a deterioration of the reference portfolio. While the overcollateralization ratio is calculated based on the par value of the collateral assets in a cash flow CDO, a market value CDO uses mark-to-market prices in testing overcollateralization. The coverage tests involve comparing a tranche’s coverage ratios with the tranche’s required minimum ratios as specified in the guidelines. Higher ratios provide greater protection for the investors. A representative coverage test ranges are provided in the Table1 below.

AAA BBB

O/C I/C O/C I/C High-Yield CDO 150-130 120-130 105-112 110-120 Investment Grade CDO 108-115 115-125 103-105 100-105 Structured Finance CDO 110-125 115-125 103-105 100-105

Table1:

Overcollateralization Ratio: Principal Par Value of the Reference Portfolio O/C Ratio for Class A = -------------------------------------------------------------------------- Principal par Value of Class A only Principal Par Value of the Reference Portfolio O/C Ratio for Class B = -------------------------------------------------------------------------------- Principal par Value of Class A + Principal Par Value of Class B Interest Coverage Ratios: Scheduled interest due on the reference portfolio I/C Ratio for Class A = --------------------------------------------------------------------------------- Scheduled Interest on Class A only Scheduled interest due on the reference portfolio I/C Ratio for Class B = --------------------------------------------------------------------------------- Scheduled Interest on Class A + Scheduled Interest on Class B

Cash flow CDO: Interest Waterfall Sample

Cash flow CDO: Principal Waterfall Sample

Sponsor’s Motivation CDOs are categorized based on the motivation of the sponsor of the transaction. If the motivation of the sponsor is to earn the spread between the yield offered on the collateral assets and the payments made to the various tranches in the structure, then the transaction is referred to as an arbitrage transaction. If the motivation of the sponsor is to remove debt instruments (primarily loans) from its balance sheet, then the transaction is referred to as a Balance Sheet Transaction (This handled in more detail, little later).

Sponsors of balance sheet transactions are typically financial institutions such as banks and insurance companies seeking to reduce their capital requirements by removing loans due to their higher risk-based requirements.

Economics of an Arbitrage Transaction

The key as to whether or not it is economic to create an arbitrage CDO is whether or not a structure can offer a competitive return for the subordinate/equity tranche. To understand how the subordinate/equity tranche generates cash flows, consider the following basic $100 million CDO structure with the coupon rate to be offered at the time of issuance as shown:

Tranche Par Value Coupon Rate Senior $80,000,000 LIBOR + 70 basis points Mezzanine $10,000,000 Treasury rate plus 200 basis points Subordinated/equity $10,000,000 -------

Suppose that the collateral assets consist of bonds that all mature in 10 years and the coupon rate for every bond is the 10-year Treasury rate plus 400 basis points. Notice that the collateral assets pay a fixed rate but 80% of the capital structure is based on a floating rate (LIBOR). Thus, there is a mismatch with respect to the coupon characteristics of the collateral assets and the liabilities.

One way that the asset manager hedges this mismatch is by using an interest rate swap.

A swap is simply an agreement to periodically exchange interest payments with the payments benchmarked off of a notional amount. The notional amount is not exchanged between the two swap parties. Rather it is used simply to determine the dollar interest payment of each party. This is all we need to know about an interest rate swap in order to understand the economics of an arbitrage transaction. Keep in mind, the goal is to show how the subordinate/equity tranche can be expected to generate a return.

The interest rate swap that the asset manager would use would have a notional amount

of $80 million. Suppose that the terms of the interest rate swap are as follows: • The asset manager must pay a fixed rate each year equal to the 10-year Treasury rate

plus 100 basis points • The asset manager receives LIBOR

Let's assume that the 10-year Treasury rate at the time the CDO is issued is 7%. Now we can walk through the cash flows for each year. Look first at the collateral assets. The collateral assets will pay interest each year (assuming no defaults) equal to the 10-year Treasury rate of 7% plus 400 basis points. So the interest will be: Interest from collateral assets = 11 % × $100,000,000 = $11,000,000 Now let's determine the interest that must be paid to the senior and mezzanine tranches. For the senior tranche, the interest payment will be: Interest to senior tranche = $80,000,000 × (LIBOR + 70 bp)

The coupon rate for the mezzanine tranche is 7% plus 200 basis points. So, the coupon rate is 9% and the interest is: Interest to mezzanine tranche = 9% × $10,000,000 = $900,000 Finally, let's look at the interest rate swap. The asset manager is agreeing to pay the swap counterparty each year 7% (the 10-year Treasury rate) plus 100 basis points, or 8% of the notional amount. In our illustration, the notional amount is $80 million. The reason the asset

manager selected the $80 million is because this is the amount of principal for the senior tranche. So, the asset manager pays to the swap counterparty: Interest to swap counterparty = 8% × $80,000,000 = $6,400,000 The interest payment received from the swap counterparty is LIBOR based on a notional amount of $80 million. That is, Interest from swap counterparty = $80,000,000 × LIBOR Now we can put this all together. Let's look at the interest coming into the CDO: Interest from collateral assets = $11,000,000 Interest from swap counterparty = $80,000,000 × LIBOR Total Interest Received = $11,000,000 + $80,000,000 × LIBOR The interest to be paid out to the senior and mezzanine tranches and to the swap counterparty includes: Interest to senior tranche = $80,000,000 × (LIBOR + 70 bp) Interest to mezzanine tranche = $900,000 Interest to swap counterparty = $6,400,000 Total Interest paid = $7,300,000+ $80,000,000 × (LIBOR + 70 bp) Netting the interest payments coming in and going out we have: Total Interest Received = $11,000,000 + $80,000,000 × LIBOR (-) Total Interest paid = $7,300,000+ $80,000,000 × (LIBOR + 70 bp) Net Interest = $3,700,000 - $80,000,000 × (LIBOR + 70 bp) Since 70 basis points times $80 million is $560,000, the net interest remaining is $3,140,000 (= $3,700,000 N $560,000). From this amount any fees (including the asset management fee) must be paid. The balance is then the amount available to pay the subordinate/equity tranche. Suppose that these fees are $634,000. Then the cash flow available to the subordinate/equity tranche is $2.5 million. Since the tranche has a par value of $10 million and is assumed to be sold at par, this means that the return is 25%.

Obviously, some simplifying assumptions have been made. For example, it is assumed that there are no defaults for the collateral assets. It is assumed that all of the collateral assets purchased by the asset manager are non-callable and therefore the coupon rate would not decline because issues are called. Moreover, as explained earlier, at the end of the reinvestment period the asset manager must begin repaying principal to the senior and mezzanine tranches. Consequently, the interest swap must be structured to take this into account since the entire amount of the senior tranche is not outstanding for the life of the collateral assets. Despite the simplifying assumptions, the illustration does demonstrate the basic economics of the CDO, the need for the use derivative instruments—in the example, an interest rate swap—and how the subordinate/equity tranche will realize a return.

Arbitrage and Balance Sheet CDOs Most CDOs can be placed into either of two main groups: Arbitrage and Balance Sheet transactions. Figure 1shows the conceptual breakdown between the two structures. Before looking at these two structures in detail we will first try to understand the difference between Cash flow CDOs and Market Value CDOs.

Cash flow CDOs: A cash flow CDO is one where the collateral portfolio is not subjected to active trading by the CDO manager. The uncertainty concerning the interest and principal repayments is determined by the number and timing of the collateral assets that default. Losses due to defaults are the main source of risk.

Market value CDOs; A market value CDO is one where the performance of the CDO tranches is primarily a mark-to-market performance, i.e. all securities in the collateral are marked to market with high frequency. Market value CDOs leverage the performance of the asset manager in the underlying collateral asset class. As part of normal due diligence, a potential CDO investor needs to evaluate the ability of the manager, the institutional structure around him, and the suitability of the management style to a leveraged investment vehicle.

Figure1: CDO Structure

Arbitrage CDOs The aim of Arbitrage CDOs is to capture the arbitrage opportunity that exists in the credit-spread differential, between the high yield collateral and the highly rated notes. The idea is to create collateral with a funding cost lower than the returns expected from the notes issued. Most arbitrage deals are private ones, where size is not large and the number of assets included in the deal is very limited compared to the cash flow type.

Arbitrage market value CDOs Arbitrage market value CDOs, unlike balance sheet CDOs where there is no active trading of loans in the portfolio; go through a very extensive trading by the collateral manager, necessary to exploit perceived price appreciations. This type of CDO relies on the market value of the pool securitized, which is monitored on a daily basis. Every security traded in capital markets, with estimated price volatility, can be included in this type of CDO. In fact, the primary consideration is the price volatility of the underlying collateral. The important aspect is the collateral manager’s capacity to generate a high total rate of return. The CDO manager has a great deal of flexibility in terms of the asset included in the deal. During the revolver period, the collateral manager can increase or decrease the funding amount that changes the leverage of the structure.

CDO

Arbitrage Balance Sheet

Cash Flow Market Value Cash Flow

Arbitrage cash flow CDOs By their very nature, collateral assets have been purchased at market price and are negotiable instruments, therefore most assets are bonds. However syndicated loans, usually tradable, have been included in past transactions. As arbitrage deals, the collateral assets can be refinanced more economically by re -tranching the credit risk and funding cost in a more diversified portfolio. Unlike arbitrage market value CDOs, the collateral assets are not traded very frequently.

Balance sheet cash flows CDOs Balance sheet deals are structures for the purpose of capital relief, where the asset securitized is a lower yielding debt instrument. The capital relief reduces funding costs or increases return on equity, by removing, the assets that take too much regulatory capital, from the balance sheet. These transactions rely on the quality of the collateral that is represented by guaranteed bank loans with a very high recovery rate. The relative low coupon attached to these assets, results in a smaller spread cushion than the corresponding arbitrage structure. However, given their relative superior quality, they require less subordination when used in a CDO deal. In the majority of the cases, the sold assets are loan-secured portfolios. The size of a typical balance sheet CDO is in general very large, as the transaction must have an impact on the ROE of the institution looking for capital relief.

Synthetic CDO A synthetic collateralized debt obligation, or synthetic CDO, is a transaction that transfers the credit risk on a reference portfolio of assets. The reference portfolio in a synthetic CDO is made up of credit default swaps. Thus, a synthetic CDO is classified as a credit derivative. Much of the risk transfer that occurs in the credit derivatives market is in the form of synthetic CDOs. Understanding the risk characteristics of synthetic CDOs is important for understanding the nature and magnitude of credit risk transfer. In most conventional, Cash Flow CDOs, assets are actually transferred into the SPV. However, the process of transferring loans to the SPV requires significant up front work. A loan-by-loan analysis is necessary to check it complies with the securitization program and to verify that there are no special clauses attached to any loan limiting its transfer. The first stage of evolution of the conventional CDO arrived when the credit risk was transferred into the SPV through a credit default swap (CDS), and when the underlying credit ownership of the underlying pool remained in the originator’s book. For this the term synthetic is used, since the risk was synthetically transferred out of the originator’ balance sheet. With synthetic CDO’s, the big advantage is that sensitive client relationship issues arising from loan transfer notification, assignment provisions and other restrictions can be avoided. Also, client confidentiality can be maintained. Not to mention that it takes less time to complete the transaction.

Fully Funded Synthetic Transactions: Historically, the fully funded CDO was the first to be used as an alternative to the more traditional structure. In a fully funded synthetic CDO, the SPV issue notes for approximately 100% of the reference portfolio. The proceeds of these notes are generally invested in high quality securities used as collateral that have a 0% risk weight. In order to hedge its credit risk exposure in its loan portfolio, the originating bank enters into a Credit Default Swap (CDS) with either the same SPV or with an OECD (bank. With the CDS the originator buys credit protection in return for a premium. The premium received is then added to the interest notes received by the note investors.

Partially Funded Synthetic Transactions: In fully funded CDOs, the bank originator is far from achieving an efficient capital use. Fully funded CDO-CLO may sometimes be a relatively expensive program. However, it is also true that as term funding debt, a CDO/CLO program remains less exposed to the risk that credit spreads may widen.

The structure behind a partially funded CDO transaction is very similar to that of a fully funded one. The originator bank buys credit protection directly from an SPV or from an OECD bank. The difference is that the SPV issues a lower amount of notes because it guarantees a lower amount of collateral. What really characterizes this structure is the un-funded piece called the Super Senior. This is a very high quality financial paper, virtually with a zero probability of being exposed to a credit loss. The originating bank enters in a CDS (super senior CDS) with an OECD bank for the amount of the super senior tranche.

Documents

FIAG Primer