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Structured Finance CDOs: An Analytical Framework - Part 1

This article examines why structured finance CDOs are attractive and the structural features of the instruments. Next week's article will look at collateral and ratings.

Collateralized debt obligations referenced to structured finance securities, known as CDOs of ABS, have become one of the fast growing areas of the securitization market. Last year 23% of the European CDO/CLO market was made up of structured finance CDOs, a massive jump from the 5% market share the deals had the previous year. While the overall CDO market has contracted over the past two years, the growth trend in SF CDOs has continued, with annual issuance of USD22 billion last year and an expected USD30 billion in 2003.

Structured finance CDOs source collateral from a wide range of structured asset classes, including RMBS, CMBS, CDOs, Consumer Finance and Real Estate ABS. According to the underlying weightings, SF CDOs are usually categorized as:

* CDO of CDOs, in which the majority or the totality (60-100%) of the collateral pool is invested in CDO notes;

* Real Estate CDOs with a majority (typically more than 60%) is in RMBS, CMBS and other Real Estate ABS;

* Diversified SF CDOs which are characterized by a multisector and diversified asset pool.

Although the primary rationale for these transactions is credit arbitrage, a significant number have been driven by balance sheet management. In addition, SF CDOs are increasingly structured in a synthetic form. In these deals the transfer of the risk is accomplished through 'loss definitions,' rather than through the sale of the underlying collateral. In addition, some of the tranches, usually the senior ones, are unfunded.

Structured Finance CDOs :
Why Are They Attractive To Investors?

These 're-securitizations' are particularly attractive from an 'investor point of view for the following reasons:

* Historically better credit performance of the underlying asset portfolio. Recent studies carried out by rating agencies have shown significantly lower rating migration for structured finance securities compared to corporate bonds. This is particularly true for the BBB segment. In the structured finance markets both in Europe and the U.S., the negative ratings drift has been lower than in the global corporate bond market between 1998-2002. In 2002 alone, the European structured finance market had a lower ratings drift than U.S. structured finance and global corporate market, according to Moody's Investors Service.

* More stable credit performance than other CDO segments due to more diversification. The CDO sector overall has contributed the majority of downgrades in the ABS markets, SF CDOs, however, accounted for only 4% of CDO downgrades last year and so far have seen no downgrades this year.

* Structured finance CDOs can lock in some of the illiquidity premium of the structured finance securities as compared to corporate credits. Historically, mainly because of small tranche size and structure complexity, structured finance securities have often traded cheaply relative to the equivalent corporate credits, both in senior tranches and the lower rating categories. The chart below shows the primary market pricing of benchmark AAA rated RMBS transactions in Europe compared to the HSBC AA rated corporate index and SF CDOs.

The chart shows that the spread pattern in RMBS and SF CDOs is much more stable, and on average, the AAA rated RMBS have yielded more than the AA rated corporate index. It also highlights that the AAA SF CDOs yield a substantial pick-up over the prime RMBS sector and over AA rated corporates.

Structural Features

The structure of a SF CDO is in many respects similar to a corporate credit CDO. The use of asset-backed securities as collateral, however, requires some additional considerations.

Long Legal Maturities

The legal final maturity of a structured finance CDO is usually longer than that of more traditional corporate credit transactions. This reflects the longer legal maturity of the underlying asset-backed securities. For example, it is not surprising to see legal maturities in the region of 30-35 years against 10-12 years for most traditional CDOs. The expected maturity for the liabilities is usually shorter.

In particular, SF CDOs incorporate mechanisms that, other things being equal, shorten the expected life either by incentivizing the manger/equity holders to retire the underlying securities pool to avoid severe penalties in the equity return or by providing for a faster paydown of the notes.

Accelerated Deleveraging, Step-Up, Equity
Return Cap, Auction Calls

Some deals do not have a reinvestment period and therefore the notes are paid down as the collateral prepays or amortizes, delevering the deal while it is still performing rather than waiting for a breach of any overcollateralisation tests.

Another characteristic feature is the 'step-up' coupon that--if the credit quality of the collateral remains strong--should provide an incentive for the managers/equity holders to repay the notes and retire the collateral in order to avoid severe penalties.

Other deals incorporate an Equity Return Cap feature whereby some of the excess spread generated (in excess of a predefined hurdle IRR for the equity piece) during the reinvestment period is utilized to amortize mezzanine notes before the paydown period starts. This will shorten the average life of the mezzanine notes whilst boosting available excess spread. Also, the senior notes gain protection in terms of overcollateralization build-up.

In other structures, the trustee is required to conduct an auction on a regular basis, typically after 10-12 years from closing, to gather bids on the collateral pool. If no deterioration of the pool has occurred throughout the life of the deal, the call will probably be in-the-money and the notes will be retired. This auction call can also mitigate extension risk for ABS holders if the underlying collateral amortizes down more slowly than the expected schedule.

Dynamic Ramp-Ups

Another peculiar feature of structured finance CDOs is a longer ramp up than for common CDOs due to the relatively thin supply of structured finance securities compared to the corporate credit market. This is true especially for the subordinated segment of the market. In this respect, dynamic funding structural mechanisms are employed to lessen the impact of the resulting negative carry. Typical remedies include variable funding notes and the issuance of additional notes. The former is based on CDO liabilities structured as revolving credit facilities that can be drawn at short notice. These type of notes are usually attractive for asset-backed commercial paper conduits. The latter solution, instead, allows for an increase of the CDO notes (in accordance with pre-agreed rating agencies guidelines) to reflect the ramp-up of the underlying portfolio.

OC/ IC Tests

Similarly to other CDOs, SF CDOs often include interest coverage and overcollateralization tests. If at any time these ratios fall below a trigger level, a portion of the cash flow available to junior noteholders is redirected to repay senior notes. By way of deleveraging the deal, relatively more subordination becomes available for the senior investors, providing an additional cushion for potential losses.

This week's Learning Curve was written by Francesco Cuccovillo, manager in structured credit trading, and Markus Herrmann, director and head of asset-backed securities and structured credit research, at HSBCin London.

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