Table of Contents

Preface xiii

About the Authors xxi

Part One Introduction to Cash CDOs 1

Chapter 1 Cash CDO Basics 3

Why Study CDOs? 3

Understanding CDOs 4

Credit Structures 10

A CDO Structural Matrix 13

CDOs Being Offered Today 14

Parties to a CDO 14

Chapter 2 Cash Flow CDOs 17

Distribution of Cash Flows 17

Restrictions on Management: Safety Nets 20

Credit Ratings 23

Call Provisions in CDO Transactions 38

Part Two Loans and CLOs 41

Chapter 3 High-Yield Loans: Structure and Performance 43

The Loan Market 44

The Syndication Process 46

Loan Structure and Leaders 48

Loan Interest Rates and Upfront Fees 49

Loan Credit Quality 51

Lender’s Liability 52

Overview of Loan Terms 53

Loan Terms versus Bond Terms 58

A Tale of Two Loans 58

The Secondary Market 60

Loan Recovery Rates 61

Loan Default Rates 63

High-Yield Loan CLO versus High-Yield Bond CBO Performance 67

Conclusion 74

Chapter 4 European Bank Loans and Middle Market Loans 75

European Bank Loans 75

Middle Market Loans 91

Conclusion 99

Part Three Structured Finance CDOs and Collateral Review 101

Chapter 5 Review of Structured Finance Collateral: Mortgage-Related Products 103

Residential Mortgage-Backed Securities 103

Commercial Mortgage-Backed Securities 125

Real Estate Investment Trust Debt 129

Chapter 6 Review of Structured Finance Collateral: Nonmortgage ABS 135

Credit Card Receivable-Backed Securities 135

Auto Loan-Backed Securities 137

Student Loan-Backed Securities 139

SBA Loan-Backed Securities 141

Aircraft Lease-Backed Securities 142

Franchise Loan-Backed Securities 145

Rate Reduction Bonds 148

Chapter 7 Structured Finance Default and Recovery Rates 153

Structured Finance versus Corporate Default Rates 154

S&P Rating Transition Studies and the Matrix Multiplying Approach 156

Results of Multiplying S&P Rating Transition Matrices 158

S&P on Structured Finance Loss Given Default 159

S&P Constant Annual Default and Recoveries 159

Moody’s Material Impairment Study 160

Comparing and Reconciling Structured Finance Default Rates 162

Moody’s on Structured Finance Historical Loss Rates 164

Moody’s Constant Annual Default and Recoveries 166

Blending S&P and Moody’s Studies 167

Applying CDRs and Recoveries to SF CDOs 167

Conclusion 170

Chapter 8 Structured Finance Cash Flow CDOs 171

SF CDOs versus High-Yield CDOs 172

Rating Agencies on Structured Finance CDOs 174

Structured Finance Assets’ Negative Convexity 182

Extension Risk 183

Conclusion 185

Part Four Other Types of Cash CDOs 187

Chapter 9 Emerging Market CDOs 189

EM Sovereign Bond Defaults 190

Why the Better Track Record? 192

CDO Rating Differences: EM versus High Yield 193

Conclusion 198

Chapter 10 Market Value CDOs 201

Cash Flow versus Market Value Deals 201

The Rating Process 202

How Advance Rates are Derived 212

Conclusion 215

Part Five Synthetic CDOs 217

Chapter 11 Introduction to Credit Default Swaps and Synthetic CDOs 219

Credit Default Swaps 219

Synthetic CDOs 229

Conclusion 239

Chapter 12 Synthetic Balance Sheet CDOs 241

Cash CLOs for Balance Sheet Management 241

Partially Funded Synthetic CDOs 249

Conclusion 253

Chapter 13 Synthetic Arbitrage CDOs 255

Full Capital Structure Synthetic Arbitrage CDOs 256

Single-Tranche CDOs 260

Standard Tranches of CDS Indices 261

Conclusion 262

Chapter 14 A Framework for Evaluating Trades in the Credit Derivatives Market 265

Assessing Single-Name and CDO Tranched Exposures 266

Assessing CDO Equity versus a Basket Swap 274

Conclusion 280

Chapter 15 Structured Finance Credit Default Swaps and Synthetic CDOs 281

Differences between Corporate and Structured Finance Credit 282

Difficulties in SF CDS 284

SF CDS Effect on SF CDO Management 294

Two New Types of SF CDOs 295

Effects of SF CDS on CDO Credit Quality and Spreads 296

Conclusion 297

Part Six Default Correlation 299

Chapter 16 Default Correlation: The Basics 301

Default Correlation Defined 301

Default Probability and Default Correlation 305

Conclusion 321

Chapter 17 Empirical Default Correlations: Problems and Solutions 323

Empirical Results 323

Problems with Historical Default Correlations 327

Proposed Solutions 330

Conclusion 344

Part Seven CDO Equity 345

Chapter 18 Why Buy CDO Equity? 347

Nonrecourse Term Financing 347

The Forgiving Nature of CDO Financing 354

CDO Options 356

CDO Equity as a Defensive Strategy 359

Conclusion 360

Chapter 19 CDO Equity Returns and Return Correlation 361

Flawed Methodologies 362

The Appropriate Lesson from History 365

Loan Defaults and Recoveries 367

Cash Flow Modeling Defaults and Recoveries 370

Structured Finance Defaults and Recoveries 371

SF CDO Cash Flow Modeling 372

Return Correlation and Nonrecourse Leverage 374

Conclusion 378

Part Eight Other CDO Topics 379

Chapter 20 Analytical Challenges in Secondary CDO Market Trading 381

Important Developments: Spread Tightening, Increased Activity 382

Pitfalls in Secondary CDO Trading 384

Eight-Point Checklist in Evaluating a CDO in the Secondary Market 387

Prescription for Making Primary Issuances Conducive to Secondary Trading 408

Conclusion 409

Chapter 21 The CDO Arbitrage 411

Building Blocks 411

Impact of CDO Arbitrage on Structure 422

Conclusion 425

Chapter 22 How to Evaluate a CDO and Manage a CDO Portfolio 427

Incentive Clashes in CDO Structures 427

Evaluate Structural Enhancements 428

Evaluating the Manager’s Track Record 429

Conclusion 434

Chapter 23 Quantifying Single-Name Risk Across CDOs 435

Collateral Overlap in U.S. CLOs 436

Favorite CLO Credits 437

Collateral Overlap in U.S. Structured Finance CDOs 439

Single-Name Risk and Tranche Protections 441

Excess Overcollateralization and Excess Overcollateralization Delta 443

Monte Carlo Simulation of Single Credit Risk 446

Comparing the Two Approaches 449

Conclusion 450

Chapter 24 CDO Rating Experience 453

CDO Rating Downgrade Data 454

CDO and Tranche Rating Downgrade Frequency 456

CDO Downgrade Patterns 458

Why Downgrade Patterns? 460

Downgrade Severity 462

Downgrades of Aaa CDO Tranches 464

Extreme Rating Downgrades 464

CDO Defaults and Near Defaults 469

Conclusion 473

Index 477

About the Author

DOUGLAS J. LUCAS is Executive Director and Head of CDO Research at UBS. He is also Chairman of The Bond Market Association's CDO Research Committee and ranked top three in CDO research in the Institutional Investor's fixed income analyst survey. Lucas has been involved in the CDO market for nearly two decades, having developed Moody's rating methodology for CDOs in 1989.

LAURIE S. GOODMAN, PHD, is Managing Director and co-Head of Global Fixed Income Research at UBS. She manages U.S. Securitized Products and Treasury/Agency/Derivatives Research. Goodman has worked on Wall Street for over twenty years and is well regarded by the investor community, having won more #1 slots on the Institutional Investor All-American Fixed Income Team than any other analyst.

FRANK J. FABOZZI, PHD, CFA, CPA, is an Adjunct Professor of Finance and Becton Fellow at Yale University's School of Management and a Fellow of the International Center for Finance. Fabozzi is the Editor of the Journal of Portfolio Management.