Contents

Property CDS set for launch

Standardised US product terms already under discussion

A new generation of property-based credit derivatives products are targeted for launch in the US in a matter of weeks. Expectations are that the new instruments will mirror the huge growth seen in CDS of ABS.

The initiative, dubbed home price derivatives, is being led by Goldman Sachs and will initially focus on three-month to five-year contracts based on the S&P/Case-Shiller home price indices. Home price derivatives will take the form of credit default swap-like contracts, forwards and total return swaps.

Goldman has licensed the indices, so can theoretically already trade the products with its customers, but is currently making sure it has all its internal processes in place to do so. Rajiv Kamilla, who is responsible for new products trading within Goldman Sachs' structured products business, says that at the same time: "We have begun discussions with other dealers and ISDA, suggesting we all work together to create standardised products with standardised terms and documentation."

The discussions involve more than half a dozen banks who are major players in the global mortgage and structured products markets. Kamilla adds that work is being done in conjunction with ISDA to develop standardised contracts and he expects that this project will be finalised within a few weeks. He hopes that this standardisation will have the same affect as that seen in the CDS of ABS market, where the outstanding notional was about US$10bn at the beginning of 2005 and is now estimated to be around US$1tr.

In addition, a significant interdealer effort on property derivatives in Europe is underway, revolving around total return swaps on commercial real estate indices. However, CDS-like structures have not yet appeared in this space.

The US CDS-like contracts mimic the inherent leverage of a credit default swap, where the structure would provide levered exposure funded on a running basis. A contract will specify a running premium, a defined "credit event" and a contingent payout on an agreed notional.

A credit event would be the home price index falling below a specified strike. The payout would be calculated as a percentage of notional.

The new products aim to provide instruments where a whole range of investors can directly express positive or negative views on US real estate, which has not previously been possible. Furthermore, the CDS-like structure will potentially enable the creation of synthetic real estate CDOs.

The possibilities are endless for what can be done once we have rolled out the first suite of derivatives products benchmarked on this index, Kamilla says. Once there is liquidity and participants understand the flows, it will open up enormous potential – particularly with the CDS-like index swap products. He believes they may become rated products because the structure has many of the features that are present in rated bond instruments – there is a stated coupon, a notional at risk and there are certain likelihoods of losing money.

In addition to CDS products, forwards and total return swaps, it is expected that options, caps and floors, as well as funded notes based on US home prices will eventually be rolled out. The 10 metropolitan areas on which Goldman expects to trade derivatives on home prices include Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco and Washington, DC. It will also offer contracts on a national composite.

MP

European loan CDS index near

LevX and bespoke tranches on their way

The long talked about launch of a European leveraged loan CDS index, LevX, is now "close". Dealers plan to offer bespoke tranches on the index straight away, hoping to attract a broader range of investors to the product. But concerns remain over access to restructuring agreements and sensitive information associated with LCDS.

The new index has been heavily hyped as a significant kicker for the nascent European LCDS market, but has also been considerably delayed – the most recent deadline passed was 20 September (See SCI Issue 1). However, a dealer involved with the project confirms that: "Launch is close – it's now only a couple of weeks away."

"We are just working on a few outstanding items," he explains. "Primarily, we want to get the reference obligation database sorted out – the delay has been partly to do with the fact that we reshuffled some of the credits that we put in the index, which meant the lawyers had to scrub new loan agreements."

LevX will comprise two separate indices – one 35-name index will cover first-lien loans and another will cover 35 subordinated names. As expected, the indices will initially be written so that they are cancellable in the event of a full refinancing of a loan to mirror current European single-name LCDS market practice. But should that practice change – and dealers are already working to bring in non-cancellable European trades – then the next series of LevX will follow the prevailing pattern.

The current cancellable basis of LCDS has been one reason that some structured credit investors have expressed dissatisfaction with LevX compared with the planned US index. This is expected to be on a non-cancellable basis and therefore will trade more like a corporate CDS and have a wider appeal than primarily to loan portfolio managers.

Equally, the US index was initially hailed as being more tranche-friendly than its European counterpart. This characteristic, at least, has changed.

"We are looking to tranche LevX up immediately, albeit on a bespoke basis in the first instance. That should make it interesting to CLO investors because it will give them a means of managing their exposure on existing CLO tranches," states the dealer.

Investors say that tranching would make LevX more attractive than had previously been envisaged, although the limited number of names involved is still considered to be a disadvantage. A more significant criticism, however, is that CLO managers – who dealers hope will be the core users of the instrument more broadly – are discouraged because, unlike cash loans, with LCDS they have no say over restructuring or access to sensitive information.

Nevertheless, the dealer sees additional uses for LevX. "I think it's going to be used by CLO managers to put money to work when they have excess cash. And there will be other structured credit investors who will use it as a means to take views on general macro spreads in the market," he says.

When launched, LevX will come under the aegis of the International Index Company. The major European LCDS dealers – Barclays Capital, Credit Suisse, Deutsche Bank, Dresdner Kleinwort, Lehman Brothers and Morgan Stanley – are understood to have agreed to act as market-makers.

MP

"The market will cope with a downturn"

This week's Provider Profile is of structured credit lawyer Jeffrey Stern

Jeffrey Stern

Jeffrey Stern, a partner in the structured finance practice at Stroock & Stroock & Lavan LLP in New York, has rich experience in the structured credit markets. He has been providing legal advice to market participants since the mid 90's – working for banks, collateral managers and monolines on all aspects of CDO and derivatives deals.

Despite common perceptions of his profession, Stern maintains that the job of derivatives law is particularly creative. "The work involves a great deal of structural design, both at the microscopic level of crafting terminology, test formulations and the like, and with respect to the broader economics of the transactions, so we need to be fluent in structural choices and advise both sides on how to streamline or improve the efficiency of deal structures. Our work has been integral to developing synthetic structures, from the use of embedded shorting positions to the auctioning process," he says.

"We also add value to a deal by counselling on what makes sense for a particular transaction. In these transactions, technical, legal and regulatory issues have economic implications, so we have to examine the range of possible structures for each particular circumstance," adds Stern

In recent years, many of Stern's clients have migrated toward synthetic and hybrid structures as an effective vehicle for executing CDOs. He explains: "The separation of risk transfer from cash assets, and the use of credit derivatives to aggregate collateral, has allowed collateral managers to focus on credit analysis. They can now concentrate on the credit arbitrage of the portfolio, instead of devoting their primary energies to obtaining issuance allocations or getting in line to acquire securities, as was the case with cash assets. Furthermore, the use of shorts to reduce exposure creates some unique mechanisms for disposing of positions or hedging and rebalancing portfolios."

The benign macro economic landscape in the last few years has also facilitated a broader range of structured credit issuers. "It has been easier in this environment for deals to be generated, particularly where there is no need to ramp up in cash. Overall, the tremendous broadening of asset classes and user base means CDOs are no longer an exotic asset," says Stern

Deepening liquidity in the market has however brought its own challenges. Stern observes: "The incredible spread compression that we have witnessed, with so much cash looking for yield, has caused problems. While is has become easier to execute a CDO, it has become measurably more difficult to fill it up with well priced assets. This circumstance raises the spectre of weaker deals entering the pipeline, which could, in the long term, represent a risk to the growth and maintenance of the current, robust CDO market. We have also seen the recent increases in mortgage defaults which may have future ramifications for CDOs of MBS."

From Stern's perspective the story is a far better one than in the past, however. "The CDO market stalled during the early 90s when some of the earlier vintage CDOs were hit by defaults on high yield bonds. However, the current CDO technology for exploiting arbitrage has now become more powerful and broadly based. There will be some bumps in the road ahead, undoubtedly, but these may not be as severe as those in the younger days of CDOs, because of improvements in CDO structuring, the breadth of its application across a variety of assets types and the depth of the investor base. This means structured credit will continue to be a very significant part of capital markets in the future," he notes.

Technology has also allowed a convergence of the sector. Stern explains: "The dis-aggregation of credit risk from financed assets has been a fascinating development in this market, and has encouraged the convergence of derivatives, insurance and structured finance. We have done extensive work in and across all three of these areas. We are also now seeing a remarkable interpenetration of markets, for example with monolines now offering supersenior credit protection on CDOs, and insurers using structured finance for capital formation and portfolio risk transfer."

Several structural issues still pose challenges for the synthetic CDO market. For example, Stern sees that ratings agencies are still playing catch-up, although "they have come a long way recently", with many of their methodologies still in flux, which can "cause uncertainty and may damage some of the economic value in transactions."

In addition, the market is, in Stern's view, still wrestling with some of the technical elements of credit default swaps referencing ABS, MBS and CDOs, including the use of "variable cap" payments – where a credit protection seller takes on exposure for interest shortfalls that is greater than just the potential loss of its stream of premium payments – and "implied writedown" – where the protection seller makes a credit protection payment in connection with erosion of the collateral underlying the reference obligation, rather than upon an actual default under that reference obligation. The nuanced use of these and other devices in this market will affect the shape of the synthetic CMBS, RMBS and CDO markets in the coming years.

Overall though, Stern is positive. "The market will cope with a downturn in the credit environment. Highly compressed spreads have many challenges, and changes – even adverse change – in the economic environment may create new and possibly richer arbitrage opportunities, and may stimulate new growth in various CDO sectors," he concludes.

JW

Cohen hires for ABS CDO business

The latest people and company moves

Cohen & Company hires for ABS CDO business
Frank Viola has become md and ABS portfolio manager at Strategos Capital Management, the ABS CDO management unit of Cohen & Company. Previously, Viola was at Merrill Lynch Investment Managers, where he served as lead portfolio manager for the organisation's ABS CDO programme, as well as a member of the fixed income senior portfolio management team that managed over US$25bn in assets.

"We anticipate that Cohen & Company will complete at least eight ABS CDO transactions in 2006, a significantly larger volume when compared to 2005, and a validation of the progress we are making towards our goal of becoming a leader in the ABS CDO management space through our Strategos unit. Frank's hiring reflects our commitment to continuing to build our team and provide our Strategos business with the necessary resources to achieve our goal of ABS CDO market leadership," says Chris Ricciardi, ceo of Cohen & Company.

Washington Square heads east
Washington Square Investment Management has hired Zachary Carvell to heads its operations in Vienna. As md of Washington Square Vermögensberatung, he will be responsible for spearheading the firm's efforts in the German speaking region, Eastern Europe and Switzerland.

Prior to joining Washington Square, Carvell was head of portfolio management in the group large corporates division at Erste Bank in Vienna, where he was responsible for developing a modern RAROC approach to the credit portfolio with the ultimate goal of optimising the portfolio along risk/return parameters and facilitating the transfer of risk. He has extensive experience within structured credit and worked for a number of years as a senior portfolio manager within Erste Bank's CDO investment team.

Changes at RBS strategy
Matthew Wiesner is to join Royal Bank of Scotland's structured credit strategy team on 23 October. He arrives from Standard & Poor's Paris, where he has spent the last six years rating cash and synthetic CDOs. In his new role, Wiesner will focus on bespoke synthetic products and will report to Siobhan Pettit, who heads the team.

RBS's structured credit strategy unit is understood to have more hires in the pipeline before year-end. Meanwhile, another RBS structured credit strategist, Michael Hampden-Turner, has left the bank and is understood to be joining the European quantitative credit strategy and analysis team at Citigroup later this year.

Javid moves to Asia
Deutsche Bank has made Sajid Javid head of global credit trading, Asia (ex-Japan). He will relocate to Singapore from London and will be regionally responsible for all cash and derivative credit trading, CDOs, securitisation, structured finance, convertibles and for the commodities business.

Javid will report to Rajeev Misra, global head of global credit trading, and to Boon-Chye Loh, head of global markets Asia. Javid was previously global head of emerging market structuring at Deutsche, where he was responsible for the structuring and sourcing of emerging market assets for distribution to clients.

Rabobank hires Shaffran
Rabobank has announced the appointment of Alan Shaffran as its new global head of structuring within its global financial markets business. Shaffran joins Rabobank from Citigroup, where he spent 19 years – most recently as head of business development for global structured credit products and previously as head of European credit derivatives, based in London.

Morriss becomes XLCA head of origination
Wynne Morriss has been appointed to the newly-created position of head of origination for XL Capital Assurance (XLCA), a triple-A rated financial guarantee insurance provider. In this role, Morriss will directly oversee the operations of all of XLCA's product groups – commercial and consumer asset-backed securities, global infrastructure, power and utilities, specialised risk, structured investment products (CDOs) and US public finance.

Morriss joined XLCA in 1999 as a member of the firm's founding leadership team and previously led the firm's structured single risk group, which encompasses its public finance, global infrastructure, power & utilities, and specialised risk businesses.

RBC hires Kleinwort director
RBC Capital Markets has hired Paul Grimsey as director and head of euro cash trading. Grimsey is expected to take up his new role in December and will report to John Greenslade, head of liquid products trading.

Grimsey had previously been co-head of the investment-grade cash and synthetic credit trading group at Dresdner Kleinwort. The other co-head, James Deighton, will continue to lead the group, reporting to Henry Nevstad, head of credit flow products.

Lehman hires for Italian solutions
Raffaele Ricci has joined Lehman Brothers as md in fixed income structured solutions. Ricci will focus on balance sheet and capital management solutions for Italian institutions and reports to Phillipe Dufournier, head of structured solutions group Europe.

Ricci joins Lehman Brothers after six years at Dresdner Kleinwort in London, where he specialised in derivative solutions for financial institutions across Europe. Prior to that, Ricci held several structured credit sales positions at BNP Paribas.

MP

Price is tight for innovative Jubilee

A round up of this week's structured credit news

Price is tight for innovative Jubilee
Alcentra's eleventh European CLO, the €400m-equivalent Jubilee CDO VII, priced last week at the tightest level so far for the sector – at 15bp over the benchmark for the senior triple-A rated tranche. The deal, which was arranged by Barclays Capital and rated by Moody's and Standard and Poor's, included an innovative dual currency facility.

The CLO will invest entirely in European leveraged loans, of which at least 90% will be in senior leveraged loans with a bucket of up to 10% for mezzanine loans. While Jubilee VII is a traditional European CLO structure, an innovative dual-currency revolver was incorporated to increase funding flexibility and reduce the cost of foreign exchange hedging through the addition of an advanced macro hedging strategy. In the past, CLOs have relied on expensive and illiquid perfect asset swaps to hedge the sterling denominated loans in their portfolio.

Investor participation was broadly spread across Europe and Asia, and featured a number of repeat buyers as well as some new investors to the Jubilee programme. Edward Cahill, European head of CDOs at Barclays Capital, comments: "It is a great testament to the franchise that the Alcentra team have built in Europe that we achieved such broad participation and tight spread levels across all tranches of Jubilee VII. [The manager] can consistently bring quality CLOs to market because of [its] incredible access to the underlying collateral market – this deal is expected to be 75% ramped up at closing."

Associations highlight calculation agents
The International Capital Market Association (ICMA) and ISDA have published an explanatory note that aims to promote awareness among market participants of certain issues with respect to the role of calculation agent in the issuance of debt securities with embedded derivatives. The note follows extensive discussions within a dedicated working group of experts representing the membership of both trade associations, the associations say.

The note focuses on three issues relevant to the calculation agency role:

• First, it addresses the need to identify as early as possible who is to be the calculation agent in relation to the securities and allow adequate time to agree the terms of its appointment. (The note recommends at least 7 working days for finalisation of the terms of appointment of a calculation agent, from the time of circulation of the draft issuance documentation.)
• Second, it emphasises the need for clarity as to the role and responsibilities of the calculation agent. (Where these responsibilities include notifications, particular procedural arrangements may need to be ensured.)
• Finally, it discusses the interrelationship between the derivative securities and any associated hedge, including where the hedge provider is also calculation agent under both the hedge and the derivative securities.

Fitch and Markit join forces
Fitch Ratings and Markit Group have entered into an agreement whereby Markit's suite of credit derivatives data and tools will be integrated into Fitch's Risk Analytics Platform for Credit Derivatives (RAP CD).

RAP CD allows market participants to independently price synthetic CDOs in a mark-to-model framework, and to evaluate the key elements driving market volatility in these instruments. RAP CD provides users with unprecedented transparency throughout the length of an investment from origination to maturity, Fitch says.

Under the agreement, Markit's pricing for single-name CDS, bonds and loans, European ABS, convertible bonds, and the iTraxx and Dow Jones CDX indices, as well as the Markit Reference Entity Database (RED) will be integrated into RAP CD. RAP CD users will also have access to Markit Portal.

"The addition of Markit's data and tools clearly enhances the transparency that RAP CD brings to the market," says Kimberly Slawek, group md, Fitch Ratings. "We're driven to provide a solution for investors to help them with the most challenging aspects of investing in synthetic CDOs – managing and anticipating portfolio volatility."

Lance Uggla, ceo of Markit, comments: "Working together with Fitch RAP CD is an important move to enhance the quality of market risk tools for the synthetic CDO market, and a significant investment by Markit. We look forward to continuing to work with organisations, such as Fitch, that are deeply committed to bringing transparency to the OTC derivative marketplace."

Swapswire hits 100,000
SwapsWire handled over 100,000 tickets in September - almost double the volume it reported in February. Since the beginning of the year, the company has repeatedly broken previous volume records.

Such volume growth is attributed to a combination of new dealers and clients using the system, new products and features, and growth in the underlying OTC derivative markets. Three additional major dealers began using the service in 2006, bringing the total number of participating dealers to 31. In addition, the number of buy-side clients using the service has more than doubled over the year.

Andy Hudis, md at Goldman Sachs, says: "SwapsWire is a crucial part of our operational risk strategy. By confirming trades on trade date, generally within minutes of execution, we are able to eliminate that part of the risk equation. The efficiencies we've gained have allowed us to handle a significantly higher volume of business without the associated increase in operational staffing costs."

Fitch updates VECTOR model
Fitch Ratings has released an updated version of its Default VECTOR Model. The launch of VECTOR 3.0 – which replaces version 2.2 – is the culmination of extensive testing, an initial beta release in August, and a market comment period.

The rating agency is also releasing an updated Global Rating Criteria for CDOs to coincide with the new model's debut. Two separate updated reports addressing the unique criteria for the rating of cashflow and credit derivatives CDO portfolios are also due to be released in the near future.

VECTOR 3.0 includes an updated framework for emerging markets and provides a more user-friendly interface with the introduction of a reference entity feed (REF). The new model incorporates several updated assumptions with respect to asset default probabilities, recovery rates and correlation.

Adjustments have been made to default probability assumptions in order to increase the integrity of the default probability curves and to create a smoother progression of default probabilities over time. For lower- rated assets, the default assumptions have been slightly front-loaded, while for more highly rated assets, the default probabilities have been slightly back-loaded. Overall 10-year default probability assumptions have not changed, however.

The model incorporates updated recovery rate assumptions in several areas, such as European corporate debt, as well as certain structured finance asset types. In addition, the update includes a more flexible functionality to treat asset-specific recovery rates. The agency will use this functionality to incorporate recovery estimates based on its corporate asset recovery ratings in CLOs, where appropriate.

Correlation changes in VECTOR 3.0 only affect CMBS, where inter and intra industry correlations are reduced to 75% of their VECTOR 2.2 levels in recognition of the more idiosyncratic property type, geographic and other correlation factors present in CMBS in comparison to other structured finance securities.

The new version also includes a revised framework for the analysis of emerging market assets in internationally rated deals. The approach puts greater weight on regional and country concentrations when determining asset correlation, rather than on industry concentrations.

MP

The cash CDO-squared market: small, but significant

The increasingly important CDO resecuritisation (CDO of CDO) sector is discussed by Ratul Roy, global head of CDO strategy, and Ed Trampolsky, an associate in CDO strategy, at Citigroup in New York

Resecuritisations of CDOs (often called CDOs of CDOs, or "CDO squareds" [CDO²]) is a small, but significant part of the structured credit markets. The importance of this sector goes far beyond its mere share of the overall CDO market – as a buyer of other CDOs, the CDO² market contributes to the robustness of the remainder of the CDO market.

An important point needs to be made upfront. The term "CDO²" is often used in the context of synthetic transactions in which counterparties sell protection on a tranche of a portfolio (the outer CDO). This report excludes such products, and interested readers should refer to Citigroup's earlier publication (Understanding CDO-Squareds, R. Roy, M. King, and D. Shelton, Citigroup, February 2005). Throughout this report, we will refer to the product as "Cash CDO²", or simply, "CDO²" even though individual transactions may include in their portfolio synthetic CDOs of ABSs, or even synthetic corporate bespoke tranches.

The Cash CDO² market has existed since the early days of arbitrage Cash CDOs. To our knowledge, the first transaction closed in 1999 and has been managed by the Zais Group, which has since closed several other transactions. After a slump in 2003–04, investors regained interest in Cash CDO² products in 2005, and we anticipate record issuance for 2006.

Managers and collateral
The universe of managers for Cash CDO² deals is limited, compared to other types of CDOs. The field has been dominated by such established managers as Zais Group and Babson Capital. The recent CDO² history saw the entry of several new players, including Tricadia Capital, Dynamic Credit Partners, and CSFB Alternative Investments.

Managing CDO² portfolio requires an appropriate knowledge of structured finance and investment in infrastructure. The complexity of the product, relative to CLOs, for example, naturally limits the size of the investor base.

The portfolio of CDOs backing these transactions tends to be diversified, a point that we will return to later when discussing the return profile of Cash CDO². Earlier transactions would have a mix of CLO and CBO tranches, while more recent transactions mainly include CLO and ABS CDO tranches.

The other distinction is the portfolio quality. The traditional formula to structuring Cash CDO² deals is to use mezzanine, BBB rated, collateral. A few deals have been executed using a higher-quality portfolio with an average rating of AA/A.

A case for cash CDO²
In many ways, the CDO² structure is attractive to investors. High rating-adjusted liability spreads, the insulation from the first defaults in the inner CDO portfolios by equity holders, and the double layer of protection enjoyed by senior debt holders are some of its favourable factors. There is also a larger diversity of individual credits and managers achieved through a careful selection of CDOs within the portfolio.

High diversification – low event risk
Investors in CDO² transactions benefit from broad diversification, attained by including CDOs with different collateral portfolios that are managed with different investment styles. This leads to significantly lower single-asset exposure than in typical CDOs and diversification by both managers' style and the CDO collateral. The table below summarises six representative deals originated in 2004–05 and their diversity metrics.

First-loss protection for equity, double for debt
A Cash CDO² is a securitisation of the mezzanine tranches of several CDOs, its equity tranche is insulated from the first few defaults within each of the inner CDO portfolios. (Note, unlike a synthetic CDO, a few defaults in one or several of the inner CDOs can make the specific mezzanine tranches temporarily defer interest, that is, PIK, even if there is no principal loss.)

A flat return profile for equity
CDO² equity is a defensive play, well suited for a turn in the credit cycle. By securitising mezzanine tranches of 'inner' CDOs, CDO² equity is insulated from the first few defaults within each of the 'inner' CDO portfolios. In contrast to first-loss equity of the traditional CDO structure, returns of CDO² equity maintain a flat profile as long as the defaults of underlying CDO deals are not extreme. Moreover, CDO² have significantly lower single-asset exposure than typical CDOs because of broad diversification attained by the inclusion of CDOs with different portfolios that are managed with different investment styles.

Double protection for debt
Likewise, any debt tranche above the equity then has two layers of protection – one arising from the subordination above the individual mezzanine tranches, and the second from any subordination above the tranche within the CDO² debt holders also benefit from high rating-adjusted spreads.

Individual CDOs can weaken profile
CDO selection is key. A situation, for example, where 5% or 10% of the CDO portfolios within the CDO² are "weak" and experience twice the average default rate is not impossible. As mentioned earlier, the strength of CDO² equity is its defensive profile. Given the threat to CDO equity returns that stems from poorly chosen inner CDOs managers with significant structured finance and CDO expertise should outperform.

Credit overlap
Many investors are justifiably concerned about credit overlap among the inner CDOs. Absent any other mitigant, high overlap can accelerate losses in a stressful scenario, as the defaulting credits would impair a bulk of underlying CDOs, bringing the CDO² closer to loss. This simple analysis, though insightful, ignores differences in CDO structures and manager styles in selecting and managing portfolios. Even for the deals of the same vintage collateral overlap among deals managed by different managers is low, thus contributing to CDO² diversification.

For example, analysis of Tricadia CDO 2005-4 Ltd. revealed that none of the issuers across all deals represented more than 1% of the total portfolio – thanks to the relatively low overlap among CLOs from different managers – and that the top 100 names, of more than 1,500 names across the various CDO portfolios, accounted (by balance) for only 23% of underlying collateral. Cash CDO² have limitations on single managers; therefore, this serves the dual purpose of containing the influence of poorly performing managers within the portfolio and, indirectly, single asset exposure.

Prepayment risk
Prepayment, and, hence, reinvestment risk of collateral, is present in all CDO structures. Yet, this risk to CDO² structures may be higher in cases where most of the inner CDOs come from the same vintage and have similar reinvestment and non-call periods. As such, CDO² structures are prone to the risk that a significant fraction of underlying deals may be called at the same time. This would leave the manager with a pile of cash and negative carry during the reinvestment period or will result in significant delevering of the CDO structure if the optional redemption occurs soon after the end of the CDO² reinvestment period.

In cases when the multiple call occurs after the non-call period of CDO² deals, however, the equity holders of the CDO² deal would most likely elect to call the deal as well (although it may take time and may not be easy to organise equity holders) without suffering significant decrease in IRR. The case in which the inner CDO calls occur within the non-call period poses a real threat – due to limited liquidity of CDO market (much less than that of ABS or loan market) the manager may find it hard to source eligible CDO securities fast and at attractive prices. Managers may wish to therefore diversify collateral not only across managers and underlying deal types but also across vintages.

PIKing risk of inner CDOs
The risk of default is not the only one faced by CDO² investors. PIKing in inner CDO deals may also have a potentially damaging effect, as no payments will be made to the CDO². Most CDO² structures nowadays mitigate the PIK risk by introducing liquidity swap to the structure. Upon the terms of the swap, in exchange for a premium, based on collateral balance, the swap counterparty pays the CDO² interest due but not received as result of PIKing for a period of up to approximately 24 months. While decreasing yield to equity holders, this swap, we believe, provides for more steady cash flows and improves overall risk return balance of the deal.

Debt reasonable on a spread-adjusted basis
A traditional CDO mezzanine tranche has leveraged exposure to the underlying collateral once any subordination below the tranche has been eroded. The mezzanine tranche of a CDO² has leverage on the inner tranches once any of its subordination is gone; as a result, the loss profile under stress is magnified. If there is high correlation among the inner CDOs (because they are created from the same collateral type, for instance), or the inner CDOs lose principal rapidly (for example, because they are thin tranches with high exposure to their own collateral), the impact on the CDO² debt will be that much higher. However, on a spread-adjusted basis, senior CDO² tranches look reasonable.

© 2006 Citigroup Global markets. All rights reserved. This Research Note was first published on 6 September 2006, as part of a report.