Structured Investment Vehicles Financial Engineering in the Bond Markets

Readings The Barclay’s Capital Guide to Cash Flow Collateralized Debt Obligations Bloomberg Readings

Structured Investment Vehicles (SIVs) What are these securities? What problems have occurred and who are some of the players? What are Collateralized Obligations? How are COs structured, and how could this lead to future problems?

SIVs Structured Investment Vehicles are “Stand- alone” companies that transform cash-flows of “certain assets” into desired cash-flows of “particular investors”. Certain assets can be Bonds, Loans (Consumer or Commercial) or Mortgages. Particular Investors can be Pension Plans, Public Entities, Hedge Funds, Financial Institutions, and many, many others.

SIVs: Stand-Alones Class A: Seeking AAA Class B: Seeking A Class C: Seeking < BBB Equity: Seeking Speculation or Providing Credit Enhancemt.

SIVs: Some Definitions (Barclay’s Guide) Balance-Sheet vs. Arbitrage Ramp-up vs. Re-Investment vs. Amortization Figure 2, Page 23 of Barclay’s Guide Tranching vs. Senior/Subordinated Notes Overcollateralization vs. Reserves Excess Spread Risks and Hedges (Pgs and Pgs )

Problems and Players Summer 2007 Fall 2007 Governments (Riskless Players) Banks (Risk Arbitrage Providers) More to Come

Collateralized Obligations On Mortgages (CMOs) On Loan Portfolios (CLOs) On Bond Portfolios (CBOs or CDOs) First two are generally securitizing assets held on a Bank’s Balance Sheet Third is a structure that has a portfolio that may not have existed before CO executed

CMOs and CLOs CMOs: Mortgage bonds guaranteed by FNMA, FHLMC or GNMA, then CFs split to create “tranching” and separate payment risks, CLOs: Banks Loans made (Consumer or Commercial & Industrial) and needing removal from Bank’s balance sheet.

CDOs Credit Enhance quality of standing or accumulated Bond Portfolio to split credit AAA or AA Senior claims (low default risk) BBB or BB Subordinated Claims (higher risk) Equity (Credit Enhancement) (highest risk) Essentially create riskless debt from risky debt by getting Subordinated and Equity claims to accept ALL credit risk

Bond Review Intro Finance: Default-Free Bond Price a function of expected CFs and market rate Coupon * PVA (R,t) + Principal * PVF(R,t) Advanced Finance: Defaultable Bond Price a function of expected CFs and adjusted rate Coupon * PVA (R *,t) + Principal * PVF(R *,t) The question is what is the acceptable R * ? Can take market price and solve for R *, or adjust r from a comparable default-free bond.

Defaultable Bond Adjust R = R* How much return to compensate for loss? Probability of Default Loss given default = (1 – Recovery Rate Percentage) R * = R Non-Default + [Prob * LGD] Example: Non-Default R = 5% Probability of Default = 2%] Recovery Rate = 30% R * = 5% + [2% * (1 -.3)] = 6.4%

Structuring a Collateralized Obligation Assume $500 million in Mortgages are held in a portfolio. No Ramp-Up or Reinvestment. Assume 3 tranches: AAA (Sr.) $400m, BB (Subordinated) $75m and Equity (Z-tranche). Assume AAA given 3% coupon, BB given 5%, Mortgages pay 7%, and Admin is 0.5%. Assume Waterfall, sequential principal payment and proportional interest payment. Assume no prepay for now.

How much will Equity make? $500m in Bonds, with $475m in AAA/BB. Equity is then $25m. 7% Asset return. 3% on $475m, 5% on $75m debt costs. 0.5% Admin cost. Excess Spread = Asset Return – Debt Cost – Admin cost. = 7% - ((400/500*3%) + (75/500*5%)) - 0.5%. = 3.35%

What does CF pattern look like? PO/IO Spreadsheet Assumes no Prepay. Prepay, like default, reduces value of Equity first, then if significant enough, reduces lower-grade tranche values. If SIV, then possible some of funding is also Commercial Paper by issuer, and if Equity held, this may also yield CP downgrade, and further Equity erosion.