Structured Finance: Synthetic ABS Prof. Ian Giddy New York University

Structured Finance Asset-backed securitization Corporate financial restructuring Structured financing techniques

Collateralized Debt Obligations Collateralized loan obligations (CLOs) Collateralized bond obligations (CBOs)

Collateralized Debt Obligations Cash flow backed CLOs and CBOs Market value backed CBOs Synthetic CLOs

Cash Flow Backed CLOs BANK (SELLER) SALE OR ASSIGNMENT Motivations: Free up capital Lower cost of funding Distressed loan arbitrage (3rd party sponsors) BANK (SELLER) LOANS SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE ISSUES LOANS ASSET-BACKED CERTIFICATES

CLO Transaction Structure

CLO Rating Criteria Initial Review On-Site Due Diligence Originator’s credit evaluation system Pool composition & stress testing On-Site Due Diligence Legal Integrity Bankruptcy-remoteness of SPV Validity of asset transfer to SPV Perfection of security interests in underlying collateral Determining Credit Enhancement

Source: Fitch, ”Bank CLOs: an Overview”

SPV Cash flow Backed CLOs Investors CREDIT ENHANCEMENT Senior-Sub with priorities of cash flows Cash reserve accounts Letters of credit Guarantees LOANS SPV Investors Cash flows ABS flows

Senior-Sub CLO Structure

Cash Flow Backed CBOs MANAGER SALE Motivation: Cash flow arbitrage (bonds have good returns relative to risk, but may be illiquid) MANAGER BONDS SALE SPECIAL PURPOSE VEHICLE ISSUES BOND ASSET-BACKED PORTFOLIO CERTIFICATES

Cash Flow Backed CBOs Cash flow CBOs are built around a pool of assets with predictable cash flows. As such, these structures are restricted to investments that meet minimum credit quality, tenor and expected recovery characteristics. The analysis of a cash flow deal and determination of credit enhancement is based on the expected probability of default, severity of loss, and timing of default and recovery of the assets in the pool. The ongoing market price of collateral assets is not important in a cash flow deal. Instead, it is the ability of each asset to pay scheduled principal and interest that makes these deals successful.

Collateral cash flows meet ABS interest & principal needs Cash Flow Backed CBOs MANAGER Selects portfolio Collateral cash flows meet ABS interest & principal needs BONDS SPV Investors Cash flows ABS flows

Market Value Backed CBOs Motivation: Price arbitrage (bonds are underpriced, and tradeable) BONDS MANAGER SALE SPECIAL PURPOSE VEHICLE ISSUES BOND ASSET-BACKED PORTFOLIO CERTIFICATES

Market Value CBOs A market value CBO can be generally described as an investment vehicle that capitalizes on the arbitrage opportunities that exist between high yielding investments and the lower cost funds of highly rated debt. The transaction is typically capitalized with multiple classes of rated debt and a layer of unrated equity and invests in a pool of investments that is diverse in obligor, industry, and, frequently, asset class. In order to gauge the performance of the transaction, the asset manager will mark the value of each investment to market on a regular basis, usually weekly or biweekly.

Market Value Backed CBOs MANAGER Trades bonds to meet interest & principal needs BONDS SPV Investors ABS flows Cash flows

Characteristics of Market Value CBOs Market value transactions are often collateralized by leveraged loans, high-yield bonds, mezzanine debt, distressed debt, and public and even private equity. Market value transactions are less restrictive with respect to cash flow requirements, credit quality, and maturity of the collateral. The manager can trade the securities.

Rating Agencies Analyze Price Volatility to Determine CE Requirements

Advance rates determine how much rated debt can be issued against the market value of an asset.

Example of Market Value CBO Asset Mix and Financing

Asset-Backed Securities: The Typical Structure FORD (SPONSOR) LOANS. Servicing Agreement SALE OR ASSIGNMENT SPECIAL PURPOSE VEHICLE ISSUES LOANS. ASSET-BACKED CERTIFICATES

The Alternative: Synthetic ABS DB (Originator) REFERENCE POOL OF LOANS (Stay on balance sheet) CREDIT SWAP AGREEMENT SPECIAL PURPOSE VEHICLE ISSUES TOP QUALITY ASSET-BACKED INVESTMENTS CERTIFICATES

Synthetic ABS or Collateralized Loan Notes CLNs are SPV debt backed by the credit of the selling bank (or better) No loans are sold to the SPV But performance is based on the performance of a reference pool of loans If the reference credits perform, full debt service is made on the CLN If the reference credits default, the CLN is deemed “defaulted”and payment is halted.

Synthetic ABS GERMAN BANK (Originator) REFERENCE POOL OF LOANS (Stay on Balance Sheet) CREDIT SWAP AGREEMENT SPECIAL PURPOSE VEHICLE TOP QUALITY INVESTMENTS ISSUES ASSET-BACKED CERTIFICATES

Synthetic ABS GERMAN BANK (Originator) REFERENCE POOL OF LOANS (Stay on Balance Sheet) PROTECTION against POOL DEFAULTS EURIBOR plus “PREMIUM” SPECIAL PURPOSE VEHICLE TOP QUALITY INVESTMENTS ISSUES ASSET-BACKED CERTIFICATES

Credit Swaps in Synthetics: Doubts Problems with the collateral Debates about “events of default” Workouts and other pre-default losses Problems with the sponsor bank Obtaining title to the collateral Those “high quality investments” And all those swaps

Typical Credit Default Swap Arrangement BANK SPV REFERENCE POOL OF LOANS ABS Deposit and credit guarantee The guarantee: Pledge of a deposit in the sponsor bank Part or all of that deposit will be forfeited if there are pool losses “Losses in the transaction are defined as amounts written off in compliance with the bank’s usual procedures”

Leveraged CDO (Super Senior Tranche)

Promises, Promises

Promising

Case Study: Global High Yield Bond Trust What is the legal structure of this deal? What are the assets? What are the different classes of securities, and their terms? How do the synthetic CLOs work? (Draw a diagram) Should investors buy the subordinated tranche?

Global High Yield Bond Trust

www.stern.nyu.edu

www.giddy.org

Contact Info Ian H. Giddy NYU Stern School of Business Tel 212-998-0426; Fax 212-995-4233 Ian.giddy@nyu.edu http://giddy.org