Introduction to Securitization

BALANCE SHEET CDOs

Balance sheet CDOs are not a new type of securitization but rather an application of the securitization methodology. Balance sheet CDOs parcel out a portfolio of loans, usually low-rated loans or emerging market credits and below investment-grade bonds held by large banks. Balance sheet CDOs may be either cash CDOs or synthetic CDOs.

Traditional, Cash CDOs

The traditional, cash CDO structure was used for the first time by Nations Bank in 1997, and then by LTCB (PLATINUM), IBJ (PRIME), Sumitomo (WINGS) Bankboston (BANKBOSTON), Bank of Montreal (LAKESHORE), Sanwa (EXCELSIOR), and SG (POLARIS), and so on. The methodology in all of these was fairly simple—transfer of a near-homogenous portfolio of loans into a special purpose vehicle (SPV) and issue of liabilities that are easily sellable to investors.

The Creation of a Balance Sheet CDO

The way a balance sheet CDO is created is as follows:

• The originator identifies the portfolio that the originator intends to securitize (i.e., to pool). Let us say, the pool size is $1 billion.

• The probability distribution for the pool is worked out. Let us suppose the model comes up with a distribution suggesting that, with a credit enhancement of 2%, it may be possible to get a rating of BB, while a credit support of 3.5% may be enough to get a BBB rating. Similarly, the required enhancement levels for an A rating and AAA rating are worked out as 5% and 8%, respectively. ⁵³

• This would mean, we can have a Class A with ...