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Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization, Second Edition

Book Description

An up-to-date look at the exploding CDO and structured credit products market

In this fully updated Second Edition, financial expert Janet Tavakoli provides readers with a comprehensive look at the CDO and structured credit products market amid recent developments. In addition to a detailed overview of the market, this book presents key issues in valuing structured financial products and important quality control issues. Tavakoli shares her experiences in this field, as she examines important securitization topics, including the huge increase in CDO arbitrage created by synthetics, the tranches most at risk from new technology, dumping securitizations on bank balance sheets, the abuse of offshore vehicles by companies, the role of hedge funds, critical issues with subprime, Alt-A, and prime mortgage securitizations, and securitizations made possible by new securitization techniques and the Euro. While providing an overview of the market and its dynamic growth, Tavakoli takes the time to explore the types of products now offered, new hedging techniques, and valuation and risk/return issues associated with investment in CDOs and synthetic CDOs.

Table of Contents

  1. Title Page
  2. Copyright Page
  3. Preface
  4. Acronym Key
  5. CHAPTER 1 - Securitization Terminology
    1. SIMPLIFIED CASH CDO
    2. THE CDO ARBITRAGE
  6. CHAPTER 2 - Structured Finance and Special Purpose Entities
    1. SPCs AND HISTORICAL ABUSE
    2. SPEs AND SPVs
    3. DOCUMENTATION
    4. SETUP COSTS
    5. EXAMPLE OF A MULTIPLE ISSUANCE ENTITY
    6. CAYMAN-DOMICILED SPEs
    7. REPACKAGINGS TO SATISFY INVESTOR DEMAND
    8. CREDIT-LINKED NOTES AND FUNDING COSTS
    9. STRUCTURED FLOATERS
    10. PRINCIPAL-PROTECTED NOTES
    11. LOAN REPACKAGINGS
    12. LIQUIDITY
    13. MISMATCHED MATURITIES
    14. UNWIND TRIGGERS LINKED TO DERIVATIVES TRANSACTIONS
    15. DAX-LINKED NOTE WITH TRIGGERS
    16. RATINGS
    17. MASTER TRUSTS
    18. OWNER TRUSTS
    19. GRANTOR TRUSTS
    20. REAL ESTATE MORTGAGE INVESTMENT CONDUITS
    21. MULTISELLER AND SINGLE-SELLER CONDUITS
    22. DOMESTICALLY DOMICILED CORPORATIONS
    23. BANKRUPTCY-REMOTE?
    24. ENRON, JPMORGAN CHASE, AND SURETIES
  7. CHAPTER 3 - Credit Derivatives and Total Rate of Return Swaps
    1. RISK TO PORTFOLIO VALUE
    2. CREDIT DERIVATIVES AND CREDIT DEFAULT SWAPS
    3. NEGOTIATED LANGUAGE
    4. BASIS RISK: PERSISTENT CDS LANGUAGE ISSUES
    5. PHYSICAL SETTLEMENT AND CASH SETTLEMENT NEGOTIATIONS
    6. DIGITAL, BINARY, ZERO-ONE, ALL-OR-NOTHING, OR FIXED RECOVERY CASH SETTLEMENT
    7. INITIAL VALUE × (PAR - MARKET VALUE)
    8. NORMALIZED PRICE METHOD—ALTERNATE TERMINATION PAYMENT
    9. HEDGE COSTS IN CASH AND SYNTHETIC CDOs
    10. DELIVERABLES: CDOs AND THE CHEAPEST-TO-DELIVER OPTION
    11. CONVERTIBLE BONDS AND ASSET SWAPS
    12. NEGATIVE BASIS TRADES
    13. DEFAULT AND RECOVERY RATE
    14. THE DEFAULT PROTECTION SELLER: COUNTERPARTY CREDIT AND CORRELATION
    15. DEFAULT LANGUAGE FOR SOVEREIGN DEBT
    16. DEFAULT LANGUAGE FOR NONSOVEREIGN DEBT: CONTROVERSY AND CDOs
    17. CDS PRICING ISSUES
    18. SYNTHETIC CDOs
    19. TOTAL RATE OF RETURN SWAPS (TOTAL RETURN SWAPS)
    20. PRICING TRORS ON LEVERED CDO TRANCHES
    21. TRORS VERSUS REPOS
    22. EQUITY TRORS: CORPORATE LOANS DISGUISED AS CAPITAL INJECTIONS
    23. INFORMATION ASYMMETRY AND MORAL HAZARD
    24. CDS VERSUS TRORS
    25. PAY-AS-YOU-GO
    26. INDEXES
  8. CHAPTER 4 - CDOs and the Global Capital Markets
    1. EVOLUTION OF THE CDO MARKET
  9. CHAPTER 5 - Risk and Valuation Issues
    1. THE PORTFOLIO DIVERSIFICATION MYTH
    2. MODERN PORTFOLIO THEORY: BANE OF CDOs
    3. ABNORMAL IS NORMAL
    4. MARK-TO-MARKET HAZARD
    5. CASH FLOW HAZARD
    6. GLOBAL DERIVATIVES RISK
    7. LOANS AND LEVERAGED LOANS
    8. THE LEVERAGE PARADOX
    9. NEW STRUCTURED FINANCE DEALS
    10. FRAUD
    11. HEDGE FUNDS: A NEW INVESTOR CLASS
    12. TAVAKOLI’S LAW, HEDGE FUNDS, AND THE GREAT UNWIND
    13. BRAIN DAMAGE THEORY
    14. DEAD MAN’S CURVE AND LEVERAGED FUNDS
    15. MARGIN OF SAFETY VERSUS ONE-SIDED ILLIQUID LEVERAGED BETS
  10. CHAPTER 6 - Early CDO Technology
    1. TRUE SALE HYBRID AND SYNTHETIC STRUCTURES
    2. CREDIT ENHANCEMENT
    3. MONOLINE AND MULTILINE INSURANCE
    4. CDO CLASSIFICATION
    5. MARKET VALUE CDOs
    6. CASH FLOW CDOs
    7. THE ORIGINS OF U.S. SECURITIZATION
    8. COLLATERALIZED MORTGAGE OBLIGATIONS
  11. CHAPTER 7 - Early Warning Commercial Financial Services
    1. RATING AGENCIES’ FAILED MODELS
    2. ANATOMY OF A FLAWED PROCESS
    3. TERMINOLOGY
    4. EARLY RED FLAGS
    5. CFS GETS CREATIVE
    6. SELLING OUT THE FUTURE
    7. IGNORING AN AUDIT REPORT
    8. LESSONS TO BE LEARNED
    9. FALLOUT FROM CFS’S BANKRUPTCY
  12. CHAPTER 8 - Subprime and Alt-A Mortgages: Collateral Damage
    1. TRUTHINESS IN LENDING AND BORROWING
    2. THE PREDATORS FALL
    3. CLASSIC PONZI SCHEME
    4. PORTFOLIO RISK
    5. THE RISK MANAGERS’ DILEMMA
    6. HOW TO CREATE A SECURITIZATION DISASTER
    7. MODELS VERSUS COMMON SENSE
    8. LACK OF APPROPRIATE DUE DILIGENCE AND/OR DISCLOSURE
    9. INVESTORS AND RATINGS
    10. HEDGE FUNDS AND ABX INDEXES: ALPHA BETS
    11. A GOOD YEAR (FOR SOME)
    12. BSAM’S HEDGE FUNDS UNDONE BY LEVERAGE
    13. BEAR STEARNS’ HEDGE FUND LENDERS BAILOUT
    14. DISCLOSURE: INVESTOR FALLOUT FROM THE MORTGAGE DEBACLE
    15. “THE FIRST THING WE DO, LET’S KILL ALL THE LAWYERS”
    16. MARKET FALLOUT FROM THE MORTGAGE DEBACLE
    17. REDLINING AND RED INK
  13. CHAPTER 9 - Cash versus Synthetic Arbitrage CDOs
    1. COMPARISON OF MANAGED ARBITRAGE CDO FEATURES: CASH VERSUS SYNTHETIC DEALS
    2. THE ARRANGER AND THE MANAGER
    3. MANDATE AGREEMENT
    4. DEAL ASSEMBLY
    5. CDS LANGUAGE FOR THE SYNTHETIC CDO
    6. SELECTING THE PORTFOLIO AND IMPACT ON RATING
    7. RATING CRITERIA AND RESTRICTIONS
    8. SUBSTITUTION AND REINVESTMENT CRITERIA
    9. WAREHOUSING ASSETS
    10. PRICING AND CLOSING
    11. RAMPING UP THE PORTFOLIO
    12. REINVESTMENT PERIOD
    13. NONCALL PERIOD
    14. PAY-DOWN PERIOD
    15. WEIGHTED AVERAGE LIFE AND EXPECTED FINAL MATURITY
    16. EARLY TERMINATION
    17. LEGAL FINAL MATURITY
    18. TRANCHING AND THE SYNTHETIC ARBITRAGE ADVANTAGE
    19. WATERFALLS FOR CASH VERSUS SYNTHETIC ARBITRAGE CDOs
    20. PAYMENT-IN-KIND TRANCHES
    21. PSYCHIC RATINGS: RATING AGENCY TREATMENT OF PIK TRANCHES
    22. THE SUPER SENIOR ADVANTAGE
    23. CDS VERSUS CASH ASSET SPREADS
    24. HEDGING THE CDO PORTFOLIO CASH FLOWS
    25. SETTLEMENT IN EVENT OF DEFAULT OR CREDIT EVENT
    26. DOCUMENTATION
    27. CASH VERSUS SYNTHETIC ARBITRAGE CDO EQUITY CASH FLOWS
    28. SAMPLE CASH FLOWS
    29. SUMMARY OF CASH ARBITRAGE CDOs VERSUS SYNTHETIC ARBITRAGE CDOs
  14. CHAPTER 10 - CDO Equity Structures
    1. ACCRUING ERRORS
    2. PROBABILITY OF RECEIPT
    3. THE BEST AND WORST EQUITY INVESTMENTS
    4. THE BEST EQUITY EARNS ALL RESIDUALS
    5. EQUITY INVESTOR INJECTS CASH AS OVERCOLLATERALIZATION
    6. RATED EQUITY EARNS STATED COUPON APPROPRIATE TO RATING
    7. RATED EQUITY: STATIC DEAL
    8. EQUITY INVESTOR EARNS A STATED COUPON ON THE REMAINING EQUITY INVESTMENT
    9. MORAL HAZARD AND CONFLICT OF INTEREST
    10. LEVERAGING THE BEST: UNFUNDED EQUITY INVESTMENTS—ULTIMATE LEVERAGE
    11. ACTIVELY TRADED AND LIMITED SUBSTITUTION SYNTHETIC ARBITRAGE CDOs
    12. INTEREST SUBPARTICIPATIONS: WHEN EQUITY ISN’T FIRST LOSS
    13. PARTICIPATION NOTES
    14. CAPPED PARTICIPATION NOTES
    15. COMBINATION NOTES
    16. INVESTOR MOTIVATION
    17. PRINCIPAL-PROTECTED STRUCTURES
    18. FIRST- (AND NTH-) TO-DEFAULT BASKET SWAPS
    19. FIRST-TO-DEFAULT NOTES
    20. THE SMARTEST EQUITY INVESTMENT: PROTECTION MONEY
  15. CHAPTER 11 - CDO Managers
    1. BEST PRACTICES
    2. THE VALUED FEW
  16. CHAPTER 12 - Balance-Sheet CLOs and CDOs
    1. TRUE SALE (FULLY FUNDED): DELINKED STRUCTURE
    2. LINKED NONSYNTHETIC STRUCTURES
    3. LINKED BLACK-BOX CLN CDOs
    4. SYNTHETIC STRUCTURE WITH SPE
    5. PARTIALLY SYNTHETIC LINKED CDOs
    6. FULLY SYNTHETIC CDOs
    7. SMALL TO MEDIUM-SIZE ENTERPRISES—EUROPE
    8. SMEs: UNITED STATES VERSUS EUROPE
    9. SECURED LOAN TRUSTS
    10. BANK REGULATORY CAPITAL AND BASEL II
  17. CHAPTER 13 - Super Senior Sophistry
    1. CASH FLOW MAGIC TRICK
    2. RATING AGENCIES—MOODY’S TRANCHING
    3. THE AAA DISAPPEARING ACT
    4. RATING AGENCIES AND RATINGS SHOPPING
    5. TRIPLE-A BASKET WITH 2 PERCENT FIRST-LOSS TRANCHE
    6. SUPER SENIOR ATTACHMENT POINT
    7. SUPER SENIOR PRICING
    8. SUPER SENIORS OR SENILE SENIORS?
    9. WHERE ARE THE REGULATORS?
    10. JUNIOR SUPER SENIORS
    11. SUPER SENIOR INVESTORS
    12. NEGATIVE BASIS TRADES
    13. LEVERAGED SUPER SENIORS AND CONSTANT PROPORTION PORTFOLIO INSURANCE
    14. FINAL THOUGHTS ON SUPER SENIORS
  18. CHAPTER 14 - Synthetics and Mark-to-Market Issues
    1. SYNTHETIC CASH WINDFALL
    2. SYNTHETIC EQUITY
    3. PORTFOLIO SWAPS
    4. BESPOKE TRANCHES: SINGLE-TRANCHE CDOs
    5. SHORT MEZZANINE AND LONG EQUITY
    6. BANKS’ INVISIBLE HEDGE FUNDS
    7. EXTRAORDINARY POPULAR DELUSIONS AND THE MADNESS OF CORRELATION
    8. DELTA HEDGES, CORRELATION MODELS, AND JUNK SCIENCE
    9. SYNTHETIC NOTIONAL AND ACTUAL RISK
    10. EXPLOSIVE GROWTH, UNCERTAIN FUTURE
    11. FOUND MONEY AND MORAL HAZARD
  19. CHAPTER 15 - Comments on Selected Structured Finance Products
    1. MULTISECTOR CDOs: CDOs
    2. FUTURE FLOWS: PAYMENT RIGHTS SECURITIZATIONS
    3. EMERGING MARKET CAVEATS
    4. CONSTANT PROPORTION DEBT OBLIGATIONS AND RATING AGENCIES
    5. CONSTANT PROPORTION PORTFOLIO INSURANCE
    6. MULTILINE INSURANCE PRODUCTS: DISAPPOINTMENT AND PROMISE
    7. HOLLYWOOD FUNDING
    8. TRANSFORMERS
    9. SEC GASLIGHT ON LIFE SETTLEMENTS
    10. SPECIAL PURPOSE ACQUISITION COMPANIES
  20. CHAPTER 16 - Credit Funds
    1. CREDIT HEDGE FUNDS
    2. HEDGE FUNDS AND STRUCTURED CREDIT
    3. IO AND PO TRANCHES: JUNIOR TRANCHES AND EQUITY OIDs
    4. LIMITED PURPOSE FINANCE CORPORATIONS
    5. STRUCTURED INVESTMENT VEHICLES
    6. CREDIT DERIVATIVE PRODUCT COMPANIES
    7. HEDGE FUNDS AND COLLATERALIZED FUND OBLIGATIONS
  21. CHAPTER 17 - The Credit Crunch and CDOs
    1. RATING AGENCIES, REGULATORS, AND JUNK SCIENCE
    2. SAVVY INVESTORS IGNORE RATINGS
    3. MISFORTUNE’S FORMULA: STRUCTURED CREDIT RATINGS
    4. ABCP CRISIS AND MLEC
    5. CONSTELLATION CDOs: FALLING STARS
    6. NEW FLAWED MODELS REPLACE OLD FLAWED MODELS
    7. RATING AGENCIES IN CRISIS
    8. MONOLINE MELTDOWN: FINANCIAL GUARANTORS IN CRISIS
    9. RATING AGENCIES IN DENIAL
    10. OVERWHELMING LOSSES
    11. POOR ACTUAL RECOVERIES
    12. UNDERCAPITALIZED FINANCIAL GUARANTORS
    13. DICEY DEALS DONE DIRT CHEAP
    14. COMPETITIVE PRESSURE
    15. UNCERTAIN FUTURE
    16. COUNTRYWIDE’S BAILOUT AND MORAL HAZARD
  22. CHAPTER 18 - Future Developments in Structured Finance
    1. REGULATORY FAILURE: INVESTORS ARE ON THEIR OWN
  23. APPENDIX - Interesting Web Sites
  24. Bibliography
  25. Index