Structured Finance and Collateralized Debt Obligations€¦ · Structured Finance and Collateralized Debt Obligations New Developments in Cash and Synthetic Securitization Second

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FM JWBK237-Tavakoli July 29, 2008 7:31 Printer: Yet to come

Structured Financeand Collateralized

Debt ObligationsNew Developments in Cash and

Synthetic Securitization

Second Edition

JANET M. TAVAKOLI

John Wiley & Sons, Inc.

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Debt Obligations

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Debt ObligationsNew Developments in Cash and

Synthetic Securitization

Second Edition

JANET M. TAVAKOLI

John Wiley & Sons, Inc.

iii



Copyright C© 2008 by Janet M. Tavakoli. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

Originally published as Collateralized Debt Obligations and Structured Finance.

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Library of Congress Cataloging-in-Publication Data:

Tavakoli, Janet M.[Collateralized debt obligations and structured finance]Structured finance and collateralized debt obligations : new developments in cash

and synthetic securitization / Janet M. Tavakoli. — 2nd ed.p. cm. — (Wiley finance series)

Originally published in 2003 under title: Collateralized debt obligations andstructured finance

Includes bibliographical references and index.ISBN 978-0-470-28894-8 (cloth)1. Asset-backed financing—United States. 2. Mortgage-backed

securities—United States. I. Title.HG4028.A84T38 2008332.63′2044—dc22

2008008483

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

iv

www.wiley.com



Contents

Preface xiii

Acronym Key xix

CHAPTER 1Securitization Terminology 1

Simplified Cash CDO 4The CDO Arbitrage 5

CHAPTER 2Structured Finance and Special Purpose Entities 7

SPCs and Historical Abuse 10SPEs and SPVs 16Documentation 18Setup Costs 19Example of a Multiple Issuance Entity 19Cayman-Domiciled SPEs 22Repackagings to Satisfy Investor Demand 24Credit-Linked Notes and Funding Costs 25Structured Floaters 27Principal-Protected Notes 27Loan Repackagings 28Liquidity 29Mismatched Maturities 29Unwind Triggers Linked to Derivatives Transactions 30DAX-Linked Note with Triggers 32Ratings 34Master Trusts 34Owner Trusts 35Grantor Trusts 36Real Estate Mortgage Investment Conduits 36Multiseller and Single-Seller Conduits 37

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Domestically Domiciled Corporations 39Bankruptcy-Remote? 40Enron, JPMorgan Chase, and Sureties 43

CHAPTER 3Credit Derivatives and Total Rate of Return Swaps 45

Risk to Portfolio Value 45Credit Derivatives and Credit Default Swaps 47Negotiated Language 49Basis Risk: Persistent CDS Language Issues 49Physical Settlement and Cash Settlement Negotiations 50Digital, Binary, Zero-One, All-or-Nothing, or

Fixed Recovery Cash Settlement 52Initial Value × (Par − Market Value) 53Normalized Price Method—Alternate Termination Payment 54Hedge Costs in Cash and Synthetic CDOs 55Deliverables: CDOs and the Cheapest-to-Deliver Option 55Convertible Bonds and Asset Swaps 56Negative Basis Trades 62Default and Recovery Rate 62The Default Protection Seller: Counterparty Credit

and Correlation 65Default Language for Sovereign Debt 65Default Language for Nonsovereign Debt: Controversy

and CDOs 66CDS Pricing Issues 69Synthetic CDOs 70Total Rate of Return Swaps (Total Return Swaps) 72Pricing TRORS on Levered CDO Tranches 74TRORS versus Repos 75Equity TRORS: Corporate Loans Disguised as

Capital Injections 76Information Asymmetry and Moral Hazard 78CDS versus TRORS 78Pay-as-You-Go 79Indexes 81

CHAPTER 4CDOs and the Global Capital Markets 83

Evolution of the CDO Market 84



Contents vii

CHAPTER 5Risk and Valuation Issues 91

The Portfolio Diversification Myth 91Modern Portfolio Theory: Bane of CDOs 92Abnormal Is Normal 96Mark-to-Market Hazard 98Cash Flow Hazard 99Global Derivatives Risk 100Loans and Leveraged Loans 101The Leverage Paradox 103New Structured Finance Deals 104Fraud 104Hedge Funds: A New Investor Class 107Tavakoli’s Law, Hedge Funds, and the Great Unwind 110Brain Damage Theory 112Dead Man’s Curve and Leveraged Funds 113Margin of Safety versus One-Sided Illiquid Leveraged Bets 114

CHAPTER 6Early CDO Technology 117

True Sale Hybrid and Synthetic Structures 117Credit Enhancement 119Monoline and Multiline Insurance 119CDO Classification 121Market Value CDOs 124Cash Flow CDOs 124The Origins of U.S. Securitization 126Collateralized Mortgage Obligations 135

CHAPTER 7Early Warning Commercial Financial Services 143

Rating Agencies’ Failed Models 143Anatomy of a Flawed Process 144Terminology 145Early Red Flags 147CFS Gets Creative 149Selling Out the Future 149Ignoring an Audit Report 150Lessons to Be Learned 151Fallout from CFS’s Bankruptcy 153



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CHAPTER 8Subprime and Alt-A Mortgages: Collateral Damage 155

Truthiness in Lending and Borrowing 158The Predators Fall 160Classic Ponzi Scheme 162Portfolio Risk 164The Risk Managers’ Dilemma 164How to Create a Securitization Disaster 165Models versus Common Sense 167Lack of Appropriate Due Diligence and/or Disclosure 172Investors and Ratings 173Hedge Funds and ABX Indexes: Alpha Bets 174A Good Year (for Some) 177BSAM’s Hedge Funds Undone by Leverage 181Bear Stearns’ Hedge Fund Lenders Bailout 184Disclosure: Investor Fallout from the Mortgage Debacle 186“The First Thing We Do, Let’s Kill All the Lawyers” 188Market Fallout from the Mortgage Debacle 190Redlining and Red Ink 191

CHAPTER 9Cash versus Synthetic Arbitrage CDOs 193

Comparison of Managed Arbitrage CDO Features:Cash versus Synthetic Deals 193

The Arranger and the Manager 195Mandate Agreement 196Deal Assembly 197CDS Language for the Synthetic CDO 197Selecting the Portfolio and Impact on Rating 198Rating Criteria and Restrictions 199Substitution and Reinvestment Criteria 207Warehousing Assets 207Pricing and Closing 208Ramping Up the Portfolio 208Reinvestment Period 209Noncall Period 209Pay-Down Period 210Weighted Average Life and Expected Final Maturity 210Early Termination 210Legal Final Maturity 211Tranching and the Synthetic Arbitrage Advantage 211Waterfalls for Cash versus Synthetic Arbitrage CDOs 212



Contents ix

Payment-in-Kind Tranches 218Psychic Ratings: Rating Agency Treatment of PIK Tranches 218The Super Senior Advantage 219CDS versus Cash Asset Spreads 220Hedging the CDO Portfolio Cash Flows 226Settlement in Event of Default or Credit Event 233Documentation 236Cash versus Synthetic Arbitrage CDO Equity Cash Flows 236Sample Cash Flows 237Summary of Cash Arbitrage CDOs versus Synthetic

Arbitrage CDOs 246

CHAPTER 10CDO Equity Structures 247

Accruing Errors 250Probability of Receipt 253The Best and Worst Equity Investments 254The Best Equity Earns All Residuals 256Equity Investor Injects Cash as Overcollateralization 257Rated Equity Earns Stated Coupon Appropriate to Rating 259Rated Equity: Static Deal 260Equity Investor Earns a Stated Coupon on the

Remaining Equity Investment 262Moral Hazard and Conflict of Interest 268Leveraging the Best: Unfunded Equity Investments—

Ultimate Leverage 270Actively Traded and Limited Substitution Synthetic

Arbitrage CDOs 273Interest Subparticipations: When Equity Isn’t First Loss 273Participation Notes 276Capped Participation Notes 278Combination Notes 278Investor Motivation 279Principal-Protected Structures 280First- (and nth-) to-Default Basket Swaps 282First-to-Default Notes 290The Smartest Equity Investment: Protection Money 290

CHAPTER 11CDO Managers 291

Best Practices 292The Valued Few 293



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CHAPTER 12Balance-Sheet CLOs and CDOs 295

True Sale (Fully Funded): Delinked Structure 295Linked Nonsynthetic Structures 299Linked Black-Box CLN CDOs 301Synthetic Structure with SPE 304Partially Synthetic Linked CDOs 307Fully Synthetic CDOs 308Small to Medium-Size Enterprises—Europe 310SMEs: United States versus Europe 315Secured Loan Trusts 318Bank Regulatory Capital and Basel II 321

CHAPTER 13Super Senior Sophistry 331

Cash Flow Magic Trick 333Rating Agencies—Moody’s Tranching 334The AAA Disappearing Act 337Rating Agencies and Ratings Shopping 338Triple-A Basket with 2 Percent First-Loss Tranche 340Super Senior Attachment Point 341Super Senior Pricing 342Super Seniors or Senile Seniors? 343Where Are the Regulators? 345Junior Super Seniors 346Super Senior Investors 347Negative Basis Trades 348Leveraged Super Seniors and Constant Proportion

Portfolio Insurance 349Final Thoughts on Super Seniors 350

CHAPTER 14Synthetics and Mark-to-Market Issues 353

Synthetic Cash Windfall 353Synthetic Equity 354Portfolio Swaps 356Bespoke Tranches: Single-Tranche CDOs 357Short Mezzanine and Long Equity 359Banks’ Invisible Hedge Funds 365Extraordinary Popular Delusions and the Madness

of Correlation 365



Contents xi

Delta Hedges, Correlation Models, and Junk Science 367Synthetic Notional and Actual Risk 369Explosive Growth, Uncertain Future 370Found Money and Moral Hazard 371

CHAPTER 15Comments on Selected Structured Finance Products 373

Multisector CDOs: CDOsN 373Future Flows: Payment Rights Securitizations 374Emerging Market Caveats 379Constant Proportion Debt Obligations and Rating Agencies 382Constant Proportion Portfolio Insurance 384Multiline Insurance Products: Disappointment and Promise 384Hollywood Funding 386Transformers 388SEC Gaslight on Life Settlements 390Special Purpose Acquisition Companies 394

CHAPTER 16Credit Funds 397

Credit Hedge Funds 397Hedge Funds and Structured Credit 398IO and PO Tranches: Junior Tranches and Equity OIDs 399Limited Purpose Finance Corporations 399Structured Investment Vehicles 401Credit Derivative Product Companies 402Hedge Funds and Collateralized Fund Obligations 403

CHAPTER 17The Credit Crunch and CDOs 405

Rating Agencies, Regulators, and Junk Science 405Savvy Investors Ignore Ratings 407Misfortune’s Formula: Structured Credit Ratings 408ABCP Crisis and MLEC 412Constellation CDOs: Falling Stars 413New Flawed Models Replace Old Flawed Models 415Rating Agencies in Crisis 415Monoline Meltdown: Financial Guarantors in Crisis 417Rating Agencies in Denial 418Overwhelming Losses 419Poor Actual Recoveries 420



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Undercapitalized Financial Guarantors 422Dicey Deals Done Dirt Cheap 422Competitive Pressure 425Uncertain Future 425Countrywide’s Bailout and Moral Hazard 426

CHAPTER 18Future Developments in Structured Finance 429

Regulatory Failure: Investors Are on Their Own 430

APPENDIXInteresting Web Sites 435

Bibliography 437

Index 439



Preface

W hat’s new in structured finance? Since the first edition of this bookcame out in 2003, the structured finance landscape has sustained sev-

eral seismic shifts, particularly in the collateralized debt obligation (CDO)market. New technologies blossomed, along with problems of transparencyand application. Rapid growth became explosive growth, peaking in thesecond half of 2007. Abuse led to a rapid decline in new CDO issuance in2008, and future deals will employ more tested tradecraft and fewer opaquefinancial engineering techniques.

Post-Enron accounting changes have made CDO equity a hot potatofor former investors who do not want to consolidate entire deals on theirbalance sheets. This has opened the door to the rise of inexperienced CDOmanagers, new and unknown offshore entities, hedge fund investors, andprivate equity investors.

CDO managers of all types—from the savvy to the naıve—waded intothe global securitization market. Even former stints at SEC-alleged Ponzischemes or fines paid after SEC-alleged accounting fraud were not deterrentsfor investment banks doing business with reinvented CDO managers. CDOmanagers giving the appearance—if not the reality—of investing in CDOequity were pushed through internal approval committees of investmentbanks.

Not-so-savvy hedge funds purchased the sucker tranches of CDOs.Savvy hedge funds became CDO managers recognizing the benefits of beingon the right side of a cash flow engineering windfall. Some hedge fundsbecame major participants in the CDO market, embracing the leverage af-forded by synthetic technologies, financial engineering, and the fees to beearned by managing CDOs. Other hedge funds became independent specu-lators in the CDO markets, using hedging techniques such as shorting theABX indexes as tools for wildly profitable speculation.

Single-tranche CDOs rose and waned to be overshadowed by constantproportion debt obligations (CPDOs), constant proportion portfolio insur-ance (CPPI), and other highly structured leveraged products.

Cash securitizations explored novel asset classes. Belts and braces some-times gave way under the strain of unrealized cash flow. Investment banks

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have become major lenders to originators of products with unprecedentedlylow underwriting standards combined with unprecedentedly risky products.

Retail investors are being solicited through products that employ form-over-substance sleight of hand. Products that could not be sold to retailinvestors through the debt markets in the United States due to Securitiesand Exchange Commission (SEC) restrictions are being sold through thestock markets, through structured notes, through mutual funds, and throughpension funds.

New products require another look at credit default swaps (CDSs) andtotal rate of return swaps in the context of synthetic securitizations. Syn-thetics introduce unique structural risks to CDOs and structured financeproducts. We will look at recent changes in the CDS market posed by CDSson asset-backed securities (CDSs of ABSs). We will also look at syntheticindexes.

Securitization groups continue to use their financial institutions’ bal-ance sheets. Securitization technology originally moved mortgage-backedsecurities, consumer loans, and other loans off financial institutions’ bal-ance sheets so they could reduce balance sheet risk and do more business.In recent years, securitization groups added risk to a variety of financialinstitutions’ balance sheets, added invisible risk to trading books, or placedrisk in stagnant conduits in order to earn fee income. As a result, banks,investment banks, hedge funds, insurance companies, and conduit investorswere more exposed to concentration risk and losses due to fraud.

The Sarbanes-Oxley Act of 2002 (Sarbox) was meant to combat fraudon a corporate level for firms regulated by the SEC. Whatever its value at thecorporate level, it has not hampered structured financing as many feared,nor has it affected the evolution both positive and negative of structuredfinance in a significant way. In fact, evidence is presented later in this bookthat suggests securitization professionals feel free to ignore the beneficialintent of Sarbox.

Fraud has been an ongoing concern, particularly in the way we originateassets. Even when fraud is absent, markets have been plagued by poorunderwriting standards combined with risky assets. The current market hasseen a surge in problematic loans. The subprime and Alt-A mortgage loanmarkets in several countries provide handy examples. This book focusesprimarily on the dynamics of the U.S. mortgage market because it is thelargest of the affected markets and the most egregious offender. The role offinancial institutions that provided credit to mortgage bankers is examined inChapter 8. While the mortgage market is one example, it is not the only one.Other asset classes present their unique problems: commercial real estate,project loans, corporate receivables, and more.



Preface xv

As we are all aware, fraud can be internal to an arranger securitizinga deal; fraud can be external, as when a corporation fudges its accounting;and fraud can take the form of a conspiracy when both external parties andinternal deal makers agree to hide relevant facts. We shouldn’t be surprisedby fraud; we should expect to deal with it and can take steps to guardagainst it.

For instance, we know that in the United States one-third of small busi-nesses that lose money do so not because of utility cost increases, not becauseof rent increases, not because big companies take their business, but becauseof employee fraud. We’ve also discovered that fraud isn’t committed bypetty thieves or uneducated thugs. Eighty percent of fraudulent employeesare white; they are 16 times as likely to be managers or executives, 4 timesas likely to be men, and 5 times as likely to have postgraduate degrees. Wealso know that many employees will commit fraud given the right circum-stances. These “right circumstances” are known as the fraud triangle: need,opportunity, and the ability to rationalize one’s behavior.

Knowing human nature, we can’t expect it to change in large corpora-tions, in commercial banks, in investment banks, in insurance companies, inhedge funds, or in other financial institutions. We can expect the individualto feel his own needs are greater than those of the whole. The need for aRolex, the need for an estate in Florida, the need for a castle in the South ofFrance, the need for an enormous annual bonus—all of these so-called needsseem to be greater in the finance business. Given the keen intelligence of theplayers and the complexity of structured financial products, opportunityand the ability to rationalize behavior may be greater as well. Decreasingopportunity increases sound business.

While we look at some instances of fraud in this book, we also look atinstances of gray-area opportunities presented by structured products. Andwe look at opportunity costs due to both ignorance and intent.

One would think that in an efficient market, the deterrents in placewould stop this behavior. Even in the absence of legal remedies, censure byother firms can be costly. Yet even with predetermined sanctions, the marketis not always efficient about routing out this behavior, and we shouldn’texpect it to be.

In isolated incidents we see financial institutions and individuals black-balled for pulling a fast one, but increasingly it is also true that we see peoplerelying on the depth and breadth of the market to move on to a new set ofunaware market players.

Synthetic CDOs—namely, securitizations incorporating credit deriva-tives technology to transfer asset risks and cash flows—make up most of theCDO market. This is due to the seeming arbitrage advantage of syntheticversus cash assets caused by creation of a super senior tranche, and the



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increased leverage of the equity tranche. The ability to sell synthetic CDOsbacked by investment-grade collateral is another huge advantage over cashCDOs in the current credit environment.

Cash CDO issuance has also ballooned, as financial institutions rushedto securitize everything from mortgage loans to the value of intellectual capi-tal. The availability of credit derivatives to hedge cash CDOs has contributedto the unprecedented growth of this market.

CDOs are still an evolving product, especially in Europe where specialvenue considerations introduce technological challenges. This market hasenthusiastically embraced credit derivatives, since synthetic structures solvecertain venue issues for risk transfer. Credit derivatives also often allowspecial gimmicks to be employed, which can produce certain regulatoryadvantages.

The purpose of this book is to point out key issues in valuing structuredfinancial products. I review the basics of the market so that any reader withsome knowledge of the capital markets will understand the componentsrequired to evaluate structured products. Readers looking for a book onmodels should go elsewhere.

The irony of the complex CDO market is that the basic principles ofsound finance are often violated in ways the models cannot capture. Modelsare a secondary overlay in determining fundamental value. Therefore, thisbook focuses on preserving fundamental value, and it does not focus onmechanical models. Yet model building is in vogue, particularly the buildingof inferior correlation models, and the industry has produced many “modelmonkeys.” They produce encyclopedias of code, but even if the code iscorrect, it is often of little practical value.

Richard Feynman once pointed out that students in Brazil memorizedthe definition and formulas for triboluminescence, but they had no idea whatthey meant. While they could spout the theory of the production of lightin the destruction of a crystalline lattice, the students had no idea whichcrystals produce light when crushed or why they produce light. Feynmanwanted to send them into a closet with a sugar cube and a pair of pliers toobserve the faint blue flash of light produced by crushing the crystals.

I’m not saying models have no value; I use models. I’m simply pointingout that if you don’t know where you are going, writing a model isn’t goingto get you there.

Quality control in CDOs and structured credit products is uneven. Asmall number of firms have built sound business models with strong pro-fessional teams, but they are the exceptions. Many structurers and creditderivatives professionals are inadequately trained in the capital markets tobe competent in their jobs, and the investor community is suffering the re-sults. A major problem in today’s markets is lack of cross training. The result



Preface xvii

is poor understanding of the basic mechanics of the products of the globalfinancial markets. The problem is exacerbated by the fact that securitizationshave recently become a lot more global.

Credit derivatives professionals often have never traded cash products ortraded an interest rate swap. Some have no exposure to the bond markets, oreven the currency or swap markets. Many cannot explain how to constructa par asset swap, one of the benchmark relative-value instruments for theirmarket. Some have no exposure to repurchase agreements. This lack ofgeneral knowledge has caused dangerous misunderstandings.

I believe the reason this problem falls below the radar screen is thatfinancial institutions rapidly grow these departments and need to dub adhoc “experts” to satisfy a need. The growth in business of managing CDOs,and the influx of new participants such as hedge funds and pension funds,has made what was formerly a big problem into a critical one. The requiredqualifications and training take a backseat to representing to upper manage-ment that departments are in place. Upper management is often confusedby the complexity of these products and, as a result, many institutions aregoing through growing pains, and some may not make it to full maturity.

Another reason this problem hasn’t been solved is that upper manage-ment often has difficulty assessing true performance. If a group has lostmoney, there seems to be a ready reasonable excuse. Many groups have noclear idea why they lose money or why they make money. They make a betand it either wins or it loses. There is no business model in place to supportconsistent revenue growth. If they make a little money, they persuade man-agement that a hockey stick profit projection profile depicts the future oftheir fledgling department. The philosophy is to tell management what theywant to hear, even if it isn’t close to the truth. Don’t tell management thedepartment is nothing more than just a few guys taking bets. Opportunitycost is invisible.

In Europe in particular, where synthetic securitizations often seem topose a solution to sticky venue issues, there is a dearth of capital marketsexperience in the structuring community. Virtually any asset can be securi-tized, and virtually anyone thinks he can do it.

One securitization professional told me he’d been an unsuccessfulemerging markets trader, but now he felt he’d found his niche. Lack ofexperience was no impediment. He informed me he was a native Italian, andthe language skill was more valuable. He cloned mandate letters of his moreexperienced colleagues and sent them to banks to ask them to allow him todo their balance sheet securitizations. When that strategy wasn’t successful,he simply lowered his costs. In his mind, that was all it took. The ability tooffer creative structural solutions or value added wasn’t a chief concern forhim. This attitude has the potential to hurt this growing market.



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Cash flows can be manipulated to solve almost any problem; they canalso be manipulated to hide almost any problem. Much of what we considerunethical practice is a matter of custom, legislation, and the time in which welive. That applies as much to financial practices as it does to sexual practices.Giving kickbacks in Europe was almost standard operating procedure untilthe Lockheed scandal caused vilification in the United States of the U.S.participants. Many Europeans were initially confused by the uproar, but inthe end, the negative publicity caused the European business community torethink this practice. Determining what is unethical is sometimes a difficultcall, and opinions are divided. Nonetheless, I attempt to address this issuewhere applicable.

I do not delve deeply into tax products or accounting issues, becauseit would require an additional book to do them justice. Furthermore, theseissues change and they vary by venue. One should always refresh the rel-evant rules when doing a securitization. Structured finance tax productshave long hangovers. Investors may need to produce documentation for ac-counting and tax-related transactions years after the product matures. OneCayman Islands–based investor received calls from the U.S. Department ofthe Treasury for 15 years after a tax-related product matured. Tax laws areconstantly changing. Single-venue tax code interpretation is complex, andcross-border tax code interpretation adds another layer of complexity.

Despite the caveats, I’m an enthusiastic proponent of structured financialproducts and welcome the growth of new products in the market. Whereverpossible, I’ve tried to point out how existing structuring technology hasbenefited new markets and has the potential to create even better products.It is my intent to facilitate a clearer understanding of these products that willencourage investors to confidently participate in this fascinating market.



Acronym Key

ABS asset-backed securityACH checking transfersAFC available funds capAIG American International GroupAlt-A Alternative-A mortage loans (just above subprime)ARM adjustable-rate mortgage (see also hybrid ARM)BaCa Bank Austria Credit AnstaltBAFin Bundesanstalt fur Finanzdienst-leistungsaufsicht

(Bundesbank Regulations and Guidance)Bank One Bank One Capital Markets (successor by merger to

BancOne)BBA British Bankers’ AssociationBBVA Banco Bilbal Vizcaya Argentaria S.A.BEY bond equivalent yieldBIS Bank for International SettlementsBISTRO broad index secured trust offeringBofA Bank of America, N.A. (successor by merger to

NationsBank, N.A.)BofA Sec Bank of America Securities LLC (successor by merger to

NationsBanc Montgomery Securities LLC, or NMS)BOJ Bank of JapanBP basis pointC&I commercial and industrialCAG cash against goodsCBO collateralized bond obligationCBOE Chicago Board Options ExchangeCBOT Chicago Board of TradeCDO collateralized debt obligationCDPC credit-derivative product companyCDS credit default swapCEO chief executive officerCFO collateralized fund obligation; chief financial officerCFTC Commodity Futures Trading Commission

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xx ACRONYM KEY

Chase Bank The Chase Manhattan Bank (successor by merger to Chem-ical Banking Corp.)

Chase Sec Chase Securities, Inc. (successor by merger to ChemicalSecurities, Inc.)

Chase USA Chase USA, N.A.CJE Calamity Jones EntertainmentCLN credit-linked noteCLO collateralized loan obligationCMO collateralized mortgage obligationCN combination noteCP commercial paperCPA certified public accountantCPDO constant proportion debt obligationCPPI constant proportion portfolio insuranceCQT collateral quality testCSFB Credit Suisse First BostonCSFP Credit Suisse Financial ProductsCSLT Chase Secured Loan TrustCSO credit spread optionCUSIP Committee on Uniform Securities Identification ProceduresDBA doing business asDimat Dimat Corporation (succeeded by J.L.J., Inc.)DSCR debt service coverage ratioDTC Depository Trust CompanyEC European CommunityECB European Central BankECR estimated cash recovery, the same as credit card grading

model scoreEFC Enterprise Funding Corporation (multiseller conduit)EMCC East Mississippi Collection CorporationEMTN Euro Medium-Term NoteEOD event of defaultFASB Financial Accounting Standards BoardFASIT financial asset securitization investment trustFDCPA Fair Debt Collection Practices ActFDIC Federal Deposit Insurance CorporationFed Federal Reserve Board and the Federal Reserve SystemFHLB Federal Home Loan BankFHLMC Federal Home Loan Mortgage Corporation (Freddie Mac)FNMA Federal National Mortgage Association (Fannie Mae)FRN floating-rate noteFSA Financial Services Authority (UK)



Acronym Key xxi

FTP failure to payGAAP generally accepted accounting principlesGARP Global Association of Risk ProfessionalsGBP Great Britain pound (sterling currency)GLPC Guaranteed Loan Pool CertificateGmbH Gesellschaft mit beschrankter Haftung (limited liability

company)GNMA Government National Mortgage Association (Ginnie Mae)GREAT Global Rated Eligible Asset TrustHLT highly leveraged transactionHybrid ARM an ARM that is fixed for a set period and then

becomes adjustableIA investment adviserICO Instituto de Credito OficialIMF International Monetary FundIO interest only (tranche)IOR Istituto per le Opere di Religione (Institute of Religious

Work, also known as the Vatican Bank)IPO initial public offeringIRB internal ratings-based approachIRR internal rate of returnIRS Internal Revenue Service (U.S. tax agency)ISDA International Swaps and Derivatives Association, Inc.ISP interest subparticipation pieceJ.L.J., Inc. successor by merger to Dimat CorporationKfW Kreditanstalt fur WiederaufbauKHFC Kitty Hawk Funding Corporation (multiseller conduit)LIBOR London Interbank Offered RateLOC letter of credit (also LC)LPFC limited purpose finance corporationLSS leveraged super seniorLSTA Loan Syndications and Trading AssociationLTCM Long Term Capital ManagementM&A mergers and acquisitionsMayer Brown Mayer Brown Rowe & Maw, P.A. (successor to

Mayer Brown Rowe & Platt)MBS mortgage-backed securityMIE multiple issuance entityMLEC master liquidity enhancement conduitMTN medium-term noteN/A not applicable; not availableNAIC National Association of Insurance Commissioners



xxii ACRONYM KEY

NASD National Association of Securities DealersNAV net asset valueNER noneconomic residualNPF note purchase facilityNPV net present valueOCC Office of the Comptroller of the CurrencyOECD Organization for Economic Cooperation and DevelopmentOPM other people’s moneyOSFI Office of the Superintendent of Financial InstitutionsOTC over-the-counterP&L profit and loss statementPAC planned amortization classPAUG pay-as-you-goPCAOB Public Company Accounting Oversight BoardPIK pay-in-kind; payment-in-kindPN participation notePO principal onlyPPM private placement memorandumPPN principal-protected notePPS principal-protected SchuldscheinQIB qualified institutional buyerQSPE qualifying special purpose entityRBA ratings-based approachREIT real estate investment trustREMIC real estate mortgage investment conduitROSE repeat offering securitization entityRP repurchase agreement or repoS&L savings and loanS&P Standard & Poor’sSarbox Sarbanes-Oxley Act of 2002SCB specified correspondent bankSDA specified deposit accountSEC Securities and Exchange CommissionSFA supervisory formula approachSIV structured investment vehicleSLMA Student Loan Marketing Association (Sallie Mae)SLT secured loan trustSMART securitized multiple assets related trustSME small to medium-size enterpriseSPAC special purpose acquisition companySPC special purpose corporationSPE special purpose entity



Acronym Key xxiii

SPV special purpose vehicleSTRIPS separate trading of registered interest and principal of

securitiesSWIFT Society for Worldwide Interbank Financial Telecommuni-

cationsT-bill Treasury billT-bond Treasury bondTRORS total rate of return swap (also TRS or total return swap)USD U.S. dollarUST U.S. Technologies, Inc.; U.S. Treasury; U.S. Treasuries

(bonds)VAT value-added taxWAC weighted average couponWARF weighted average risk factorYTM yield to maturity



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c01 JWBK237-Tavakoli July 24, 2008 8:26 Printer: Yet to come

CHAPTER 1Securitization Terminology

S tructured finance is a generic term referring to financings more compli-cated than traditional loans, generic bonds, and common equity. Rel-

atively simple transactions that lower corporations’ funding costs by con-verting floating rate obligations to fixed rate obligations (or the opposite)through the use of interest rate swaps are traditionally considered structuredfinance transactions. Financial engineering involving special purpose entities(SPEs) is also considered a part of structured finance. Extremely complicatedleveraged products such as constant proportion debt obligations (CPDOs)and complicated securitizations such as collateralized debt obligations ofcollateralized debt obligations (CDOn) are also included in the definition ofstructured finance.

Key motivations for using structured finance include lowering fund-ing costs, changes in debt and equity composition of the balance sheet,taking companies public or private, freeing up balance sheet capacity, mon-etizing balance sheet assets, financing assets, regulatory capital arbitrage,sheltering corporations from operating liabilities, tax management, financ-ing leveraged buyouts, poison pill takeover defenses, hedge fund speculation,accounting rule compliance, and leverage. The structures may address sev-eral issues at once including risk transfer, accounting, taxation, bankruptcy,and credit enhancement.

Securitization is a generic term for a subset of structured finance. Asecuritization is simply the creation and issuance of securities backed bya pool of assets, also called the portfolio, usually with multiple obligors.A synthetic securitization employs credit derivatives technology to transferasset risk (see also Chapter 3, “Credit Derivatives and Total Rate of ReturnSwaps”). Securitization offers the possibility of portfolio diversification, evenwhen it doesn’t always deliver on this promise. Virtually any combinationof financial assets or stream of cash flows can be securitized. In the early1990s Prudential brought so-called death bonds to the market. These weresecuritizations of the life insurance premiums owed to Prudential. The firm

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2 STRUCTURED FINANCE AND COLLATERALIZED DEBT OBLIGATIONS

provided actuarial information showing dropout rates and potential deathrates of the premium payers so investors could get an idea of the futurecash flows. Investors learned a new meaning for the term deadbeat. Thisstructure was one of the early future flows deals. The risk was in whetherthe projected future cash flows would be realized, due to the ultimate lackof future of the premium payers.

Collateralized debt obligation (CDO) is a generic term for a subsetof securitizations. Collateralized debt obligations can be backed by anytype or combination of types of debt: tranches of other collateralized debtobligations, asset-backed bonds, notes issued by a special purpose entitythat purchases other underlying assets that are used as collateral to back thenotes, hedge fund obligations, bonds, loans, future receivables, or any othertype of debt.

The term collateralized debt obligation encompasses collateralized bondobligations (CBOs), collateralized mortgage obligations (CMOs), collateral-ized fund obligations (CFOs), asset-backed securities (ABSs), synthetic creditstructures, and more. In the U.S. capital markets, the term asset-backed secu-rities was originally used to describe deals backed by credit card receivablesand auto loans. In recent years, this term has also been used to describeresidential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS).

Terms used in the mortgage market are sometimes difficult to interpret.Collateralized mortgage obligations usually refer to mortgage-backed securi-ties with strict underwriting standards, where risk is primarily defined by theallocation of principal and interest payments. RMBS and CMBS are termsusually reserved for deals backed by a portfolio of mortgage loans tranchedinto various classes of credit risk. Similarly, mortgage-backed CDO is a termusually reserved for deals backed by a portfolio of mortgage-backed bondsthat are tranched into various classes of credit risk.

Credit derivative is the generic term for any derivative contract usedto transfer credit risk on a reference entity or reference obligor between acredit protection seller that is short the credit risk, and a credit protectionbuyer that is long the credit risk. A credit default swap is a bilateral contractbetween the protection buyer that is short the credit risk and the protectionseller that is long the credit risk.

A total return swap (TRS), also known as a total rate of return swap(TRORS), is considered a type of credit derivative, and it is fundamentallya form of financing. An investor uses financing (i.e., leverage) and obtainsthe economic benefits of an asset (or assets) without owning the asset orballooning its balance sheet. The investor is the receiver of the total re-turn on a reference asset or assets, including interest, capital gains/losses,or other economic benefits during the predefined payment period. The

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