Western Asset Arbitrage Case Solution

1. Research CDOs. How do they compare to CMOS? How are they similar or different from each other?

ii. Where does a CDO's value come from?

In essence, the value generation from CDO primarily comes through the repackaging, diversification and credit enhancement processes. Initially, the assets or securities were low rates. The repackaging of these securities is done with a distinct purpose, to generate a high rating of the resulting pool of assets. Rating agencies then determine the ratings of different securities in different tranches. If the resulting weighted average rating is greater than the original weighted average of individual securities, than the possibility of arbitrage is imminent. The SPV sells the securities on high value and investors claim the cash flows from the securities in different priorities.

iii. What are the advantages and disadvantages from the perspective of all parties involved?

The issuing entity has the advantage of transferring liability to an asset just by the creation of CDO via an SPV. The issuer of CDO sometimes gets a riskless profit without much effort. In some case, CDO allows the issuer to take certain liabilities off their balance sheet. The investors have the advantage of choosing any tranche and additionally the return on CDOs is generally higher than the return on same rated corporate bond. Even though CDOs are asset-backed if the asset defaults, investors lose the cash flow payments. Investors are also disadvantaged as different tranches get paid in different Priorities.

2. Analyze the demand for CDOs and the various tranches. What sells and why? Who are the typical investors in CDO tranches?

i. Why was everyone so eager to participate in the securitization market?

The first explanation for this participation roots in the fact that the issuing party can basically securitize or ‘cash in’ the loans. On the other hand, the CDOs also allowed banks, etc to take substantial loans off their balance sheets. This resulted in enhancing their key financial ratios. Additionally, in the post-2002 period, the rate of US treasury bonds was not substantial. CDOs offered better and enhanced returns with respect to the bond market. Therefore, investors preferred CDOs to the equivalently rated bonds. Additionally, in the same period, the demand for fixed income securities was quite high and CDOs were the only FIS that offered lucrative returns.

ii. Which market segment invests in equity tranches? Who are the typical investors in rated tranches?

Different investors have different motivations behind the purchase of tranche segment. Equity tranches comprise of the section that has the maximum possibility of loss. Therefore, to attract investors, equity tranches offer high yields. High-risk profile investors usually invest in equity tranches. In some cases, banks and hedge funds also invest in equity tranches. Individual investors with a lot of excess money are also prime sponsors of equity tranches. On the other hand, high rated tranches offer a somehow guaranteed fixed cash flow. Therefore, it is preferred by various financial institutions like insurance companies, mutual funds, hedge funds, pension funds, investment banks and etc.

iii. Should one facilitate the unsophisticated, e.g., retail, investors' participation in this particular type of securitization? If so, how? If not, why?

The whole process of securitization and CDO formation is complex and tricky. In some cases, the asset manager may combine securities that have a huge chance of default. The biggest investors in CDOs are institutional investors. They have the means to determine the worth and credibility of relevant assets. On the other hand, the retail investor just invests as he/she deems high return. This type of investor can raise the overall demand for CDOs. If a CDO fails or defaults, all investors lose. Therefore, it is better including individual investors as the loss of big and notable institutions will decrease and spread out. In this way, you can save the institutions at the cost of ‘unsophisticated investor’.

3. Investigate structuring techniques for CDOs and how they differ from other segments of the ABS market.

i. How do risk considerations affect CDO structuring? Which parties drive those considerations?

Risk is the prime factor behind CDO structuring. CDO is structured in such a way that assets or securities from different risk profiles are structured. On the other hand, there are three main constituents of CDO structuring, the waterfall, trigger, and covenant restrictions. It is quite clear that the risk profile of CDO is a direct input to the structuring of CDO. The equity tranche, in most of the cases, bears most of the risk. Therefore, it can be concluded that the credit spread in CDO is not uniform. Equity tranche is the major risk bearer of the overall risk of the security portfolio. However, the risk profile of the CDO can also be changed to incorporate or adjust for different returns to different tranches. Different parties are affecting risk considerations. The key parties include the issuer of CDO and the party that generates the cash outflows related to the asset.

ii. Research the rating process of CDOs and compare it to that of CMOS. To what degree are CDO structures driven by rating considerations? Is this aspect of structuring any different for CMOS?

The biggest factor in the structuring of CDOs is the resulting rating of the security portfolio. In the case of arbitrage CDO, the rating process is even more crucial as the spread earned by the issuer of CDO depends on it a lot. The rating process of CDOs also depends on the type of security issued. Some bonds are rated by various rating agencies while the rest are rated by fewer. Therefore, the security portfolio that has its constituents rated by various agencies is preferred. On the other hand, in the case of CMOS or collateralized debt obligations, the rating process is not extensive as there are fewer agencies present to rate mortgages. Therefore, in the case of CMO, the authenticity and credibility of the issuing party or institution is the prime value driver. In this way, CMOs are structured a little differently than CDOs as the CDO security portfolio is structured by keeping into consideration the overall rating.

4. Why do we need an SPV for CDO origination? Construct a balance sheet for the special purpose vehicle (SPV) as if it were a financial corporation.

i. Is it appropriate to view ABS SPVs (conduits) as own financial companies? What are the similarities and key differences?

In order to understand the working of special purpose vehicles, you have to construct a suggested balance sheet for the proposed SPV in the current scenario; Cayman Island Inc. Appendix B depicts the balance sheet for SPV.