Western Asset Arbitrage

9 Pages   |   2,187 Words

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

What is a CDO? Explain how it works.

A collateralized debt obligation or CDO is essentially a financial product that brings different low rated assets into one base. After pooling the assets using the principles like diversification and etc, this product reissues the securities in different tranches whose weighted average rating is well above than the weighted average of pooled assets. The different tranches have different priorities, risk profile and return. The process of CDO functioning is explained in Appendix A. CDOs are fundamentally asset backed securities. CMO is a special type of CDO in which the assets backing the cash flows are ‘mortgages’.

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 rate. 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 a high value and investors claim the cash flows from the securities in different priorities.

Yes, We Can Help!

We promise to deliver high quality papers on time which will improve your grades. Get help now!

Plagiarism Free Work
Best Price Guarantee
100% Money Back Guarantee
Top Quality Work

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

The issuing entity has the advantage of transferring a 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.

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

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

The first explanation for this participation roots in the fact that 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 on US treasury bonds were not substantial. CDOs offered better and enhanced returns with respect to the bond market. Therefore, investors preferred CDOs to the equivalent 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.


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 trenches. 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.


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 change of default. The biggest investors in CDOs are the 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’.

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

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 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 the risk considerations. The key parties include the issuer of CDO and the party that generates the cash outflows related to asset.


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 different than CDOs as CDO security portfolio is structured by keeping into consideration the overall rating.

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.

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. If you take a look at the balance sheet of Cayman Inc. or any other SPV, it would become evident that SPVs essentially are not typical financial institution. SPVs or conduits have just one purpose, to take certain elements off balance sheet or convert them into securities for further sale. On the other hand, SPVS are legal entities; therefore, from a legal perspective, they are financial companies. However, in practical life, SPVs cannot be regarded as full fledge financial institutions. They do not have many elements on their balance sheet and is spite of the fact that the liabilities or notes payable have corresponding assets backing them, and the investors cannot be promised of a reliable return.


How would you evaluate the rates of return on the SPV's assets? What about the rates of return on liabilities?

SPV’s assets are mostly medium and long term liabilities of the corresponding issuing company. How do assets earn the return is the basis question. These liabilities or mostly the ‘notes payable’ have a face value and they give away interest payment over regular intervals. The equivalent rate of return on this portion of the balance sheet is essentially the rate of return on the underlying bonds or securities. The rating of these bonds may change; therefore, the market value of assets of SPV changes. This, in turn, changes the rate of return on assets. On the other hand, liabilities have tranches and each tranche has its own return. From the overall return of the portfolio, higher rated tranches are paid first till all the return is expired or paid. High rated tranches will have relatively low return. As someone goes down the waterfall, the return on liabilities increases. The total return on liabilities will be the sum of the interest payments and appreciation in their market values.

Analyze the return potential and risks of the various investment opportunities.

What is the expected rate of return for the unrated/equity tranche investor?

Equity tranche is the lowest ranked tranche in the CDO. The probability of its default is very high; therefore, the expected return is also the highest in all the tranches. This tranche gets paid after all the tranches are paid. In this case, the rate for equity tranche is not explicitly mentioned. Therefore, let’s assume that equity investors get whatever is left after distribution to senior tranches. Therefore, the expected rate of return on equity tranche can be calculated from the following formula:
Expected Return on Equity Tranche = {Appreciation in the market value of equity + (Overall portfolio return –sum of return to all other tranches)}/ Invested Amount


What is the expected return to the unrated tranche (also known as the "equity tranche")? Would you invest in the equity tranche? Why or why not?

The expected rate of return to the unrated tranche investor also contains a portion of expected return on tranche. The expected return to the equity tranche is equal to the difference between the total portfolio return and the total return distribution to senior tranches divided by the invested amount. There can be several motivations to invest in the equity tranche. First and foremost reason borrows its inspiration from the actuality that if overall portfolio is handsome, equity investors will get a huge return. Secondly, several institutions like to invest in securities that pay regular fixed income after regular intervals with a high payout.


What other investment strategies would you consider? Are they suitable for all investor classes? If not, who should pursue which class of strategy?

The tranche selection should depend ideally on the risk return preference of the investors. The risk lover investors opt for the equity tranche as it bears the maximum return with maximum risk. As the risk preference of the investors goes down, the desired tranche selection moves up. The most risk averse and avoider investors will opt for the highest ranked tranche as it has the lowest probability of default and a guaranteed ‘first priority’ return. If I were an investor, I would choose a tranche that is mid way in between the top and bottom. In this way, the risk and return alternatives are balanced.

Propose origination, investment and arbitrage strategies for various market participants. How should Lehman approach the deal? What about Western Asset or major institutional investors?

Let’s assume that this CDO is actively managed. This means that the issuer of the CDO can actively manage the portfolio of securities and can sell or buy the securities to maintain or enhance the credit rating of securities pool. In the current situation, Western asset does not possess the capability to diversify and pool the securities effectively. On the other hand, ‘Lehman brothers’ has a peculiar taste for this sort of cash flow arbitrage CDO. In the current scenario, Western asset is also interested in the arbitrage and let’s assume that it has enough cash for purchasing the ‘low investment grading’ bonds. Western asset should initiate the process by buying the desired bonds and only then include Lehman brothers in the CDO process. For the purpose of CDO, the payment to Lehman brothers can be made in number of ways and it really depends on the deal. However, it is recommended that Lehman brothers should be paid a commission for the portfolio initiation. After that, there will not be any complexities as the tranches will be sold to investors and an SPV creation is not that difficult. For regular maintenance of the security portfolio, expertise of Lehman brothers can come in handy. The arbitrage can be carried forward easily just by maintaining the value and credit rating of the overall portfolio.


Appendix A

CDO Functioning Process


Appendix B

Suggested Balance Sheet
B+ (leveraged loans) @LIBOR'+2.35% 360
B (high-yield bonds) @8.5% 40
Total 400
Liabilities and Equity
AAA (A-1) @LIBOR+ 0.23% 238
AAA (A-2) @LIBOR+0.45% 60
AA @LIBOR +2.75% 18
A @LIBOR +2.75% 24
BBB @LIBOR +2.75% 32
Equity 28
Total 400

Download Full Answer

Order Now