in structured financial products. Reviews of
Collatereralized Debt Obligations & Structured Finance:
"Buyer Beware" "International
Financing Review" (adaptation)
"Want Good Numbers?
Watch Your Language" "HedgeWorld"
“Tavakoli
Exposes Post-Enron Dangers in New Structured Finance Book”
CBS Market
Watch
“Book
Debates Racing Deal” "Financial
Times”
Janet
Tavakoli examines a variety of finance topics never before seen
in print. Collateralized debt obligations (CDOs), credit derivatives,
and other new structured finance techniques confound financial
regulators. Tavakoli combines mathematics and skepticism to tackle
the burning issues in the post-Enron financial world with clarity
and authority.
In Collateralized Debt Obligations & Structured Finance,
Tavakoli explains that many investors who thought they owned
AAA credits
will discover to
their dismay
that their
investments
are riskier
than
they
realized.
In fact, their investments do not merit an AAA rating. Many investors
in CDO equity will find they were short-changed on the cash
flows
they thought they owned. Many capital markets managers will discover
their employees are running hedge funds and propping up their
bonuses while stuffing the trading books with undisclosed risks.
Tavakoli unveils this and more while offering solutions and
deterrents.
Tavakoli reveals the abuse of offshore vehicles by institutions
as diverse as the Vatican Bank and Enron. She points out how
easy
it is to pull off international financial chicanery, and how
equally easy it is to prevent it. Collateralized Debt Obligations
& Structured Finance gives the most detailed explanation
of the uses of offshore vehicles currently available in financial
publications.
Structured finance is a powerful tool, and despite the shortcomings
Tavakoli is a proponent. In Collateralized Debt Obligations
& Structured Finance, she makes the case that is a necessary
tool to the continued development of financial management. For
every problem, Tavakoli suggests a reasonable solution.
Praise for Collateralized Debt Obligations &
Structured Finance: New Developments in Cash and Synthetic Securitization,
John Wiley & Sons, 2003, by Janet Tavakoli
“Caveat Emptor! Never in the history of finance has
this warning been more appropriate. With the development of CDO’s,
Credit Derivatives and other esoteric structured finance techniques,
market participants—the savvy as well as the novice—are
exposed to a bewildering array of new ideas, concepts and structures.
Janet Tavakoli has tackled these subjects in an outstanding mixture
of exposition, mathematics and skepticism. A must read for anyone
who plans to play in these markets.”
Jack Caouette
Vice Chairman
MBIA Insurance Corporation
"Structured Finance is central to the continued development
of active credit portfolio management. In this book, Ms. Tavakoli
not only provides an authoritative account of many of the Structured
Finance products employed by Portfolio Managers, but also addresses,
in a forthright manner, a number of the 'burning issues' affecting
the industry in a post-Enron world."
John Cross
Global Head, Portfolio Management
Standard Chartered Bank
“A timely and comprehensive survey of the latest developments
in structured finance, particularly given the rapid pace of change
in the last few years. The author's depth of knowledge and wide
experience are conveyed clearly to the reader. At a time when
the industry's ability to meet the complexities of the differing
requirements of market participants is under challenge from both
the events of the last cycle and the authorities, the insights
offered in this book are especially valuable.”
Mark Hale
Group Strategist
Ansbacher & Co., Ltd.
Selected
Quotes from Collateralized Debt Obligations & Structured Finance
Fraud
"We shouldn't be surprised by it; we should
actually expect to deal with it, and can take steps
to guard against it. We know that many employees
will commit fraud given the right circumstances...known
as the fraud triangle: need, opportunity, and the
ability to rationalize
one's behavior."
Leveraged
Mortgage-Backed Securities Risk:
"But what happened to the trade you ask? Interest
rates kept declining, and prepayments kept speeding
up. His mortgage-backed holdings sustained several
years of losses. He lost his lifetime job."
Offshore Special Purpose Vehicles
"The structured solution to the bankruptcy,
true sale, and debt-for-tax issues varies by venue...These
are private corporations. They don't have to disclose
anything. It is extremely difficult - if not impossible
- for you to discover the true owners and ownership
interests in the corporations."
Synthetic Collateralized Debt Obligations
and Credit Derivatives
"Structurers at banks and investment banks
attempt to exploit the 'cheapest to deliver' option
at the expense of CDO investors whenever possible."
Cash versus Synthetic Securitization
" Credit default swaps can reference virtually
any obligation of a desired reference credit. The
arranger doesn't have to scour the market for a specific
bond issue that may be tied up in a reference portfolio
as often happens for a cash deal. It is much easier
to source a portfolio of credits using CDSs than
bonds."
Cash Flow Caveats
" I can almost hear the wails of protest.
But no one gets accrued interest wrong! No one gets
forward price calculations wrong! But they do. They
get it wrong and they get it wrong frequently. In
fact, a simple error in accrued interest calculations
brought down the house. At least it brought down
the house of Kidder Peabody."
Equity Repacked in Principal Protected
Notes
" Equity is usually repackaged
with zero coupon bonds issued by highly rated
entities. A special purpose entity issues a
note with proceeds adequate to buy the zero
coupon
which
accretes
to par at maturity to pay off the principal
on the note. The remaining note proceeds are
used to purchase the equity tranche of the
collateralized debt obligation, which provides
cash flows for interest payments on
the note. "
Balance Sheet Collateralized Debt Obligations
"It is possible to directly sell equity
risk to an investor or a fund. As we’ll see
later, a modification of the secured loan trust structure
may enable the transfer of equity risk. While this
is a very good idea, most banks don’t put in
the required effort to accomplish it."
Credit Risk Concentration
"The
top of the house has to take the reins to control
the stampeding horses,
but that’s impossible when they are among the
herd...A
lender cannot expect to be rewarded for taking on large concentrations
of risk. Debt has no upside potential...In 2001 and 2002 the markets
cruelly drove home this point. Banks had large pockets of highly
concentrated risk. Recovery
rates were inversely correlated with annual default rates, and
defaults – albeit relatively rare – reached highs
that hadn’t been seen in many decades. Not only were there
more defaults on highly concentrated risk, when defaults occurred,
the banks recovered a lower percentage of their initial high
concentrations."
Enron, JP Morgan, and Sureties - Conflict over the Mahonia
Transactions
"Game theory is the study of conflict between thoughtful
and potentially deceitful opponents. In his minimax theorem John
von Neumann mathematically proved there is always a rational
solution to a precisely defined conflict between two players
whose interests are completely opposed. When Enron declared bankruptcy,
the interests of the insurers and of J.P. Morgan were opposed."
Super Senior Tranches
"The rating agencies do not rate a super
senior tranche. In fact, the rating agencies do not
acknowledge the existence of a super senior tranche.
The super senior tranche is a convention created
by collateralized debt obligation structurers."
Hollywood Funding
"Standard & Poor's said it believes...
Lexington has waived all of its defenses to payment
on the policies. They further believe
the policies meet the standards of the capital market
for credit enhancement of financial market instruments.
Nonetheless, they downgraded these deals from AAA
to BB."
Future Developments
"Structures that do the traditional job
will become a key focus. Structures that reduce balance
sheet risk will get more attention. Structures that
create value for investors will get more attention.
Structures that are transparent will get more attention.
It seems the market is efficient, after all."
Please Note Sources at Bottom of Page
Definition of Structured
Finance: Structured
finance is a generic term referring to financings more complicated
than traditional loans, vanilla bonds and common equity. Relatively
simple transactions that lower corporations' funding costs
by converting floating rate obligations to fixed rate obligations
(or the opposite) through the use of interest rate swaps are
traditionally considered structured finance transactions. Financial
engineering involving special purpose entities is also considered
a part of structured finance. Extremely complicated leveraged
products such as constant proportion debt obligations (CPDOs)
and complicated securitizations such as collateralized debt
obligations of collateralized debt obligations (CDO^n) are
also included in the definition of structured finance.
Key motivations for using structured finance include lowering funding costs,
changes in debt and equity composition of the balance sheet, taking companies
public or private, freeing up balance sheet capacity, monetizing balance sheet
assets, financing assets, regulatory capital arbitrage, sheltering corporations
from operating liabilities, tax management, financing leveraged buyouts, poison
pill takeover defenses, hedge fund speculation, accounting rule compliance and
leverage. The structures may address several issues at once including risk transfer,
accounting, taxation, bankruptcy and credit enhancement.
Definition
of Securitization: Securitization is a generic term for a subset of structured
finance. A
securitization is simply the creation and issuance
of securities backed by a pool of assets, also called the portfolio, usually
with multiple obligors. Securitization offers the possibility of portfolio
diversification, even when it doesn’t always deliver on this possibility.
Virtually any combination of financial assets or stream of cash flows can
be securitized.
Definition
of Collateralized Debt Obligation (CDO): Collateralized
debt obligation is a generic term for a subset of securitizations. The
term collateralized
debt obligation encompasses collateralized bond obligations (CBOs), collateralized
mortgage obligations (CMOs), collateralized fund obligations (CFOs) and more.
Collateralized debt obligations can be backed by any type or combination of
types of debt: tranches of other collateralized debt obligations, asset backed
bonds, notes issued by a special purchase entity that purchases other underlying
assets, which are used as collateral to back the notes, hedge fund obligations,
bonds, loans, future receivables or any other type of debt.
Definition of
CDO Arbitrage: A collateralized debt obligation may consist
of tranches of varying degrees of risk. For example, a collateralized debt
obligation backed by a portfolio of bonds might be tranched into four classes
of risk with the following ratings: a senior (“AAA”) tranche, mezzanine
tranches rated anywhere from AA to B, and unrated first loss risk. First loss
risk is also called “equity,” or “preferred shares,” or
by other names, but it is not to be confused with common equity or preferred
shares issued by corporations with ongoing businesses. The difference between
the income from the portfolio and its value and the cash owed to the investors,
the liabilities, less the deal expenses (legal, rating agencies, structuring
fees, and more) is known as the CDO “arbitrage”. In particular,
the investment bank arranger will normally pre-sell the first-loss tranche,
the riskiest tranche. The implied internal rate of return at which this first-loss
risk can be sold to an outside investor is a key determinant of what is known
as the collateralized debt obligation arbitrage (CDO arbitrage).
Definition
of Credit Derivative: Credit derivative is the generic term for any derivative
contract used to transfer credit risk on a reference entity or reference obligor
between a credit protection seller that is short the credit risk, and a credit
protection buyer that is long the credit risk. Credit derivatives are distinct
from financial guarantees and credit insurance. The credit protection buyer
does not have to own the underlying security or actually suffer a loss. The
credit protection seller has no recourse to the reference entity and does not
have the right to sue the reference entity/obligor for recovery.
Definition of Credit Default Swap: A credit default swap is a bilateral
contract between the protection buyer that is short the credit risk
and the protection
seller that is long the credit risk. Usually the protection buyer pays a periodic
fee to the protection seller in exchange for the protection seller’s contingent
payment if a pre-defined credit event affects the reference entity or reference
obligor.
Definition of a Total Return Swap (TRS), or Total Rate
of Return Swap, (TRORS): A total return swap is considered
a type of credit derivative, and it is fundamentally
a form of financing. An “investor” uses financing, i.e., leverage,
and obtains the economic benefits of an asset (or assets) without owning the
asset or ballooning its balance sheet. The investor’s counterparty essentially
finances the asset/s for the investor and buys protection against both credit/value
deterioration and loss. The investor is the receiver of the total return on a
reference asset/s including interest capital gains/losses or other economic benefits
during
the pre-defined payment period. The investor's counterparty receives a
specified fixed or floating cash flow usually related to the credit worthiness
of the investor. Typical reference assets include bonds, loans, indexes, hedge
fund obligations, equity and commodities. The reference asset may be virtually
any financial obligation.
Total return swaps are popular with hedge funds due to the leverage they provide.
Banks and investment banks with lower funding costs usually require upfront collateral
from hedge funds that is a fraction of the initial asset value, often allowing
hedge funds 20:1 leverage.
Definition of Synthetic Securitization: A synthetic securitization employs credit
derivatives technology to transfer asset risk.
Definition of Special Purpose Entity (SPE): Special
purpose entity is a global term and is used interchangeably with the
term Special
Purpose Vehicle (SPV). Special
Purpose Entities are powerful structured finance tools. An SPE
is either a Trust or a Company. Special purpose corporations are used
for a variety of
purposes,
including
structured risk management solutions. In securitizations, the SPE houses
the asset risk either through the purchase of the assets or in synthetic
form. The assets are then used as collateral for notes issued by the
SPE. SPEs can be either on shore or offshore. SPEs are normally off-balance
sheet, bankruptcy-remote, and private nature.
All of the following are examples of SPEs: Special Purpose
Corporations (SPCs) which may or may not be Special Purpose Subsidiaries
or captives;
Master Trusts; Owners Trusts; Grantor Trusts; Real Estate Mortgage
Investment Conduits (REMICs); Financial Asset Securitization Investment
Trust (FASIT); Multiseller Conduits; Single Seller Conduits; and certain
Domestically Domiciled Corporations.
Adapted and simplified from the following sources:
Tavakoli,
J. Collateralized Debt Obligations & Structured Finance, John
Wiley & Sons, 2003.
and Tavakoli, J. Credit Derivatives &
Synthetic Structures, John Wiley & Sons, 2nd Edition 2001.
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