Structured Finance & Collateralized Debt Obligations & Securitization & Tavakoli Structured Finance
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Collateralized Debt Obligations & Structured Finance
by Janet Tavakoli
Collateralized Debt Obligations & Structured Finance & Securitization & Tavakoli Structured Finance

Collateralized Debt Obligations & Structured Finance: New Developments in Cash and Synthetic Securitization, John Wiley & Sons, 2003, by Janet Tavakoli. Currently the global bestseller in the field. See quotes at bottom of page.
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Caveat Emptor! New developments in structured finance make this warning more appropriate today than in the entire history of finance. Collateralized Debt Obligations and Structured Finance is the essential navigation guide to dangerous international financial waters for finance professionals who want to steer clear of the shoals inherent

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
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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
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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.


Janet Tavakoli, President: jt@tavakolistructuredfinance.com TEL: (312) 540-0243
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