3 CDO Introduction

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Collateralized Debt Obligations

(CDOs): An Introduction

BEAR

STEARNS

March 2005

Bear, Stearns & Co. Inc.

383 Madison Avenue

New York, NY 10179

(212) 272-2000

www.bearstearns.com

Gyan Sinha

(212) 272-9858

[email protected]

Ranajoy Sarkar

(212) 272-0998

[email protected]

The research analysts who pre-

pared this research report

hereby certify that the views

expressed in this research report

accurately reflect the analysts'

personal views about the subject

companies and their securities.

The research analysts also cer-tify that the analysts have not

been, are not, and will not be

receiving direct or indirect com-

pensation for expressing the

specific recommendation(s) or

view(s) in this report.


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Overview

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OverviewCollateralized Debt Obligations, which are more widely known by their

acronym - CDOs, are investment vehicles that issue equity and debt tofinance their purchase of a wide range of fixed-income assets. CDO struc-

tures are created by utilizing the same basic structuring technology that has

been in use in the Asset Backed Securities (ABS) market. As in the case of

ABS structures, where this technology is applied to diverse pools of assets

such as home equity loans or auto loans, CDOs are created using assets as

diverse as senior secured bank loans, high yield bonds and ABS, to name a

few.

In that sense, a CDO can be compared to a managed fund where the

underlying portfolio provides diversified exposure to one or more asset

classes for the funds debt and equity holders. CDOs are managed by profes-

sional portfolio managers with established track records in the relevant asset

classes and are designed to provide diversification with respect to issuers,

industry sectors and/or asset classes, all subject to predetermined limits and

guidelines that are determined by the collateral manager, rating agencies and

investors at the commencement of the transaction. Collateral managers inCDOs range from large institutions to smaller boutique firms whose primary

business is the management of CDOs.

Size of the CDO MarketAlthough the first CDOs were issued in the late 1980s, the sector gained in

prominence much later, starting in 1996. Starting off primarily in the U.S. as

a means for risk-transfer for banks, the CDO market has grown by leaps and

bounds over the past few years and is now global in scope, spanning the

U.S., European and Asian financial markets. Global CDO issuance reached

approximately $194 billion in 2004, with the size of the outstanding market

estimated between $700 billion and $800 billion as of the end of 2004. A

vast majority of issuance originates from the U.S. and Europe, although the

Asian CDO market is expected to grow rapidly over the next few years.


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Size of the CDO Market

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Figure 1: Growth of the Global CDO Market ($ Billions)

Source: Bear Stearns CDO Research

As in the case of the ABS sector, the CDO market has rapidly evolved since

its inception. Issuance volumes have shown steady growth, new asset classes

have been securitized using CDO technology and the investor base for CDO

debt and equity has expanded rapidly. In our opinion, the CDO markets in

the U.S. and in Europe reached the stage of maturity in 2003 and 2004.

15.7

45.4

92.696.7

103.298.2

77.1

114.2

143.7

2.7 3.0 4.0

11.815.1

23.8

42.9

49.8

-

20

40

60

80

100

120

140

160

1996 1997 1998 1999 2000 2001 2002 2003 2004

Cash Funded Synthetic


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Size of the CDO Market

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Figure 2: Bear Stearns CDO Investors (Oct. 1996 to August2004)

Source: Bear Stearns

We tend to think of CDOs not so much as an asset class in the traditional

sense, but more as a financing technology that provides term, non-recourse

funding for investors to participate in the underlying collateral markets.

From that point of view, CDOs will be appropriate, at different times, for

various kinds of underlying assets. Some of the major sub-sectors in the

CDO market, as of the end of 2004, are as follows:

ABS CDOs - backed by Residential A, Residential B/C, manufactured

housing loans etc.

Arbitrage CLOs - backed primarily by senior secured bank loans

High Yield CBOs - backed by high yield bonds

Bank/ Private Bank,

57.0%

Asset Manager, 20.0%

Insurance, 13.0%

Pension Fund, 7.0%

Hedge Fund, 2.0%

Other, 1.0%

Hedge Fund, 2%Other, 3%

Insurance, 15%

Bank/ Private Bank, 38%

Pension/ Endowment/

Public Assets/ Religious

Organizations, 3%

Asset Manager, 39%

U.S. Debt, 48.3% Non-U.S. Debt, 51.7%Non-U.S. Equity, 46%U.S. Equity, 54%

U.S. vs. Non-U.S. Debt Investors U.S. vs. Non-U.S. Equity Investors

Debt Investors by Dollars Equity Investors by Dollars


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The CDO Structure

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Synthetic CDOs - backed primarily by investment-grade credit default

swaps

Trust Preferred CDOs - backed by bank and/or insurance Trust Pre-

ferred securities

Balance Sheet CLOs - backed by senior secured bank loans

CDO-squareds - backed by tranches of other CDOs

Figure 3: Increasing Diversity of Assets in the CDO Sector (% ofIssuance Volume)


The CDO StructureAs mentioned above, CDOs are financing vehicles created to fund the pur-

chase of underlying pools of fixed-income assets. The portfolio of assets in a

CDO is typically financed by a credit tiered capital structure consisting of

both investment grade and non-investment grade debt tranches, as well as an

equity (or preferred share) tranche. CDOs are structured as Special Purpose

Vehicles (SPVs), and the rated notes and equity are issued by these bank-

ruptcy-remote SPVs.

The majority of the financing for a CDO is usually provided by triple-A

rated notes, thereby making the weighted average cost of debt for these vehi-

20041998

Balance Sheet

CLO

51%

HY Bond

20%

HY Loans

11%

EM Bonds

5%

Synthetic

Bonds/Loans

3%

Other

10%

ABS

32%

Synthetic

Bonds/Loans

25%

HY Loans

20%

Balance Sheet CLO

2%

Trust Preferred

3%

HY Bond

1%

CDO

6% Other

10%


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The CDO Structure

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cles significantly lower than the interest being generated from the underly-

ing portfolio of assets. Below the rated debt of a CDO is a tranche of equity.

Equity holders typically receive all residual cash flows from the assets (ateach payment date) after payment of related fees as well as interest to the

debt investors. Therefore, the equity tranche is the beneficiary of the spread

differential (often referred to as the arbitrage) between the returns on the

portfolio of assets and the weighted average cost of debt plus fees. CDO

equity allows investors to take credit exposure in a relatively pure form -

since other forms of risk such as interest rate risk and currency risk are usu-

ally hedged out - while the financing is provided on a term, non-recourse

basis with no mark-to-market requirements on the underlying portfolio.CDOs as an asset acquisition vehicle therefore have a natural advantage over

investors subject to these constraints.

Figure 4: CDO is Similar to a Limited-Life Bank


In many ways, a CDO with a legal final maturity date can be thought of as a

limited-life bank, or any other corporation for that matter. In the case of a

corporation, equity holders typically raise financing in the form of debt

Assets

OversightManagement

Liabilities

Loans, Mortgages, Etc.

Traditional Bank

CEO

CFO

Treasurer

FDIC

OCC

Debt

90% - 92%

Equity

8% - 10%

Assets

OversightManagement

Liabilities

Bonds or Loans

CDO

Collateral

Manager

Rating

Agencies

Trustee

Debt

(71% AAA, 21%

Mezz.)

Equity

8%


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The CDO Structure

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(bank loans, bonds etc.) and use the proceeds to purchase assets that provide

a stream of future cash flows. These assets can range from C&I loans and

mortgages for a bank to plant and machinery for an industrial company. Cashflow from assets is then used to pay operating and administrative costs and

interest to the companys debt holders. Residual cash flows are then either

passed through to shareholders in the form of dividends or retained by the

company (retained earnings) for future asset purchases. If we assume that

this company is of the limited-life variety, then its equity holders will sell all

of the companys assets at the end of the term and retain all excess proceeds

after paying debt holders at par.

The CDO structure works in an analogous way. In this case, the CDO equity

investors are the shareholders in the SPV and retain the upside to future asset

valuations. The equity investors, like the limited-life company in our exam-

ple, finance the purchase of the underlying assets of the CDO by issuing debt

in the form of rated notes (also known as the CDO liabilities). The cash flow

from these assets are then used at each payment date to pay interest to the

CDO note holders and any residual cash flow is then generally passed

through to the equity investors, akin to paying shareholder dividends in ourprevious example. At the final maturity of the transaction, proceeds from the

sale of all assets are used to first pay off any remaining debt holders at par

while the remainder goes to the CDO equity holders.

There are other similarities as well. In the case of a company, there is a man-

agement team typically comprising a CEO, CFO, Treasurer and so on. In

many cases, they are paid a base fee for their services (base salaries) as well

as a performance based fee (bonuses) if they meet or exceed pre-established

benchmarks. The same concept works in a CDO. The collateral manager of a

CDO can be compared to the management team of a corporation, who gener-

ally gets paid a base collateral management fee and an additional collateral

management fee subject to meeting certain performance requirements. In the

case of a company, entities such as the SEC or the FDC act as independent

regulators. This oversight role for CDOs is generally played by rating agen-

cies (Fitch, Moodys, S&P) and the trustee for the transaction.


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The CDO Structure

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Figure 5: The CDO Balance Sheet

1. Bonds in the portfolio are assumed to yield L+2.85%

2. Percentages do not sum to 100% as equity amount must reflect fees and

expenses, etc.


Given that a typical CDO structure resembles a limited-life company in

many ways, the concepts of balance sheet and income statement are also

portable between these two legal entities. In Figures 5 and 6, we show the

balance sheet and income statement for a hypothetical CDO backed by

leveraged loans and high yield bonds.

CDO

Special Purpose

Vehicle

$300 Million

Weighted Avg.

Yield:

3mL+2.85%1

97% U.S.Corporate Senior

Secured Bank

Loans

3% High Yield

Bonds

Senior Notes

$216.8 Million

Aaa/AAA

3mL+0.32%

Mezzanine Notes$65.0 Million

Aa2/AA - Ba2/ BB

3mL+2.00%

Preferred Shares

$25.4 Million

Excess Interest

72.3% of

Total

Assets2

21.7% of

Total

Assets

8.5% of

Total

Assets

SPV


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Role of the CDO Manager

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Figure 6: The CDO Income Statement, a.k.a. The Cash FlowWaterfall

Role of the CDO ManagerCDOs can be divided into two categories - static or managed - based on the

role (or lack of it) of the collateral manager in a transaction. While the port-

folio of assets in a static transaction is generally fixed at inception, managed

transactions have the ability to trade in and out of underlying assets subject

to certain restrictions. Managed transactions constitute the vast majority ofCDO issuance across the various asset classes.

The manager of a CDO is responsible for initial portfolio selection as well as

subsequent monitoring and trading of the collateral in exchange for a fee.

The life of a CDO can generally be divided into two main periods - the initial

Revolving Period, which typically ranges from three to five years, and the

subsequent Amortization Period, which runs until maturity. During the

revolving period, all proceeds from principal in the collateral pool are rein-vested into new assets, subject to guidelines. After the revolving period, all

principal proceeds are used to pay down the rated tranches of debt in order of

priority.

Income

2% Losses/ 75% Recoveries

L + 2.85%

(0.50%)

Trustee & Administration Fees (0.10%)

Base Collateral Management Fee (0.125%)

Interest to Senior Notes (L + 0.32%)

Senior Overcollateralization Test

Interest to Mezzanine Notes (L + 2.00%)

Mezzanine Overcollateralization Test

Additional Collateral Management Fee (0.375%)

Excess to Equity 1.04%

Return on Equity (IRR) 15.83%

Leverage (11x - 12x)


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What is CDO Equity?

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The CDO manager is generally compensated with fees that are based on the

principal amount of the collateral and may also receive incentive fees (as

shown in Figure 6) if certain hurdles for current distributions or total returnto equity are met. In many cases, the collateral manager owns a portion of

the equity or other notes in the transaction.

The evolution of the CDO market over the last few years has led to the cre-

ation of a breed of collateral managers with established track records in one

or more sub-sectors, much to the advantage of investors who can use this

knowledge as an input to their investment decisions. The emergence of a

class of managers with substantial stakes in this business (through equityinvestments and otherwise) also bodes well for the future of the CDO market

in general. The managed CDO has also allowed for the globalization of

structured credit investing by allowing investors across the world to partici-

pate in markets where they do not have a presence. The delegation of the

security selection and monitoring roles to CDO managers allows for the

funding and risk-taking functions to be separated from the origination

function. In the process, investors achieve better geographical diversity in

their exposure to credit risk while the underlying credit markets becomebroader and deeper.

What is CDO Equity?CDO Equity represents the ownership interest in a limited-purpose company

(the SPV) that has been set up for the sole purpose of investing in a pool of

assets. CDO Equity investors get term, non-recourse financing through the

CDO vehicle, thereby allowing them to reap high returns through a lever-

aged investment in the underlying assets.

CDO Equity can be viewed as a hybrid between traditional fixed income and

alternative investment strategies. Similar to a bond paying regular coupons,

CDO Equity makes quarterly or semi-annual distributions to investors.

However, the return hurdles on CDO Equity are typically significantly

higher than traditional fixed income instruments, thus making them compa-

rable to alternative asset classes such as hedge funds or private equity. These

higher returns are attained through the use of leverage on a diversified port-

folio of fixed income assets using long-term, low cost financing with nomark-to-market and no recourse.


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What is CDO Equity?

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Returns on financial assets can typically be generated through either current

income or principal appreciation. For alternative investments such as venture

capital and private equity, principal appreciation is the primary driver ofreturns on investment, as these assets provide little or no current income and

overall returns are typically back-ended. CDO Equity, on the other hand,

relies on current income for the majority of its total return. This current

income is generated from the assets in the underlying collateral pool from

the initial investment date. As is the case for fixed income instruments, the

risk-reward profile of CDO Equity investments is driven by the credit per-

formance of the underlying assets and not by their earnings performance, the

latter driving returns for investments such as private equity. Therefore, boththe timing and the source of returns make CDO Equity a natural complement

to other alternative investment strategies.

Investing in CDO equity within an alternative investment portfolio comple-

ments established strategies, such as a hedge fund allocation, in other ways.

Traditionally, hedge funds tend to do well in a high market volatility envi-

ronment. In contrast, a leveraged play on credit (which is what CDO equity

can be thought of in simple terms) is likely to outperform in a low volatilityenvironment. Absolute return investors can use investments in structured

credit equity to express a low volatility view as a hedge against other high-

return strategies that are premised on a high volatility market environment.

The hybrid nature of CDO Equity and their front-loaded return profile have

led to a significant increase in the breadth of investors for these investments.

The global appetite for CDO Equity has grown by leaps and bounds since

the inception of this market, with banks, insurance companies, pension funds

and corporate pension plans, hedge funds and endowments now becoming

the most active investors for these instruments.


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What is CDO Equity?

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Table 1: Comparison of CDO Equity to Other AlternativeInvestments

1. Source: The Benefits of Hedge Funds: 2004 Update, Isenberg School ofManagement. Exhibit 5, Page 6.

2. In the early years.

Principal-protected CDO Equity has also become a popular choice among

investors, especially for those constrained to investing in rated products.

Principal-protected CDO Equity is typically created by combining CDO

Equity with a Treasury Principal-Only strip. The amount invested in the

combined security is protected by the future payment on the Treasury strip,

and investors are assured of getting full repayment of principal if they hold

the security to maturity. The capital guarantee provided by the Treasury strip

gives the combination security a triple-A rating on the principal portion of

Medium - portfolio disclosed,

discussions with management rare

Generally limitedHigh - portfolio disclosure

monthly, typically have direct access

to management

Transparency

LimitedQuarterly or annual may have

longer lock-up

LimitedLiquidity

Yes, equity investments in highly

leveraged companies

Yes, short term with margin callsYes, term financing with no margin

callsUse of Leverage

Execution of operating strategy,

financing available, investment

valuation and terminal liquidity

VariesDefaults and related lossPrimary Risks

Low to mediumHighly variable by timing and styleMedium to HighAsset Diversification

5 to 15 yearsVaries4 to 5 yearsDuration of Cash

Returns

Generally deferred, back end

loaded

Generally at managers discretionFront end and Intermediate end

loadedCash Flow ReturnProfile

17% to 20% IRR, low current

yield

8% to 12% IRR, lower current yield13 to 16% IRR

20% + current yield2

Targeted Returns

Capital growthVaries, usually capital growth with

income secondary

Primary: Income

Secondary: Capital GrowthInvestment Goals

Equity and convertible debt of

private companies

Event Driven, Global Macro,

Equity Hedge, Merger/Risk

Arbitrage, Distressed, etc.

Public and private bonds and loans,

secured and unsecuredInvestments

Private Equity FundsHedge Fund Composite

Strate ies1

CDO Equity


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Conclusion

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the package. Other types of combination notes have also become popular for

investors with a higher appetite for risk. Recent examples include notes cre-

ated by combining CDO Equity with double-B or single-A rated tranchesfrom the same transaction.

ConclusionCDOs have emerged as the dominant buy-and-hold investor in most fixed-

income credit markets. By removing variability in margin requirements and

the cost of financing, they have allowed levered credit investors to focus on

the most important task at hand: assembling a pool of credits with the great-

est probability of generating adequate cash flow to pay off the rated debt andreturning an acceptable return on equity. The long-term, non-recourse

financing allows an intrinsically longer term view on credit to be matched up

with an appropriate and stable capital structure. In addition, managed CDOs

have led to the globalization of leveraged credit investing strategies through

the delegation of the security selection and monitoring function. In our view,

these two crucial features of managed, cash flow CDOs bode well for the

continued viability of this sector.


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