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Miguel Herschberg graduated from the London School of Economics (LSE) with a BSc. in Mathematics and Economics and a MSc. in Applicable Mathematics. He is currently at the University of Illinois at Urbana-Champaign (UIUC) specializing in Industrial Organization. He is passionate about... More
  • ABACUS 2007-ACI for dummies (part II) 0 comments
    May 10, 2010 11:50 AM | about stocks: GS, ACA, PLCC

    -          What is a CDS (credit default swap)?

    A CDS works like an insurance policy that covers the default risk. It is a contract between two parties in which one buys credit protection from the other. For example party X might purchase protection from party Y covering the credit risk of some Corporation Z. Here X is the protection buyer, Y is the protection seller and Corporation Z is called the reference entity. X agrees to pay Y a periodic fee during the term of the contract unless and until a credit event (i.e. a bankruptcy or default) occurs. So if a credit event occurs, Y has to pay X the amount specified in the contract. Generally a CDS has a “notional amount” which defines the maximum dollar level of exposure under the contract.

    Furthermore, unless Y has a very high credit rating, X generally will require Y to post collateral as a security for its obligation to pay if a credit event occurs. (This is taken from Nomura Fixed Income Research – CDOs in Plain English). In the synthetic CDO that we are analyzing the CDS were protection against the default in “some” RMBS which are residential mortgages backed securities.

    -          A brief note on the equity class:

    There are essentially two way of investing in a CDO: (i) buying the bonds it issues or (ii) investing in the CDO Equity. Bond holders receive their payment in the form of interest like in any normal bond. CDO Equity holders generally receive the excess cash flow produced by the CDO which remain after paying the CDO liabilities (i.e. the bonds). Equity investors may also receive current income in the forms of distributions (i.e. like a dividend basically). If the portfolio of the CDO is static (that means if the portfolio selection agent cannot sell or buy any of the securities in the underlying portfolio), then it doesn’t make any sense to speak about “distributions”.

    -          A brief note on the “super senior” tranche:

    A full description of this tranche will require a long article and its very hard to understand. A brilliant exposition is given in Felix Salmon and Janet Tavakoli blogs. Janet argues that there is no market definition of superior senior risk. There is also no standard means of pricing super senior risk and furthermore rating agencies don’t recognize the existence of a super senior tranche. Paradoxically, the super senior tranche makes up more than 80% of the synthetic CDO.

    The example that follows was taken and adapted from Felix Salmon’s blog.

    Suppose you have made 100 loans each one to 100 different companies and you want to free up some capital. The easiest way is to create a synthetic bond referencing those 100 loans and sell that. Essentially, the bank is taking the interest payment from the companies it has lent money to and use it to make insurance payments against those companies defaulting. If the companies default, the buyers of the synthetic bond end up sending money to the bank which will offset its loan losses. Thus, the bank has brought down its credit exposure to those companies even though it hasn’t sold the actual loans. Furthermore, its credit risk has come down, its capital requirements have come down too and therefore the bank has more free capital to use elsewhere.

    Suppose the bank structured the deal so that each of the companies is paying an identical amount of $1m each, every year. If the bank bundled up all those loans into a CDO (which technically speaking is a CLO in this case), then the CDO would be paying out $100m a year, unless the companies defaulted.

    Most likely than just sell the CDO, the bank will more likely split it up into tranches. This can be done because companies default but they don’t all at once. If the companies in question were all investment grade, you could be sure that at least 80 of them would still be making interest payments at any one time. So if you sell off the right to the first $80m of interest payments, the ratings agencies will rate it AAA. The lower classes are slip up and rated analogously.

    Tranches

    Amount

    Rating

    Class A

    $ 80

    AAA

    Class B

    $ 5

    AA

    Class C

    $ 5

    A

    Class D

    $ 5

    BBB

    Junk or Equity

    $ 5

    Unrated

    Total

    $100

     

    How do things change if the bank issues a synthetic bond rather than a cash CDO? Well, it can sell off the equity and the junk and the A and the AA tranche, thereby protecting itself if interest payments fall by $20 million. The reason is that the bank is very confident that the $80m will be paid. The rest is uncertain. So if they sold “the rest”, they are protecting themselves in the case that “the rest” is left unpaid. 

    It can then sell off a bit of the triple-A tranche, protecting itself if payments fall by $25 million. Now remember that the first $80 million of payments are rock-solid, risk-free: that's why they carry triple-A ratings. So the bank's remaining risk, after selling off that triple-A-rated synthetic tranche, has been brought down to safer-than-triple-A levels.

    Thus the idea is that the $75 remaining is safer than AAA. So the banks made it into a different tranche and named it “super senior”. Hence our CDO would look like:

    Tranches

    Amount

    Rating

    Super Senior

    $75

    N/A

    Class A

    $ 5

    AAA

    Class B

    $ 5

    AA

    Class C

    $ 5

    A

    Class D

    $ 5

    BBB

    Junk or Equity

    $ 5

    Unrated

    Total

    $100

     

     

    Now that we understood the idea of a super senior tranche, we need to make the distinction between a funded and an unfunded senior class. In the example above, the super senior tranche is funded. Below we present the case of a CDO with an unfunded class. The example was adapted from Nomura’s paper.

    An unfunded class is like a CDS that references the whole underlying portfolio of the synthetic CDO. An investor that purchases an unfunded class does not pay a purchase price. Rather, the investor receives payments as a protection seller and must pay the CDO issuer (as the protection buyer) if the underlying portfolio suffers losses above a specified level. The holder of the super senior class makes no principal investment but receives payments for assuming the risk that losses on the underlying portfolio exceed the super senior (unfunded) attachment levels.

    In our case, from the ABACUS 2007-ACI flipbook we see that:

    Class

    Amount

    Rating

    Attachment and Detachment Levels

    Super Senior (unfunded)

    $1,100,000,000   ($1.1Bn)

     

    45% – 100%

    Class A

    $480,000,000

    AAA

    21% – 45%

    Class B

    $60,000,000

    AA

    18% – 21%

    Class C

    $100,000,000

    AA-

    13% – 18%

    Class D

    $60,000,000

    A

    10% – 13%

     First Loss (equity)

    $200,000,000

     

    0% – 13%

    TOTAL

    $2Bn

     

     

     

    Note that this is an illustration only! The final deal ends up being quite different. There are no Class C, Class D and First Loss (equity). The only bonds sold were those purchased by IKB and ACA. It is also unclear if the super senior tranche was funded or not.

    So in the example above, the super senior class is unfounded which means that the holder of the super senior tranche would be required to pay the CDO issuer the amount of losses above 45% of $2Bn (=$900m). If they do, the holder of the super senior tranche would be required to pay the CDO issuer the amount of losses above that level.

    Apart from the super senior tranche, the other tranches of the synthetic CDO are funded. That is, the holders of those tranches invest the principal amount of their tranches. They receive interest payments to compensate them both for the risk that they take and for the time value of their invested principal.

    In our case:  ABACUS 2007-AC1 is a static synthetic CDO. It seems that the super senior tranche is unfunded and that it did not have an equity class.



    Disclosure: No positions

    Disclosure: No positions.
    Stocks: GS, ACA, PLCC
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