Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

ABACUS 2007-ACI for dummies (part I)

|Includes: ACA-OLD, The Goldman Sachs Group, Inc. (GS), PLCC

It’s now been over two weeks since the SEC released its complaint against Goldman Sachs and Fabrice Tourre. In this series of articles, I will try to explain in very simple words its structure.

-           What is the ABACUS 2007-ACI synthetic CDO?

The definition provided in the flipbook is: ABACUS 2007-AC1 is a $2bn notional synthetic CDO referencing a portfolio consisting of RMBS obligations.

-          Main definitions and characteristics of a CDO:

Think of a CDO like a firm –like Microsoft for example –. Microsoft raises money by issuing equity (i.e. stocks) or by issuing debt. A CDO works exactly the same way. To pay its debt, the CDO buys securities (in our case residential mortgages backed securities (NASDAQ:RMBS)) and obviously it doesn’t produce software! Suppose our CDO has bought 100 RMBS. Every month, 100 people will pay their mortgages. Every month the CDO will receive payments out of the interest and principal on the underlying mortgages.  This cash flow is then used to pay out the bonds issued and if the extra cash flow is distributed among the equity investors.

Up to now, a CDO still doesn’t make sense. Why would you consider investing in this fairly complicated product when you could easily buy the mortgages directly? The factors that made the pooling of securities very attractive to investors are a subject of current research.  However, we may distinguish two main factors.

On the one hand, CDO helped many investment banks to free up their balance sheets.  By shifting loans, RMBS and other fixed income backed securities to off balance sheet vehicles (such as CDOs), investment banks could remove liabilities from their books and decrease the capital charges imposed by Basel II and thereby free up more cash to make new loans. Technically, this enabled the banks to lend more money than what they were legally supposed to, and furthermore, it enabled them to hide potentially dangerous assets from the eyes of the regulators.

On the other hand, CDOs were created because they involved the re-allocation of risk. At the beginning, there were 100 houses which were securitized into 100 RMBS. Let us further assume that there was a significant risk that these mortgages weren’t paid and therefore they had a very bad rating (say CCC+).  It is clear that the 100 RMBS could only be bought by at most 100 bankers. This means that at most 100 bankers can carry the risk of the mortgages defaulting. Suppose instead that the 100 RMBS are held in a CDO which issues say 1 million bonds. As the principal and interest rate payments are distributed among the 1m investors, now those 1m investors share the risk of the mortgaging defaulting.

Now assume that the CDO issues 1m in “different tranches”: tranche A, tranche B and tranche C. They are constructed in such a way that: Tranche A’s bonds are very likely to be paid back, Tranche B is likely to be paid back and so on.  So Tranche A’s bonds are rated AAA, Tranche B’s bonds are AA and so on.  Formally, by tranching the bond issue we can create securities with different risk profiles (i.e. ratings). This is essential for institutional investors because many of them can purchase only investment-grade securities (those rated BBB- or higher). CDO’s allowed institutional investors to invest in assets that they on their own would have been too risky and for this reason they were not allowed by the regulatory bodies.

To me, this looks like alchemy: turning CCC+ crap into nice very safe AAA.  This is the magic of risk diversification. You can choose some percentage of the securities your CDO holds as collateral so that you are sure that the bonds in Tranche A will be paid. If the bonds in Tranche A are very likely to be paid, they deserve a AAA rating regardless of the collateral’s initial rating. Furthermore, the banks can obviously charge more for AAA than CCC+ bonds. A great business!

Formally, a CDO is “an arrangement that raises money primarily by issuing bonds and then invests the proceeds in a portfolio of bonds, loans and similar assets”.  A CDO consists of a Special Purpose Entity or also called Special Purpose Vehicle (SPV) – think of it as a fictitious company because CDO –   which holds a portfolio of underlying assets –called the collateral – and issues bonds in different tranches or classes.

The most senior tranches (think of them as the best bonds in the issue) are paid first, then the junior tranches and finally (if there is anything left), it is distributed among the equity investors. On top of the senior notes, CDO’s may also issue another tranche called “super senior”.

-          So what is a synthetic CDO?

The structure of a synthetic CDO is identical to the one of a CDO. The difference is in the collateral. In the synthetic case, the underlying portfolio is composed of Credit Default Swaps. The main risk that the CDO takes is through its portfolio of CDS. Thus the synthetic CDO receives periodic fees as a protection seller. These periodic feeds provide the cash flow to pay the bonds issued by the Special Purpose Vehicle.

Synthetic CDO in a way “mimic” the cash flow that the RMBS generate. The CDO’s SPV acts as a protection seller and receives monthly payments (which “simulate” the monthly interest rate payments that the RMBS generate) from the protection buyer.

The synthetic CDO also issues bonds in different tranches. As Fitch’s article explains:

“There is a priority scheme for the tranches to absorb pool losses. An investor starts to suffer losses on a tranche when losses in the portfolio breach an attachment point, which is typically expressed as a percentage of the total pool notional. Losses stop being allocated to a tranche when portfolio losses are greater than the detachment point, which is also typically expressed as a percentage of the portfolio notional.

Disclosure: No positions.

Disclosure: No positions.