Collateralized Debt Obligations

Since the publication of the first edition of Collateralized Debt Obligations, the CDO market has seen tremendous growth. In fact, as of 2005, $1. 1 trillion of CDOs were outstanding-making them the fastest-growing investment vehicle of the last decade.

To help you keep up with the expanding CDO market and its various instruments, Douglas Lucas, Laurie Goodman, and Frank Fabozzi have collaborated to bring you a fully revised and up-to-date Second Edition of Collateralized Debt Obligations. Written in a clear and accessible style, this book is a valuable guide that provides you with critical information regarding the evolving nature of the CDO market.

Filled with in-depth insights gleaned from years of investment and credit experience, Collateralized Debt Obligations, Second Edition examines a wide range of issues, including:
* Cash CDOs
* Loans and CLOs
* Structured finance CDOs and collateral review
* Emerging market and market value CDOs
* Synthetic CDOs

CDOs offer exciting opportunities for those who understand their complexities. With Collateralized Debt Obligations, Second Edition as your guide, you can begin to understand and take advantage of this dynamic market and its products.

Preface xiii
About the Authors xxi
Part One Introduction to Cash CDOs 1
Chapter 1 Cash CDO Basics 3
Why Study CDOs? 3
Understanding CDOs 4
Credit Structures 10
A CDO Structural Matrix 13
CDOs Being Offered Today 14
Parties to a CDO 14
Chapter 2 Cash Flow CDOs 17
Distribution of Cash Flows 17
Restrictions on Management: Safety Nets 20
Credit Ratings 23
Call Provisions in CDO Transactions 38
Part Two Loans and CLOs 41
Chapter 3 High-Yield Loans: Structure and Performance 43
The Loan Market 44
The Syndication Process 46
Loan Structure and Leaders 48
Loan Interest Rates and Upfront Fees 49
Loan Credit Quality 51
Lender's Liability 52
Overview of Loan Terms 53
Loan Terms versus Bond Terms 58
A Tale of Two Loans 58
The Secondary Market 60
Loan Recovery Rates 61
Loan Default Rates 63
High-Yield Loan CLO versus High-Yield Bond CBO Performance 67
Conclusion 74
Chapter 4 European Bank Loans and Middle Market Loans 75
European Bank Loans 75
Middle Market Loans 91
Conclusion 99
Part Three Structured Finance CDOs and Collateral Review 101
Chapter 5 Review of Structured Finance Collateral: Mortgage-Related Products 103
Residential Mortgage-Backed Securities 103
Commercial Mortgage-Backed Securities 125
Real Estate Investment Trust Debt 129
Chapter 6 Review of Structured Finance Collateral: Nonmortgage ABS 135
Credit Card Receivable-Backed Securities 135
Auto Loan-Backed Securities 137
Student Loan-Backed Securities 139
SBA Loan-Backed Securities 141
Aircraft Lease-Backed Securities 142
Franchise Loan-Backed Securities 145
Rate Reduction Bonds 148
Chapter 7 Structured Finance Default and Recovery Rates 153
Structured Finance versus Corporate Default Rates 154
S&P Rating Transition Studies and the Matrix Multiplying Approach 156
Results of Multiplying S&P Rating Transition Matrices 158
S&P on Structured Finance Loss Given Default 159
S&P Constant Annual Default and Recoveries 159
Moody's Material Impairment Study 160
Comparing and Reconciling Structured Finance Default Rates 162
Moody's on Structured Finance Historical Loss Rates 164
Moody's Constant Annual Default and Recoveries 166
Blending S&P and Moody's Studies 167
Applying CDRs and Recoveries to SF CDOs 167
Conclusion 170
Chapter 8 Structured Finance Cash Flow CDOs 171
SF CDOs versus High-Yield CDOs 172
Rating Agencies on Structured Finance CDOs 174
Structured Finance Assets' Negative Convexity 182
Extension Risk 183
Conclusion 185
Part Four Other Types of Cash CDOs 187
Chapter 9 Emerging Market CDOs 189
EM Sovereign Bond Defaults 190
Why the Better Track Record? 192
CDO Rating Differences: EM versus High Yield 193
Conclusion 198
Chapter 10 Market Value CDOs 201
Cash Flow versus Market Value Deals 201
The Rating Process 202
How Advance Rates are Derived 212
Conclusion 215
Part Five Synthetic CDOs 217
Chapter 11 Introduction to Credit Default Swaps and Synthetic CDOs 219
Credit Default Swaps 219
Synthetic CDOs 229
Conclusion 239
Chapter 12 Synthetic Balance Sheet CDOs 241
Cash CLOs for Balance Sheet Management 241
Partially Funded Synthetic CDOs 249
Conclusion 253
Chapter 13 Synthetic Arbitrage CDOs 255
Full Capital Structure Synthetic Arbitrage CDOs 256
Single-Tranche CDOs 260
Standard Tranches of CDS Indices 261
Conclusion 262
Chapter 14 A Framework for Evaluating Trades in the Credit Derivatives Market 265
Assessing Single-Name and CDO Tranched Exposures 266
Assessing CDO Equity versus a Basket Swap 274
Conclusion 280
Chapter 15 Structured Finance Credit Default Swaps and Synthetic CDOs 281
Differences between Corporate and Structured Finance Credit 282
Difficulties in SF CDS 284
SF CDS Effect on SF CDO Management 294
Two New Types of SF CDOs 295
Effects of SF CDS on CDO Credit Quality and Spreads 296
Conclusion 297
Part Six Default Correlation 299
Chapter 16 Default Correlation: The Basics 301
Default Correlation Defined 301
Default Probability and Default Correlation 305
Conclusion 321
Chapter 17 Empirical Default Correlations: Problems and Solutions 323
Empirical Results 323
Problems with Historical Default Correlations 327
Proposed Solutions 330
Conclusion 344
Part Seven CDO Equity 345
Chapter 18 Why Buy CDO Equity? 347
Nonrecourse Term Financing 347
The Forgiving Nature of CDO Financing 354
CDO Options 356
CDO Equity as a Defensive Strategy 359
Conclusion 360
Chapter 19 CDO Equity Returns and Return Correlation 361
Flawed Methodologies 362
The Appropriate Lesson from History 365
Loan Defaults and Recoveries 367
Cash Flow Modeling Defaults and Recoveries 370
Structured Finance Defaults and Recoveries 371
SF CDO Cash Flow Modeling 372
Return Correlation and Nonrecourse Leverage 374
Conclusion 378
Part Eight Other CDO Topics 379
Chapter 20 Analytical Challenges in Secondary CDO Market Trading 381
Important Developments: Spread Tightening, Increased Activity 382
Pitfalls in Secondary CDO Trading 384
Eight-Point Checklist in Evaluating a CDO in the Secondary Market 387
Prescription for Making Primary Issuances Conducive to Secondary Trading 408
Conclusion 409
Chapter 21 The CDO Arbitrage 411
Building Blocks 411
Impact of CDO Arbitrage on Structure 422
Conclusion 425
Chapter 22 How to Evaluate a CDO and Manage a CDO Portfolio 427
Incentive Clashes in CDO Structures 427
Evaluate Structural Enhancements 428
Evaluating the Manager's Track Record 429
Conclusion 434
Chapter 23 Quantifying Single-Name Risk Across CDOs 435
Collateral Overlap in U. S. CLOs 436
Favorite CLO Credits 437
Collateral Overlap in U. S. Structured Finance CDOs 439
Single-Name Risk and Tranche Protections 441
Excess Overcollateralization and Excess Overcollateralization Delta 443
Monte Carlo Simulation of Single Credit Risk 446
Comparing the Two Approaches 449
Conclusion 450
Chapter 24 CDO Rating Experience 453
CDO Rating Downgrade Data 454
CDO and Tranche Rating Downgrade Frequency 456
CDO Downgrade Patterns 458
Why Downgrade Patterns? 460
Downgrade Severity 462
Downgrades of Aaa CDO Tranches 464
Extreme Rating Downgrades 464
CDO Defaults and Near Defaults 469
Conclusion 473
Index 477