Lb - Abs Cdo Primer

ABS CDOs – A Primer November 17, 2006 ABS CDO STRATEGY

Michael Koss 212-526-8312 [email protected] Dan Mingelgrin 212-526-7764 [email protected] CASH CDO STRATEGY

Claude A. Laberge 212-526-5450 [email protected] Lorraine Fan 212-526-1929 [email protected] STRUCTURED CREDIT STRATEGY

Ashish Shah 212-526-9360 [email protected]

OVERVIEW The ABS Collateralized Debt Obligation (CDO) market came into being in late 1999 and has grown exponentially since then. Issuance in 2006 will exceed $150 billion, doubling issuance in 2005, bringing total outstanding to more than $300 billion. We expect issuance to continue to grow briskly, as new assets get securitized and the synthetic ABS market expands over time. Almost by definition, ABS CDOs are complex, adding structural complexity to underlying assets that are often themselves quite complex. As with any securitized sector, a better understanding of structure, collateral, and risks can help uncover value in the market. Our primer is designed to help investors increase their understanding of these facets of ABS CDOs; in addition, we present a brief history of the ABS CDO market and discuss current trends therein. We focus in particular detail on the risk factors and valuation considerations that investors face today. This report covers the following major areas: •

What is an ABS CDO?

•

Role of the Collateral Manager

•

A Brief History of the ABS CDO Market

•

Collateral Performance

•

Structure Features

•

Valuation Considerations

•

Risk Factors

Gaurav Tejwani 212-526-4484 [email protected] Bradley Rogoff 212-526-7705 [email protected] Vikas Chelluka 212-526-3364 [email protected] Ashish Keyal 44-20-710-29037 [email protected]

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 27

Lehman Brothers | ABS CDOs – A Primer

Table of Contents

November 17, 2006

What Is an ABS CDO?

3

Characteristics of CDOs

3

The Importance of CDOs

5

CDO Economics 101

5

Role of the Collateral Manager

8

Portfolio Selection

8

Eligibility Criteria

8

Surveillance

8

A Brief History of the ABS CDO Market

9

Issuance Trends

9

Diversified versus Real Estate Era

10

Spread History

11

Collateral Performance

11

Rating Transitions

11

Upgrade/Downgrade Statistics

12

Structural Features

13

Credit Enhancement

13

Coverage Tests

14

Priority of Payments

15

Optional Redemption and Auction Calls

16

Additional Features

17

Valuation Considerations

20

Rating Agency and Market Pricing and Stress Assumptions

20

An ABS Loan-Level Approach to Losses and Prepayments

20

Risk Factors

22

Credit

22

Basis Risk on Fixed-Rate Security Hedges

23

Available Funds Cap Risk (AFC)

23

Call Risk/Extension Risk

23

Conclusion

24

Glossary

25

2


What is an ABS CDO? A collateralized debt obligation (CDO) is a bankrupcy remote special-purpose entity that purchases a pool of securities and funds the purchase of those securities by issuing debt liabilities collateralized by the underlying securities. The use of CDOs as a technology, rather than an asset class, increases the universe of assets that may be purchased for a CDO. Thus far, these asset classes include, but have not been limited to, leverage loans, high grade credit, high yield credit, and ABS. In this report, we focus specifically on the ABS CDO market, which now comprises about 65% of global CDO issuance.

Characteristics of CDOs

Before getting into the finer details of CDOs, some general understanding of CDO characteristics and definitions will be necessary (also see Glossary). •

•

•

•

•

Collateral Ratings: The ABS CDO market may be divided into two general categories, high grade and mezzanine. The assets in a high grade transaction tend to have a single-A rating or higher, whereas assets in a mezzanine transaction tend to be predominantly triple-B rated. The average high grade transactions issued in 20032005 had 34% AAA, 39% AA, and 23% A exposure (Figure 1). 1 While mezzanine transactions are composed of predominantly BBB (65%) assets, they also have diversification of ratings in AAA (3%), AA (5%), A (19%), and BB (7%) assets. On average, high grade and mezzanine transactions have a weighted average rating factor (WARF) of 49 (Aa3/A1) and 413 (Baa2/Baa3), respectively (see Glossary for more on WARF). Collateral Types: The breakdown of collateral types in 2003-2005 transactions is heavily weighted to real estate through the purchase of HEL, RMBS, CMBS, and CDOs. Digging deeper into HG and mezzanine collateral highlights some differences (Figure 2). High grade transactions have less HEL exposure than mezzanine transactions (52% vs. 60%), but have higher CDO 2 exposure (18% vs. 7%) (see our report on “ABS CDO exposure to CDOs of ABS” in the ABS Strategy Weekly, August 25, 2006). RMBS exposure is similar to mezzanine exposure. Floating-rate and Fixed-rate Collateral: ABS CDOs purchase floating-rate and fixed-rate securities for the portfolio. Since the CDO liabilities tend to be floatingrate, the purchase of fixed-rate securities as collateral tends to be limited in order to minimize basis risk. The fixed-rate concentration typically ranges from 0% to 30%. Currently, ABS CDOs attempt to mitigate the cash flow sensitivity to interest rate movements by purchasing amortizing swaps and caps, and in some circumstances allowing for future reinvestment in fixed-rate collateral (see our report on “ FixedRate Collateral Risk in HG ABS CDOs” in the ABS Strategy Weekly , June 2, 2006). Diversification: CDOs purchase collateral diversified by issuer, collateral type, and rating. The level of diversification is one of the drivers of rating agency models when determining the ratings of the debt liabilities. Managed and static: CDOs have the ability to buy and sell securities after the closing date. Managed transactions are permitted to buy or sell assets and reinvest principal payments from the assets. The collateral manager may buy and sell assets

1

This is an average of about 100 transactions. We assume that a portfolio with a BBB+ average rating or lower is mezzanine (WARF of 260 or higher), and A- and higher is high grade. 2 Includes ABS CDOs, CLOs, HY CBOs, etc.

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during the reinvestment period, which is typically the first three to five years of the transaction’s life. In a static transaction, asset sales/purchases are typically not permitted after the initial portfolio selection has occurred. The transaction’s portfolio advisor performs the initial portfolio selection and any ongoing monitoring that must be done. Some static transactions will allow the portfolio advisor discretionary sales of assets that have appreciated or depreciated in value. “Lightly managed” or “substitution” transactions permit some trading flexibility, but less than a typical managed transaction. Going forward, we will use the term “collateral manager” when referring to the manager or portfolio advisor of a managed and static transaction, respectively. •

Cash versus Hybrid/Synthetic: Cash CDOs have assets that are fully funded cash securities and pay a bond coupon (fixed or floating). Hybrid CDOs have a portion of the assets in cash form and the remaining portion in synthetic form (which pays a fixed premium). The synthetic portion is typically in the form of a credit default swap or total return swap. In both cash and hybrid/synthetic transactions, mark-tomarket volatility of the underlying instrument does not directly impact the transaction. On the other hand, market-value CDOs, another structure used in the marketplace, may be affected by mark-to-market volatility if certain market value triggers are breached. Although this is an important subset of the market, we will be focusing mainly on static and managed cash/hybrid transactions without the market value features throughout this primer.

Figure 1. ABS CDO Rating Composition

Figure 2. ABS CDO Collateral Composition

100% Rating

High Grade

Mezzanine

AAA

34%

3%

AA

39

5

A

23

19

BBB

3

65

BB

0

7

WARF

49 (Aa3/A1)

413 (Baa2/Baa3)

80% 60% 40% 20% 0% High Grade HEL

Source: Lehman Brothers, Intex data. 2003-2005 transactions.

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Mezzanine CDO

RMBS

Other

Source: Lehman Brothers, Intex data. 2003-2005 transactions.

4


The Importance of CDOs

CDOs serve a variety of functions within the capital markets. We describe a few of the more important functions: •

•

•

•

•

Easy access to a portfolio of assets: CDOs provide investors the ability to gain exposure to a portfolio of assets without doing all the heavy lifting that typically accompanies that task. For instance, an investor does not have to go through the process and large expenditure of building infrastructure to monitor performance, sourcing the bonds on their own, or having specific in-house expertise for each collateral type. Leveraged return on investment: In the traditional sense, CDOs were originally conceived to provide an investor a leverage return on a portfolio of assets. Through the purchase of equity in a transaction, the equity investor can gain leveraged exposure to 100% of the assets, while only dedicating 1%-6% of the capital. Assets under management: For traditional money managers, insurance companies, and hedge funds, being the manager of a CDO provides relatively stable fee income on a pool of assets which are effectively “closed-end” funds for anywhere from three to eight years. Term Financing: Some issuers, particularly hedge funds, issue CDOs to term fund their assets rather than rely on the repo market for ongoing financing. This allows the issuer to lock in a financing rate for the term of the CDO rather than run the risk of monthly changes in their repo rates and margin calls. Arbitrage Vehicles: We will discuss this in more detail in the next section, but a CDO may also be thought of as an arbitrage vehicle. CDOs will typically be issued when the average spread of the assets less the average cost of liabilities is high enough to produce an attractive return to the equityholder.

CDO Economics 101

So how is the CDO able to purchase assets and make payments to liabilities and manager fees and still have money left to pay the equityholders? Or more simply put, how is there an arbitrage in the first place and all investing parties are still satisfied? Let us first use a simplified example of the economics behind the CDO arbitrage and then look at the factors that drive it. We begin with a typical example of a managed mezzanine ABS CDO capital structure diagram (Figures 3). We will come back to this example throughout the primer. The CDO contains $1 billion in ABS assets and has issued CDO liabilities in the form of a class A (AAA-rated), class B (AA-rated), class C (A-rated), class D (BBB-rated), and equity 3. The assets are assumed to generate an average interest payment of L+180 bp. Figure 3 provides additional information regarding the class sizes and their stated coupon.

3

We chose not to further tranche the class A in this example for now, but it is important to note that the class A may be split into “super-senior” and “mezzanine” AAA-rated securities, where the super-senior is senior in the waterfall to the mezzanine AAA to the extent losses are above the class A level. In other words, if losses were to reach the class A level, the mezzanine AAA tranche would suffer 100% loss before the super-senior tranche experienced its first dollar of loss. In some high grade transactions, the super-senior is funded through the commercial paper (CP) market rather than through the term market. The CP is rolled on a periodic basis (1-6 months) and may experience liability spread tightening or widening over the life of the transaction.

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To estimate the CDO arbitrage, we calculate the gross excess spread as the difference between the average asset spread and the average liability spread. For example, Figure 4 looks at a simplistic CDO arbitrage calculation where the gross excess spread of 131 bp comes from subtracting the average liability spread of 49 bp from the average asset spread of 180 bp. Further subtracting transaction fees such as manager fees (25 bp) and administrative costs (trustee and rating agency fees; 2 bp) from the gross excess spread leaves us with the net excess spread (104 bp), or CDO arbitrage. We approximate the equity internal rate of return (IRR) by multiplying the net excess spread (104 bp) by the equity leverage (20x) and get a gross 20.8% IRR to the equity 4.

Having reviewed the economics behind the CDO arbitrage, we can look at why the arbitrage exists in the first place. •

•

•

Liability Spreads: The tighter pricing of liabilities relative to the spread on the collateral is a function of a number of factors. First, the ability to credit tranche the capital structure from AAA to equity classes allows for more efficient distribution of the underlying risk to investors with varying risk profiles. Second, as discussed earlier, CDO investors value the ability to easily source ABS portfolios without having to have the expertise or infrastructure to purchase and monitor securities. Third, investors value the collateral manager’s ability to manage the deal over time and/or their security selection expertise. Equity Returns: The equity hurdle rate, or the minimum equity return required by investors to participate in a transaction, helps determine what the CDO arbitrage level must be at any given point in time. An investor’s hurdle rate will depend on the perceived risk, attractiveness of returns versus other benchmarks, and so on. It may also depend on the motivation behind issuing a CDO. For example, as discussed earlier, hedge funds using CDOs to lock in term financing might retain the equity and could be willing to retain it at IRRs that are lower than what might be acceptable to a different investor. Asset Spreads: As long as asset spreads are high enough to support the liability cost (plus other fees and costs) and meet equity hurdle rates, a transaction may be issued. When CDOs are the marginal buyers of the specific assets (as is often the case with BBB HELs, for example), the asset spreads will adjust to ensure the arbitrage is high enough (see our report, “ABS CDO Demand: Outlook and Implications for HELs” of July 21, 2006). However, when CDOs are not the marginal buyer of the specific asset, the asset may or may not be desirable for the transaction and will heavily depend on the overall spread of the asset and whether it meets CDO investor and rating agency constraints. For example, CDOs might purchase BBB CMBS securities at tighter spreads than BBB HELs even though doing so reduces the average asset spread of the transaction. It might still make sense to purchase the security if it provides more diversification and less correlation within rating agency models (makes the capital structure more efficient) and/or investors are willing to buy CDO liabilities at tighter spread levels (for greater diversification, for example).

4

Note: this is a simplification of the equity IRR calculation. In practice, we would need to consider the changes in liability costs over time and deleveraging of the equity. Additionally, this assumes no losses and does not account for upfront underwriting fees and hedging fees.

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Figure 3.

Typical Mezzanine ABS CDO Capital Structure

ABS CDO Assets

ABS CDO Liabilities

ABS Assets

Class A (80%) AAA 3L+32 bp Ongoing P&I

$1,000,000,000 Average Coupon of Assets L+180 bp

Issuance Proceeds

Class B (8%) AA 3L+55 bp Class C (2%) A 3L+135 bp Class D (5%) BBB 3L+325 bp Equity (5%)

Source: Lehman Brothers

Figure 4.

Simple CDO Arbitrage Calculation

Average Asset Spread (bp)

180

Average Cost of Liabilities (bp)

49

Gross Excess Spread (bp)

131

Collateral manager Fees (bp)

25

Trustee, Admin, Rating Agency Fees (bp)

2

CDO Arbitrage (Net Excess Spread) (bp)

104

Equity Leverage (=100%/5%)

20

Approximate Gross Equity IRR (%) (=1.04%*20)

20.8


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Role of the Collateral Manager The collateral manager has a number of roles. To name just a few, the collateral manager selects the credits in the portfolio, manages to certain eligibility criteria, and conducts ongoing surveillance of the transaction. Portfolio Selection

The collateral manager is first and foremost responsible for selecting the initial portfolio of assets. Historically, the “ramp” period for selecting and purchasing assets for a CDO ranged from eight to 12 months. With the advent of single-name CDS, the ramp period has been dramatically shortened for synthetic/hybrid mezzanine transactions, as the majority of the portfolio may be purchased in a matter of weeks. High grade transactions still have extended ramp periods because there is limited availability of single-name CDS referencing HG bonds. As a result, HG managers are constrained to purchasing assets through the new-issue and secondary cash markets. The initial portfolio selection is perhaps the most important job of the collateral manager. Avoiding securities from the outset that have a high likelihood of being downgraded or incurring losses can help avoid discount sales of assets in the future. Future sales of discounted assets can have ramifications for the equityholders and could also reduce overcollateralization and interest coverage levels, thereby increasing the likelihood of trigger failures (see sections on credit enhancement and coverage tests below). Eligibility Criteria

Managed transactions have security eligibility criteria which must be met during the initial selection of the portfolio and when managing the portfolio during the reinvestment period. The eligibility criteria are typically established in order to provide some boundaries for the manager in terms of what they can and cannot purchase. The criteria incorporate maximum and minimum composition requirements pertaining, but not limited, to: •

Rating of securities

•

Fixed-rate securities

•

Specified types of securities (e.g., RMBS, CMBS, equipment lease)

•

Average life of securities

•

Weighted average life of the portfolio

•

PIKable securities, and more

In general, the purchase or sale of assets during the reinvestment period may be permitted as long as the eligibility criteria are satisfied, or if the criteria are not satisfied, to the extent the criteria are “maintained or improved.” Surveillance

An important role of the collateral manager is to provide ongoing surveillance for the life of the transaction. This may incorporate surveillance of the underlying securities as well as overall transaction performance. To the extent managers are able to spot assets that are underperforming and may be susceptible to future downgrades and writedowns, replacing them within the transaction might be warranted. Of course, the earlier a manager can catch underperformance, the better off the trust will be when selling the asset, making strong surveillance an important aspect of managing transactions.

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8


A Brief History of the ABS CDO Market Issuance Trends

The ABS CDO market came into being in late 1999 and has experienced exponential growth since. Today, we estimate the total ABS CDO amounts outstanding to be more than $300 billion. Initially, the ABS CDO market comprised mostly mezzanine transactions (Figure 5). From 2000 to 2003, only $4.5 billion of high grade transactions priced, compared to about $25 billion mezzanine transactions. However, in 2004, issuance of high grade transactions surpassed mezzanine transaction issuance, a trend that continues today.

The growth in ABS CDO issuance may be attributed to a number of factors: Underlying ABS market growth: As the underlying ABS markets have grown, especially the subprime mortgage market, CDO vehicles have had more than enough assets to choose from.

•

Low default history: Given the low number of bond defaults experienced in the ABS markets, investors have sought to increase their ABS exposure through CDOs.

•

Synthetics market: The growth of the single-name CDS market for subprime and CDOs provided additional supply, helping to fuel issuance of mezzanine transactions.

•

Growing investor base: The growth in investor sponsorship for the asset class across the capital structure has created more demand for CDO securities and equity.

•

Search for yield: As spreads across a variety of asset classes have compressed in recent years, investors looking for incremental spread have turned to the ABS CDO market.

•

Increase in secondary market liquidity: Liquidity within the secondary market has increased in recent years as more dealers became active, providing increased comfort to investors.

•

Figure 5.

ABS CDO Issuance

$bln 80 60 40 20 0 2000

2001

2002

2003

2004

2005

2006 YTD

Issuance Y ear High Grade

Mezzanine

Source: Lehman Brothers. Through 9/30/06.

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9


Diversified versus Real Estate Era

When ABS CDOs were first issued in 1999, transactions were diversified across a number of securitized sectors, spanning from credit cards and home equity loans to aircraft-leasing securitizations (Figure 6). The average transaction pre-2003 had 37% HEL, 24% CDO5, 10% CMBS, and 29% “other” exposures (Figure 7a). After a tumultuous period in late 2002 and early 2003, when the ABS CDO market endured distress in sectors to which it was heavily exposed, including manufactured housing, aircraft, and franchise loans, the CDO market emerged with an entirely different look and purpose. Rather than staying diversified across sectors, issuers gravitated toward real estate (e.g., subprime, resi-A, and CMBS) sectors. In stark contrast to pre-2003, the average transaction in 2003-2005 had 55% HEL, 19% RMBS, 14% CDO, 5% CMBS, and only 7% “other” exposures (Figures 7b). Figure 6.

ABS CDO Timeline

Diversified Era

Aircraft ABS incurs significant downgrades and losses following 9/11

First ABS CDO issued in late-1999

2000

Real-Estate Era

2001

Multitude of downgrades in manufactured housing (e.g. Conseco Finance, Oakwood, etc.)

2002

ABS CDO market recovers after severe downgrades in underlying sectors, emerges with more residential mortgage concentration

2003

Single-Name CDS is standardized in late-2005

High Grade CDO market begins its exponential growth

2004

2005

"Hybrid" CDOs become the norm in mezzanine

2006

2007


Figure 7a. Diversified Era (2000-2002)

Figure 7b. Real Estate Era (2003-2005)

Other CMBS 7% 5%

Other 29%

HEL 37%

CDO 14% HEL 55%

CMBS 10%

RMBS 0%

CDO 24%

Source: Lehman Brothers, Intex data

Source: Lehman Brothers, Intex data

5

November 17, 2006

RMBS 19%

Includes ABS CDOs, CLOs, HY CBOs, etc.

10


Spread History

Following the market disruption in late 2002, increased sponsorship by investors for ABS CDOs led to spread tightening across the capital structure (Figure 8). Still, the ABS CDO sector has traditionally offered wider spreads compared to other spread sectors such as subprime, RMBS, CMBS, and CLOs (Figure 9). This is partly due to the complex nature of the structures and collateral, less transparency in prices of the underlying securities, less liquidity in the secondary market, and greater leverage to weakening credit.

Collateral Performance Rating Transitions

As an overall asset class, structured finance (inclusive of ABS, CMBS, RMBS, and CDOs) has been a steady outperformer compared to corporates (when measured by rating stability). Specifically, global structured finance AAA-, AA-, and A-rated securities have experienced lower downgrade ratios than similarly rated global corporates (Figure 10). Triple-B structured finance securities, on the other hand, have experienced slightly higher downgrades than corporates (6.2% vs. 6.1%).

Figure 8.

ABS CDO Spread History

bp

bp

160

400

120

300

80

200

40

100

0 Jun-00

0 Jun-01

Jun-02 AAA

Jun-03 AA

Jun-04 A (RHS)

Jun-05

Jun-06

BBB (RHS)

Source: Lehman Brothers. Data averages high grade and mezzanine spreads.

Figure 9.

Floating-Rate Spread Comparison, bp

Rating

ABS CDOs

HEL

RMBS

CMBS

CLO

A

140

42

40

36

72

BBB

325

110

100

80

150

Source: Lehman Brothers. As of 9/30/06.

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Upgrade/Downgrade Statistics

While overall structured finance rating stability has been strong, a closer look at subsectors found in more recent ABS CDOs may show mixed results (Figure 11). RMBS and CMBS experienced very strong upgrade/downgrade ratios throughout their history, while HELs and CDOs experienced more downgrades than upgrades. CDOs stand out as the worst performing sector by far, with an 11.8 downgrade/upgrade ratio since 1996. This is mostly owing to the poor performance of HY CBOs, which experienced significant downgrades up until 2005, as well as many ABS CDOs issued in 2000-2002.

Figure 10.

Average Annual Rating Transition Matrices

Original Rating

Aaa

Aa

A

Baa

Upgrade

Stable

Downgrade

Aaa – SF

98.7

0.9

0.2

0.1

0.0

98.7

1.3

Aaa – Corp

92.6

7.1

0.3

0.0

92.6

7.4

Aaa – Diff

6.1

-6.2

-0.1

0.1

0.0

6.1

-6.1

Aa – SF

4.9

91.6

2.4

0.7

4.9

91.6

3.5

Aa – Corp

0.9

91.2

7.6

0.2

0.9

91.2

7.9

Aa – Diff

4

0.4

-5.2

0.5

4.0

0.4

-4.4

A – SF

1

3.1

92.4

2.3

4.1

92.4

3.5

A – Corp

0.1

2.6

91.1

5.4

2.7

91.1

6.2

A – Diff

0.9

0.5

1.3

-3.1

1.4

1.3

-2.7

Baa – SF

0.4

0.5

2.4

90.5

3.3

90.5

6.2

Baa – Corp

0.1

0.3

5.2

88.3

5.6

88.3

6.1

Baa – Diff

0.3

0.2

-2.8

2.2

-2.3

2.2

0.1

Source: Moody’s. The 1-yr rating transitions for each of the years 1984-2004 are averaged to compute the numbers shown. The 1-yr rating transition records any transition from the current rating at the beginning of the year for all outstanding securities to the final rating at the end of the 1-yr period. Each year’s transition numbers are then weighted by the outstanding number of rated bonds at the beginning of the given year. Half of the total withdrawn ratings for the given year are subtracted from the outstanding number of rated bonds for weighting purposes.

Figure 11.

Upgrade/Downgrade Statistics by Asset Class

Sector

Category

2005

2004

1996-2005

HEL

Downgrade Rate

1.8%

2.0%

2.1%

Upgrade Rate

2.0%

1.5%

1.7%

0.9

1.4

1.3

Downgrade Rate

0.9%

0.1%

1.2%

Upgrade Rate

6.8%

8.8%

5.2%

0.1

0.0

0.2

Downgrade Rate

3.0%

5.6%

9.7%

Upgrade Rate

1.6%

0.6%

0.8%

1.9

9.0

11.8

Downgrade Rate

3.5%

5.7%

3.6%

Upgrade Rate

16.4%

8.8%

8.7%

0.2

0.7

0.4

Downgrade/Upgrade ratio RMBS

Downgrade/Upgrade ratio CDOs

Downgrade/Upgrade ratio CMBS

Downgrade/Upgrade ratio Source: Moody’s Investors Service

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Structural Features In this section, we discuss a number of structural features common to many ABS CDOs. •

•

•

•

•

Credit enhancement: The senior/subordinate capital structure, overcollateralization, and excess spread provide the majority of protection to the bondholders. Coverage tests: In traditional ABS CDO structures, additional protection may come from coverage tests. Passing or failing the overcollateralization coverage tests (OC) or interest coverage tests (IC) will affect how cash flows are allocated to the liabilityholders. Priority of Payments: A transaction has payment rules that determine how cash flow is allocated to liabilityholders. The priority of payments will typically be determined by the deal age, status of performance triggers, and how quickly the collateral balance factors down. Optional Redemption and Auction Calls: Transactions are issued with call features, allowing for the liquidation of the assets and return of principal to bondholders and equityholders. Additional Features: Structures will vary deal-to-deal. In addition, structural nuances such as a class D turbo of principal, the presence and timing of performance triggers (or lack thereof), and swaps and reserve accounts for synthetic hybrid transactions may also be present.

Credit Enhancement •

•

•

6

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Senior-subordinate capital structure: ABS CDOs are issued as senior/subordinate transactions, where subordination acts as the primary form of credit enhancement for bonds that are more senior in priority. In our earlier example of a mezzanine transaction, the class B, C, and D (each with a rating of AA, A, and BBB, respectively) provide protection from losses to the class A. The class C and D provide protection to the class B, and so on. The size of each class will vary from one transaction to the next, depending on such factors as the collateral composition, rating composition, and structure. (See Figure 12 for a typical high grade and mezzanine capital structure.) Overcollateralization: All the debt classes begin with a certain amount of overcollateralization from the outset of the transaction. This overcollateralization comes from having the first loss piece, or equity tranche, subordinate to the debt classes. For HG transactions, equity provides about 1% subordination to the class D 6 and about 5% for mezzanine transactions. If the class D turbo is present in a transaction, this is a feature that serves to increase overcollateralization over time. (In the “Additional Features” section, we will discuss the class D turbo in more detail.) Excess spread: The difference between the interest cash flow from the assets and the interest paid to the CDO liabilities (including ongoing fees in the transaction), known as excess spread, acts as a form of additional credit enhancement available to protect debt tranches from losses. In the absence of losses, excess spread flows through to the equityholder. To the extent losses are realized, the excess spread may be redirected to paying down liabilities or “building par” if performance triggers begin to fail (more on this in the performance trigger section). Prior to failing

BB-rated securities may also be issued, in which case the size of the equity would be lower.

13


triggers, however, excess spread will continue to flow to the equityholder and any losses are effectively absorbed by the equity. Certain managed and static transactions also have the ability to sell assets. In managed transactions, this may occur during the reinvestment period. In some static transactions, the collateral manager may be able to sell highly appreciated or discounted assets 7. While the ability to sell assets is not credit enhancement in the strictest sense, providing the manager with some flexibility to sell assets could benefit bondholders to the extent that a manager is able to identify assets that may have problems down the road and sell before the market fully prices in those risks. Figure 12.

Typical ABS CDO Capital Structure, % of transaction size High Grade

Mezzanine

AAA - Super Senior

80-85%

65-70%

AAA - Mezzanine

8-10%

10-15%

AA

2-3%

7-9%

A

1-2%

1-2%

BBB

1-2%

3-5%

1%

4-6%

Equity Source: Lehman Brothers

Coverage Tests

Prior to analyzing the coverage tests, priority of payments, and call provisions in transactions, we expand on our earlier mezzanine example with some additional assumptions in Figure 13. We assume a reinvestment period of four years, an optional redemption period between the fourth and eighth year, and an auction call beginning in year 8. We also provide details on the coverage tests and their required levels. Traditional ABS CDO transactions have two performance-related coverage tests: the overcollateralization (OC) and interest coverage (IC) tests. Unlike certain collateral composition tests (e.g., WARF, weighted average spread), these are traditionally the only tests that have direct consequences on how cash flow is allocated through the CDO waterfall. As discussed earlier, a typical transaction will have class A, class B, class C, and class D. Each class has a coverage test associated with it, with the exception of class A and B, which share the class A/B coverage test. To the extent that one of the coverage tests is breached, cash flow may be diverted away from the class of bonds junior to the test (see the Glossary for a description of how coverage tests are calculated and how rating downgrades may affect the OC calculation).

7

In traditional static transactions, asset sales may occur and proceeds are applied toward paying principal. In lightly managed or substitution transactions, a collateral manager may be able to substitute collateral for assets in the pool to protect the pool from deterioration. The substituted amount is typically capped (i.e. 30% of the initial collateral balance may be substituted over the first 5 years) and must conform to the eligibility criteria.

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Figure 13.

Additional Managed Mezzanine Transaction Assumptions

Reinvestment Period

First 4 Years

Optional Redemption Period

Between the 4th and 8th Year

Auction Call

Beginning of 8th Year

Coverage Tests

Required

Class A/B OC Ratio Test

109%

Class C OC Ratio Test

104%

Class D OC Ratio Test

102%

Class A/B IC Ratio Test

112%

Class C IC Ratio Test

108%

Class D IC Ratio Test

105%

Haircut Provisions

% of Par

Ba1, Ba2, Ba3 in excess of 10%

90%

B1, B2, B3

80%

Caa1 or lower

50%


Priority of Payments

The payments of interest and principal to CDO liabilities follow specific rules that are dependent on 1) coverage tests passing or failing, 2) whether the transaction is in its reinvestment period or post-reinvestment period (for managed transaction), and 3) the collateral factor (how much of the original collateral balance is paid down). Figure 14 shows a typical interest and principal waterfall for a transaction with cash collateral. The waterfall for hybrid transactions are slightly more detailed in that the super-senior swap payments and CDS termination payments must also be considered (see the “Additional Features” section). •

•

Interest proceeds (coverage tests are passing): Certain taxes, fees, and issuer expenses are paid prior to the debtholders receiving any interest. Once those payments are made, if coverage tests are passing, interest (accrued, unpaid and deferred) is paid sequentially to the class A, B, C, and D. Any remaining interest proceeds are distributed to the class D as principal (see the “Additional Features” section), subordinate management fees and then to the equity. Interest proceeds (coverage tests are failing): If coverage tests are failing, interest is paid sequentially up to the level of the failed class. Remaining interest collections are redirected to paying principal to more senior classes. Using our mezzanine example, if the class C coverage tests fail, then any remaining interest collections after paying steps 1-8 of the interest proceeds waterfall (Figure 14) would be allocated to paying class A, B, and C principal sequentially until the class C coverage tests pass. When the class C coverage tests pass again, interest payments may be made to class D 8.

8

If a CDO class has an interest shortfall, the shortfall will accrue at t he coupon rate and such amounts may be repaid when interest and principal proceeds are sufficient according to the priority of payment rules. The shortfall amount is added to the outstanding principal balance of the bond for calculating current interest.

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•

•

Principal proceeds (coverage tests are passing): Principal proceeds are first used to ensure that steps 1-5 of the interest proceeds waterfall (Figure 14) are met. If coverage tests are passing, principal proceeds (after ensuring class A, B, C, and D accrued and deferred interest is paid) are used to purchase new assets if the transaction is still in its reinvestment period (first four years in our example). After the reinvestment period ends, the remaining principal proceeds are used to pay the class A, B, C, and D note principal pro rata (if the outstanding collateral balance is greater than 50% of the original balance) or sequentially (if the outstanding collateral balance is less than 50% of the original balance). Once the class A, B, C, and D note principal is paid down (typically through the call); any additional principal proceeds flow to subordinate collateral management fees and the equity. Principal proceeds (coverage tests are failing): If coverage tests are failing and are not cured through the interest proceeds waterfall, the principal distributions are used to pay principal to the classes senior to the trigger level until the tests are cured. All coverage tests must be cured before any principal proceeds may be reinvested (if during reinvestment period) or normal principal distributions are made.

Now we consider cases that tie in both the coverage tests and priority of payments. In our mezzanine transaction example, the equity cash flow could be diverted when the class D OC falls below 102% or the class D IC falls below 105% (Figure 13). Depending on the structure, diverted cash flow is paid sequentially as principal starting with the most senior class down to the failed class until the test is cured. Using the same example, interest proceeds would be used to pay the class A, B, C, and D sequentially until the class D OC increases above 102% and the class D IC increases above 105%. These tests are somewhat unique compared to most ABS transactions in that curing can occur in the same period. In those cases, the remaining cash flow available after tests are cured would be allocated according to the “passing” priority of payment waterfall. If more senior coverage tests are breached (e.g., class A/B, class C), junior classes will typically PIK (cease paying interest), and interest and principal proceeds would be used to pay the bonds sequentially through the failed class. In our example, if the class C OC falls below 104% or the class C IC falls below 108%, then the class D would PIK and interest and principal proceeds would be used to pay the class A, B, and C until the class C OC increased above 104% and the class C IC increased above 108%. Optional Redemption and Auction Calls

In most transactions, the equityholder has the right to call the transaction during the optional redemption period (Figures 13 and 15). The optional redemption period permits the equityholders (with a majority vote) to instruct the manager to liquidate the assets in the trust and pay down the class A, B, C, and D outstanding principal balances at par. Cash that remains after the repayment of par on the debt classes and fees is then allocated to paying subordinate manager fees and equityholders. The transaction may not be called if the liquidation proceeds are insufficient to pay the class A, B, C, and D their par amount. In our mezzanine example, the optional redemption period begins after the reinvestment period ends (year 4) and lasts until the auction call date (year 8). If the transaction is not called during the optional redemption period, the trustee will call the transaction at the auction call date. In our example, this occurs eight years after the pricing date. At the auction call date, if the value of the assets equals or exceeds the amount of outstanding debt of the class A, B, C, and D, the trustee will instruct the manager to liquidate the assets. The transaction will not be called if the class A, B, C,

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16


and D outstanding principal balances are not fully repaid. If the auction does not succeed, the trustee will attempt another auction every quarter until the notes are redeemed. Additional Features

Our mezzanine example provides the basic structural features typically found in the market, but clearly there are features that will vary from deal to deal. For instance, some transactions provide additional principal payments to the class D, called a “BBB turbo”; some transactions have an trigger holiday or no triggers at all; and many have a structure that permits the majority of collateral to be sourced synthetically. We summarize these features below: •

•

•

•

9

November 17, 2006

Class D or BBB Turbo: A BBB turbo feature may be used to pay down a portion of the class D principal early in the life of the transaction and/or over the entire life of the transaction. Some turbo features allow 10%-15% of the initial balance of the class D to be paid down during the first three to four years of the transaction’s life. A certain percentage of the excess spread may be used to pay class D principal throughout the life of the transaction. The turbo feature is typically subordinate in the interest proceeds waterfall (see item 15 in Figure 14). The class D may also turbo if the class D OC or IC test fails. In that event, rather than paying the class A, B, C, and D sequentially until the test passes, the class D is paid. However, the class D does not typically turbo principal if the class A/B and/or class C tests are failing as well. Trigger Holiday: Transactions will not have the traditional OC or IC triggers during the first four to five years of the transaction’s life. This typically coincides with the reinvestment period. Once the reinvestment period ends, the OC and IC triggers become active. This is a feature that has been used in only managed mezzanine transactions to date. Triggerless: Transactions will not have the traditional OC or IC triggers throughout the life of the transaction. Therefore, there is no mechanism in the waterfall to divert interest and principal from the class C, D, and equity. However, as a protection to more senior bondholders in the event the OC declines above a certain level, there is a trigger that allocates all principal proceeds sequentially rather than pro rata, whether the transaction is still in its reinvestment period or not. This is a feature that has been used in only managed mezzanine transactions to date. Hybrid or Synthetic Transactions: Most mezzanine transactions issued since late 2005 have a combination of cash assets and synthetic assets. When the majority of assets are synthetic, the transactions are referred to as “hybrid” or “synthetic” CDOs. The addition of synthetic assets through CDS necessitates some structural changes to the traditional cash CDO model. First and foremost, the top 65%-70% of the capital structure, typically known as the “super-senior” is issued as an unfunded swap 9, where the trust pays the swap provider a fixed premium each month and receives cash payments from the swap provider to the extent the super-senior becomes undercollateralized (Figure 16). The notes, which are issued subordinate in the capital structure (typically the bottom 30%35%) to the super-senior, are usually fully funded and pay a monthly or quarterly floating-rate coupon. The proceeds are used to purchase cash assets and establish a reserve account to be used in the event payments must be made on the CDS positions (such as writedown payments to the buyer of protection).

This may also be issued as a variable funding note (VFN) rather than in a synthetic swap form.

17


Figure 14.

Example Interest and Principal Waterfall

If Class AB Coverage Tests are not met

If Class C Coverage Tests are not met

If Class D Coverage Tests are not met

Interest Proceeds

Principal Proceeds

1. Taxes, Fees, Expenses

1. Items 1-5 of Interest Proceeds, if not paid in full

2. Senior Management Fee

2. Class A, then Class B Principal (sequential)

3. Hedge Fees & Payments, if any

3. Class C Accrued & Unpaid Interest*

4. Class A Accrued and Un paid Interest

4. Class A, B, and C Principal (sequential)

5. Class B Accrued and Unpaid Interest

5. Class C Accrued and Unpaid Deferred Interest

6. Class A, then Class B Principal (sequential)

6. Class D Accrued and Unpaid Interest*

7. Class C Accrued and Unpaid Interest

7. Class A, B, C and D Principal (sequential)

8. Class C Accrued and Unpaid Deferred Interest

8. Class D Accrued and Unpaid Deferred Interest

9. Class A, B, and C Principal (sequential)

9. Reinvestments (during Reinvestment Period)

10. Class D Accrued and Unpaid Interest

10. After Reinvestment Period & when Collateral Balance >50% of Original Balance: Class A, B, C and D Principal Pro-Rata

11. Class D Accrued and Unpaid Deferred Interest

11. After Reinvestment Period & when Collateral Balance <50% of Original Balance: Class A, B, C and D Princi pal Sequential

12. Class A, B, C and D Principal (sequential)

12. Subordinate Collateral Management Fee

13. Subordinate Collateral Management Fee

13. Additional Trustee and Other Fees

14. Additional Trustee and Other Fees

14. Additional Hedge Payments

15. Class D Principal Turbo

15. Subordinated Notes (Equity)

If Class AB Coverage Tests are not met

If Class C Coverage Tests are not met

If Class D Coverage Tests are not met

If Interest Proceeds did not pay in full

16. Additional Hedge Payments 17. Subordinated Notes (Equity) * To the extent not paid from interest proceeds, and only to the extent such payments do not cause a senior OC Ratio to fail. Source: Lehman Brothers

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Figure 15. s n o i l l i M

Paydown of CDO Liabilities (to Auction Call)

1,000 800 Reinvestment Period

600

Auction Call

Optional Redemption Period

400 200 0 0

24

48

72

96

120

144

Deal Age (mos.) Equity

BBB

A

AA

AAA


Figure 16.

Synthetic or Hybrid Transaction Structure

ABS CDO Assets

ABS CDO Liabilities

Credit Default Swaps $700,000,000

Senior Swap Agreement (70%) 15 bp

Ongoing P&I

Cash Collateral Debt Securities $200,000,000

Issuance Proceeds

Class A (10%) AAA 3L+45 bp Class B (8%) AA 3L+55 bp Class C (2%) A 3L+135 bp

Cash Reserve Account $100,000,000

Class D (5%) BBB 3L+325 bp Equity (5%)


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Valuation Considerations In this section, we summarize how transactions are rated by the agencies and typically analyzed by the market, and provide our more robust bottom-up loan-level approach to valuing ABS CDOs. Rating Agency and Market Pricing and Stress Assumptions

In rating ABS CDO liabilities, the rating agencies tend to split the task into two separate analyses. The first analysis uses default, recovery rate, correlation, and diversification assumptions to arrive at an expected loss for the portfolio. The second analysis applies those losses as well as specific cash flow stresses to the specific CDO structure in order to determine whether the CDO tranches can withstand the stresses. Each rating agency uses its own methodology for rating CDOs. This may incorporate a host of techniques 10: Moody’s uses its “correlated binomial method (CBM)” to produce the expected portfolio loss based on default, recovery, and correlation inputs through CDOROM. Standard & Poor’s CDO Evaluator incorporates the probability of default by asset types and correlations among, and within, asset types to arrive at an expected loss. Fitch’s VECTOR uses Monte Carlo simulation of defaults, losses, and correlations to produce expected losses and loss distributions. Investors, however, tend to assess transactions by analyzing cash flows through a “topdown” approach originally developed by the corporate CDO market. Default, recovery, and prepayment assumptions are used to price and stress transactions as follows: •

•

•

Prepayment rate: Each underlying security in the portfolio is priced using its pricing speed or six-month average historical prepayment rate (for seasoned securities). Each security is assumed to pass its triggers and be called at its call date. This generates the transactions aggregate collateral cash flow to which top-level defaults are applied. Default rate: A constant default rate, or investor defined curve, is applied to the aggregate balance of the portfolio as determined under the pricing speed prepayments assumptions discussed above. Recovery rate: A recovery rate is applied to the defaulted balance with a lag (typically 12 months). For example, a 60% recovery rate is often used for mezzanine transactions, but the assumption may differ from one transaction to the next depending on the asset mix.

An ABS Loan-Level Approach to Losses and Prepayments

We believe a more realistic method for developing prepayment and loss assumptions is warranted in order to capture the “ABS” nature of the collateral. We prefer to use a “bottom-up” approach that begins with a loan-level analysis of the specific securities in the transaction, accounting for the intricacies of the underlying loans and bond structures. Using an approach of this nature can more accurately reflect the timing of principal paydowns of the collateral as well as the timing of losses which could impact the average life and evaluation of risk in the CDO liabilities. For example, let us consider a “normal” and “stress” credit scenario whereby we analyze the collateral of the underlying HEL securities (i.e., the subprime loans themselves) 10

This summary of the rating agency process is an oversimplification of their methodologies. We should note that in addition to the collateral analysis, rating agencies are also very involved in the legal and structural features that are present in CDOs. We encourage investors to visit the rating agency websites for more details.

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20


within a generic static mezzanine CDO by applying different voluntary prepayment, default, severity, and delinquency vectors to the HEL loans in order to project how HEL securities perform over time. We find that writedowns of the HEL tranches (and hence CDO collateral losses) tend to be more back-ended (by at least 12 months) than typical CDO-style stress assumptions imply (Figures 17a and 17b). (For our more detailed report on the topic, see “Putting the “ABS” in ABS CDOs” in the U.S. ABS Weekly Outlook , April 21, 2006.) Turning to the prepayment assumptions currently used in the market, we find that typical prepayment assumptions at pricing are generally consistent with the realistic prepayments in “normal” credit environments, but can overstate the rate of paydowns in a “stress” case (Figure 18 – we use a static mezzanine transaction for simplicity). The reason prepayments on ABS CDO collateral could slow in a “stress” case more than what is implied by typical stress cases is that the underlying HEL performance triggers could begin to fail and cause the securities to extend significantly and underlying transactions are less likely to be called. Figure 17a. CDO Cumulative Losses – Normal

Figure 17b. CDO Cumulative Losses - Stress

Cum Loss

Cum Loss

2.0%

10%

1.5%

8%

1.0%

5%

0.5%

3%

0.0%

0% 0

12

24

36

48

60

72

84

96 108 120

0

12

24

36

Deal Age (Months) Normal

48

60

72

84

96

108 120

Deal Age (Months)

CDO Style

Stress


CDO Style


Figure 18. Static Mezzanine CDO Collateral Balance Factor Balance Factor 1.0 0.8 0.6

First Auction Call Date

0.4 0.2 0.0 0

24

48

72

96

120

144

168

192

Deal Age (Months) Pricing

Normal

Stress

Source: Lehman Brothers. Assumes a seven year auction call.

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Risk Factors Credit

A key risk in ABS CDOs is leverage. Rating downgrades and losses on CDO liabilities could increase as a result of a worsening in credit of the underlying collateral securities. While this is not unique to CDOs, the CDO liabilities can be more leveraged to worsening credit than ABS, MBS, or CMBS. For example, consider a mezzanine and high grade CDO transaction where, for simplicity sake, the portfolio is comprised of 100% HEL securities and the mezzanine has BBB HELs and high grade has AA and A HELs. If we project CDO cumulative losses in different credit scenarios by stressing voluntary prepayment, default, severity, and delinquency rates on the underlying HEL loans of HEL transactions, we find that at a certain point, the CDO collateral losses will begin to increase at a more rapid pace than the HEL loans (Figure 19). This is fairly intuitive if one thinks about the timing of how HEL loan losses would permeate through the HEL securities and into CDOs in a high stress scenario. HEL loan losses must first be high enough to result in a writedown to the most subordinate HEL securities (say the BBs) before reaching the HEL BBBs. If losses were to stop there, the CDO collateral losses would be zero, while the HEL collateral losses would be greater than zero. If losses continued to increase and were high enough to result in HEL BBB writedowns, the CDO would begin to incur its first collateral losses. If HEL loan losses continue to increase until the HEL BBBs are completely written down, this would result in 100% cumulative losses to the mezzanine CDO (assuming no paydown of principal occurred). If HEL loan losses increase further and begin writing down the HEL AA and A tranches, the high grade CDO begins to incur collateral losses. If loan losses stopped increasing at that point, they would not be high enough to reach the HEL AAAs, but would result in 100% writedown to the AAA, AA, A, and BBB classes of the mezzanine CDO and a significant portion of the high grade classes. Figure 19.

ABS CDO and HEL Collateral Cumulative Losses

Cum Losses 50% 40%

Mezzanine CDO Collateral Losses High Grade CDO Collateral Losses

30%

HEL Collateral Losses

20% 10% 0% Meltdow n

Stress

Normal


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Basis Risk on Fixed-Rate Security Hedges

When a portion of CDO collateral is fixed-rate but CDO liabilities are all floating-rate, the trust is exposed to interest rate risk (either positive or negative, assuming there are no hedges in the transaction). When short interest rates rise, the average CDO liability cost increases while only a portion (the floating rate portion) of the collateral interest increases. This results in a decrease in excess spread. The reverse occurs when short rates rally. While the trusts typically purchase amortizing swaps and caps to match the fixedrate notional over time in an attempt to hedge this risk, mismatches can occur when prepayments deviate from the pricing speed assumption. An additional risk exists whereby the weighted average coupon of the fixed-rate collateral drifts higher or lower throughout the life of the transaction. This “coupon drift” impacts the excess spread, as there may be more or less interest cash flow coming into the transaction than initially expected. The coupon drift is dependent on the interest rate scenario, the types of fixed-rate collateral, payment priority, and whether underlying transaction triggers are passing or failing (to name a few), all variables that increase the uncertainty of fixed-rate interest cash flows in the transaction (see our analysis of “FixedRate Collateral Risk in ABS CDOs” in the ABS Strategy Weekly, June 2, 2006). Of course, the “coupon drift” is not just a risk for the fixed-rate securities in the transaction, but for the entire portfolio, as the average spread on floating-rate securities will also drift based on similar variables. Available Funds Cap Risk (AFC)

Because upwards of 50% of the collateral in more recent vintage ABS CDOs are HEL securities, available funds cap (AFC) risk in HELs is also a risk for ABS CDOs. The risk to ABS CDO investors is that 1) a decline in HEL excess spread increases the chance of HEL writedowns, 2) HEL securities are downgraded because of their lower enhancement, and 3) AFC interest shortfalls on HELs result in less excess spread to the CDO. AFC risk stems from the fact that the underlying HEL securities are exposed to rising interest rates due to the basis risk between floating-rate bonds and a combination of their fixed-rate and hybrid collateral (which are subject to periodic and lifetime caps on the rate of the mortgage). As interest rates rise, the fixed-rate loans in the pool are unable to reset higher and hybrid loans may hit their caps, resulting in excess spread being squeezed. This can create problems later in the life of a transaction when losses are higher. The HEL trusts may purchase swaps and/or caps which partly offset the interest rate risk inherent in HEL transactions. Call Risk/Extension Risk

Under normal circumstances, transactions will be called during the optional redemption period or at the auction call date. The auction call will be exercised to the extent the liquidation value of the portfolio is 100% or higher. However, to the extent the transaction is not called, bondholders are susceptible to extension risk. The amount of extension risk will vary depending on the underlying portfolio characteristics and credit scenario. For example, in a normal credit scenario, AAA to BBB securities could have about two to three years of extension risk if the transaction is not called (Figure 20). However, if one applies a credit scenario stressful enough to result in underlying HEL trigger failure and CDO losses, the extension risk could be much greater.

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Figure 20.

Managed Mezzanine Liability Average Lives, to Call and to Maturity Average Life (Years, To Auction Call)

Tranche

Average Life (Years, To Maturity)

Normal

Normal

Stress

AAA – SS

6.8

9.2

11.4

AAA – Mezz

6.8

9.4

16.5

AA

6.8

9.4

18.3

A

6.8

9.4

21.1

BBB

6.3

8.6

1.6*

Source: Lehman Brothers * The average life is significantly shortened because the BBB incurs a writedown in this example.

Conclusion The tremendous growth of the ABS CDO market has created the second largest ABS sector by outstandings and has accounted for more than 60% of global CDO issuance YTD. ABS CDOs add additional complexity to what are already complex underlying sectors, but offer attractive nominal spreads compared to investing directly in the ABS, MBS, CMBS, or CLO investments. As with any securitized sector, a better understanding of structure, collateral, and risks can help uncover value in the market.

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Glossary •

•

•

Auction Call: The trustee instructs the manager to liquidate all the assets in the portfolio as long as all the debt classes receive par. This typically occurs seven or eight years after the pricing date. If the auction fails, the trustee will attempt another auction every quarter. Coupon Drift: Any deviation in the average coupon or spread of the collateral from the initial collateral spread. With respect to fixed-rate collateral, to the extent the average coupon on fixed-rate bonds drifts from the rate of the amortizing swap, excess spread could be affected. Coverage Tests: Performance-related triggers such as interest coverage (IC) or overcollateralization (OC) tests that can affect the payment priority through the waterfall. The calculation of the OC is as follows:

Class A/B OC = outstanding collateral balance (plus paydowns received during the period) / (A + B) Class C OC = outstanding collateral balance (plus paydowns received during the period) / (A + B + C) Class D OC = outstanding collateral balance (plus paydowns received during the period) / (A + B + C + D) where A, B, C, and D refer to the outstanding balance of their respective classes at the beginning of the period.

The calculation of the IC is as follows:

Class A/B IC = (S – costs – fees) / (a + b) Class C IC = (S – costs – fees) / (a + b + c) Class D IC = (S – costs – fees) / (a + b + c + d) where S is the scheduled interest proceeds on the collateral debt securities and a, b, c, and d refer to the scheduled interest plus interest on deferred interest amounts of the respective classes. Costs and fees refer to hedging and trustee costs and manager fees. An important consideration when calculating OC is that the outstanding collateral balance is determined by the par value of the assets rather than the market value. Therefore, appreciation or depreciation in the portfolio’s value will not affect the OC calculation for trigger purposes. However, when an asset is sold at a premium or discount, the gain or loss on the sale will increase or decrease the OC level as a result. Rating migration may also influence coverage tests. Rather than assuming a par value for all the assets in the portfolio when calculating OC, bonds that have incurred downgrades might incur a haircut to the par amount. In our mezzanine example, if the total Ba1, Ba2, and Ba3 exposure becomes greater than 10%, the difference between the actual exposure and 10% is haircut to 90% (Figure 13). In other words, if 15% of the portfolio is rated Ba1, Ba2, and Ba3, 5% of the portfolio (15% minus 10%) will be haircut by 10%, or effectively carried at 90% of the par November 17, 2006

25


value. This would lead to an OC decline of 0.5% when calculating the OC coverage. Additionally, any B1, B2, and B3 exposure will be haircut by 20%, or carried at 80% of the par value and any Caa1 or lower exposure will be haircut by 50%, or carried at 50% of the par value.

•

•

•

•

•

•

•

•

•

•

•

November 17, 2006

Excess Spread: The difference between the interest cash flow received from the assets and the interest paid on the liabilities (minus ongoing fees). Hybrid Transaction: When a portion of the CDO collateral is synthetic, transactions may be referred to as hybrids. Loan-to-Value (LTV): The aggregate debt outstanding divided by the value of the collateral. Managed transaction: A manager is paid a fee to select the initial CDO portfolio of assets and make investment decisions during the reinvestment period. Optional redemption period: For managed transactions, the optional redemption period begins after the reinvestment period ends and lasts until the auction call date. For static transactions, the optional redemption period begins after the “no-call” period. During this time period, the equityholders can call the transaction with a majority vote as long as the debt is paid back at par. Overcollateralization: The notional of the collateral outstanding divided by the debt outstanding. For instance, if a transaction has $103 of collateral and $100 of debt outstanding, the OC is 103%. PIK (payment-in-kind): If a debt class does not receive its full stated interest payment, the bond is considered to be PIKing. Reinvestment period: The period during a managed transaction, typically the first three to five years, when principal proceeds received on the underlying collateral may be invested for substitute collateral and/or the manager has some flexibility in buying and selling collateral securities. Sequential Pay Period: When the collateral balance is less than 50% of the original collateral balance, or the auction call is not successful, the principal proceeds are used to pay down the debt sequentially by order of seniority. Static transaction: A portfolio advisor is paid a fee to select the initial CDO portfolio and conduct ongoing surveillance. The portfolio is typically fully ramped at closing. WARF: The weighted average rating factor, or WARF, is a concept originated by Moody’s. It assigns a number to each rating which represents the expected cumulative default rate over a 10-year period (Figure 23). The cumulative default rate is rating-specific, rather than sector-specific. For CDOs, WARF is useful in providing one number to help describe the average credit of the portfolio.

26


Figure 21.

Rating Factor of Debt Securities

Rating Factor

Rating of Debt Security

Rating Factor

Rating of Debt Security

1

Aaa

940

Ba1

10

Aa1

1,350

Ba2

20

Aa2

1,766

Ba3

40

Aa3

2,220

B1

70

A1

2,720

B2

120

A2

3,490

B3

180

A3

4,770

Caa1

260

Baa1

6,500

Caa2

360

Baa2

8,070

Caa3

610

Baa3

10,000

Ca or lower

Source: Moody’s Investor Service

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Explanation of the Lehman Brothers Mortgage Model

The Lehman Brothers Mortgage Valuation Model allows investors to analyze mortgage-backed (MBS), asset-backed (ABS) and commercial mortgage-backed securities (CMBS). The model collects pertinent and material information needed to evaluate and calculate the risk measures of the security. The model provides option-adjusted spreads and durations along with other risk measures using Lehman Brothers' Prepayment, Default, and Term Structure Models. Analyst Certification

The views expressed in this report accurately reflect the personal views of Michael Koss, the primary analyst responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. Important Disclosures

Lehman Brothers Inc. and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. Lehman Brothers generally does and seeks to do investment banking and other business with the companies discussed in its research reports. As a result, investors should be aware that the firm may have a conflict of interest. To the extent that any historical pricing information was obtained from Lehman Brothers trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Lehman Brothers' global policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy . To obtain copies of fixed income research reports published by Lehman Brothers please contact Valerie Monchi ([email protected] ; 212-526-3173) or clients may go to https://live.lehman.com/. Company-Specific Disclosures

As an administrator of; and frequent issuer, structurer and dealer in structured and securitized credit products , you should assume that Lehman Brothers has a significant financial interest in one or more of the products that are discussed in this publication. As a frequent dealer in debt securities you should also assume that Lehman Brothers has a significant fina ncial interest in the underlying assets of the products that are discussed in this publication. Legal Disclaimer

This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates ("Lehman Brothers"). Lehman Brothers Inc. accepts responsibility for the content of this material in connection with its distribution in the United States. This material has been approved by Lehman Brothers International (Europe), authorised and regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is dis tributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch ("LBIS "). Where this material is distributed by LBIS, please note that it is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particul ar needs of any particular person. An investor should consult his Lehman Brothers' representative regarding the suitability of the product and take into account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. Any U.S. person who receives this material and places an order as result of information contained herein should do so only through Lehman Brothers Inc. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. With exception of the disclosures relating to Lehman Brothers, this report is based on current public information that Lehman Brothers considers reliable, but we do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers' Fixed Income Research Department and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may, from time to time, perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. © 2006 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers' entity in your home jurisdiction.

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