Analyses of Asset Securitization Products --- Subordinated Notes (Equity Tranche) Investments 杨冀川 （美联银行）
Executive Summary Investment in Subordinated Notes (Equity Tranches) Necessitates Different Analyses and Considerations from the Rated Tranches • General Considerations: • Timing of entry: vantage • Leverage • Funding gap • Asset Manager/Deal Originator: • Two basic types of securitization products: Static vs. Managed • For managed deals, Manager is the most important factor • Pricing the Risk: • Risk analysis: Bottom-up vs. Top-down approaches • Risk measurements: credit risk modeling • Investor’s enterprise level pricing guideline for the risk taken • Analyze the Structure: • Leverage level • OC and IC trigger levels • Par preservation vs. turbo mechanism
Vintage, Leverage, Funding Gap Average CLO Equity Yield and Cash-on-Cash Return by Vintage
Vintage, Leverage, Funding Gap Average CLO Funding Gap = Portfolio Spreads – Weighted Average Rated Tranche Spreads Source: Moody’s, CreditFlux, LCD and Wachovia Securities
Vintage, Leverage, Funding Gap CLO Equity Return as a Function of Leverage Source: Standard and Poor
Asset Manager/Deal Originator Qualitative Analyses and Risk Control Process • Asset Manager Due Diligence: • Conducts due diligence to review the strategy, organization structure, track record, selection and monitoring process of the manager • Detailed manager due diligence questionnaire • Committee Approvals: • Legal reviews • Accounting and tax reviews • Credit and/or market risk reviews Manager review and due diligence is the most important step in the analyses and risk control process.
Sample Manager Due Diligence Checklist INFORMATION REQUESTS/REPORTS • Last 3 years of audited financial statements • Most recent interim financial statement with prior year’s comparable period • Sample of credit files/reports of loan portfolio; (We expect to review the credit writeups on the existing portfolio after the management meeting.) COMPANY BACKGROUND • Company and industry overview • Business model • Strategic objectives • Competition and competitive advantages • Pricing pressures and susceptibility to economic cycles • Organizational structure/charts • Management team bios • Regulatory issues (eg. BDC and RIC) • Staffing requirements/projections • Discuss in-house functional capabilities vs. outsourced
Sample Manager Due Diligence Checklist FINANCIAL DISCUSSION • Capital requirements • Funding Strategy • Debt • Equity • Funding Sources • Liquidity requirements – next 12 months • Yields/Margins • Non Cash Income NEW BUSINESS ORIGINATION • Discuss marketing/origination/participation platform including transaction flow • Internal and external deal sources (company paid originators, vendors, i.e. banks, brokers, other finance companies?) • Discuss any incentive structure for originators, if applicable
Sample Manager Due Diligence Checklist • (If limited in number, walk through list of originators by loan/investment type including obligor, amount, original tenor, maturity, etc.) • Targeted profile: borrower, industry, seniority in capital structure • Origination growth projections over next 3 years UNDERWRITING • Provide department organizational chart, personnel bios and credit authorization limits • Discuss underwriting guidelines and approval process • Central or decentralized credit decision-making process (is there a credit committee and what is its role?) • Who has authority to override authorization limits? • Turnaround time for credit decisions • Due diligence process performed on investments • Policy on cash vs. non-cash (i.e. PIK) income. Any limits? • Sources used to perform analysis (financial statements, credit agencies, sponsor recommendations, etc.) • Primary financial drivers used in underwriting, i.e. coverage ratios, liquidity ratios, leverage ratios, etc. • UCC filings, closing binder follow up, etc.
Sample Manager Due Diligence Checklist • Deviations to company policy – how documented and detailed list of exceptions and related procedures • Discuss any formal limits on type and size of investments, borrower, industry, geography, etc. • Review risk rating methodology • Review asset valuation methodology, financial metrics utilized in process • Number of applicants submitted per month and percent approved • Collateral coverage requirements DOCUMENTATION AND FUNDING • Discuss documentation and funding process • Legal counsel – internal/external • Standard shelf documents used or negotiated and tailored to each transaction • Who has signing authority for company? Board Resolutions • UCC filings, closing binder follow up, etc.
Sample Manager Due Diligence Checklist PORTFOLIO MANAGEMENT AND SERVICING • Discuss collections process & mode (ACH, check or wires/Dunning cycle) • Collateral monitoring process • Workout policy/procedures • Definition of delinquent, non-accrual and charge-offs • Policy for re-aging • Policy and philosophy of restructuring loans to avoid defaults, write downs • Types (and frequency) of reports generated for portfolio management • Tracking and modifications/extensions • Fee structure for late charges, rewrites, modifications, covenant waivers, etc. PORTFOLIO STATISTICS • Portfolio performance by loan type • Historical credit losses • Historical delinquency, aging, non accruals and reserve statistics • Historical utilization and DSO on revolving accounts
Sample Manager Due Diligence Checklist • Recovery rates • Quarterly fair market value statistics by investment • Concentrations by obligor, industry, geographic territory, loan type, etc. QUALITY CONTROL/INTERNAL AUDIT • Discuss process to ensure company’s policies and procedures are being adhered to, how often internal audit is performed and what areas of the operation are audited • Safekeeping of loan/investment files SYSTEMS • Systems back up and disaster recovery plan • Documentation software • Loan servicing software • Accounting software • Integration of software packages (Is the loans servicing software linked to the general ledger, etc?)
Pricing the Risk The structural complexity of structured financial securities is one driver of their higher spread relative to comparably rated alternative fixed income investments • Risk Analysis: • Bottom-up: fundamental risk analysis of single credit • Top-down: portfolio approach • Risk Measurement: • Building a credit risk model • Establish enterprise level risk vs. return investment guideline Structured Credit Products present a gainful investment opportunity to smart and sophisticated investors!
Pricing the Risk Top-down portfolio approach is the choice of the majority of CDO investors in risk analysis • Bottom-up: fundamental risk analysis of single credit • Next to impossible to have specialized expertise in every asset type, market sector, region. • Resource intensive nature implies high cost. • May lack the view of overall interaction and correlation between assets. • Top-down: portfolio approach • More efficient and flexible risk measure and risk control environment. • Such flexibility enables portfolio managers to pick assets across various asset types, sectors and regions. • Highly sophisticated quantitative models imply more objectivity in the risk analysis. • Effectively incorporate correlation risks in the analysis. • Leverage off the rating agency work on the underlying portfolio. Not having to conduct costly analysis on each single credit is a major reason why investing in tranched CDO products is an effective return/risk investment strategy.
Pricing the Risk Deconstructing the Price Price = Risk Free Price + Risk Premium + Liquidity Premium + Exogenous Factors • Exogenous Factors are technical, psychological, and other unexplained factors. • There are typically two kinds of Liquidity Premiums: • The bid-offer spread for the product itself – the more liquid the product, the narrower the spread. • The cost associated with the standby liquidity facility to backstop the cash flow mismatch caused by different maturities. The upward slope of a yield curve is largely the result of the liquidity cost. • A fixed income instrument price is often expressed in terms of yield or spread over a benchmark. This benchmark is the so called Risk Free Price. Typical benchmarks are treasury rates and LIBOR rates. • The remaining major factor of the price is the risks embedded in the product, or the perception of the risks – the Risk Premium, which is the spread over the benchmark. • Different views on the risks may lead to different pricing of the same product. A pricing model is mainly a risk calculation model.
Pricing the Risk A step-by-step guide to build a pricing model for single tranche synthetic CDO (CPORTS) Sample CPORTS Transaction: • Investor buys a single tranche synthetic CDO (i.e., sells protection on a tranched portfolio). • The portfolio has 100 corporate credit names; each name has notional of $10mm ($1 billion portfolio notional). • The single tranche attaches at 2% ($20mm) and detaches at 4% ($40mm), and has a notional of 2% ($20mm). • Maturity of 5 years. • When losses exceeds the attachment of 2%, the investor will suffer a loss which equals the loss amount above 2% but will be capped at 4%. • When tranche losses occur, the tranche notional will be reduced by the loss amount. • The investor will receive an annual premium which is calculated based on the remaining tranche notional.
Pricing the Risk A step-by-step guide to build a pricing model for single tranche synthetic CDO (CPORTS)
Pricing the Risk A step-by-step guide to build a pricing model for single tranche synthetic CDO (CPORTS) Step One: Prepare the Main Inputs • For each credit name in the portfolio, its default probability or its term structure of default probabilities will be the main inputs. • The 5 year CDS market spread can be used to calculate the hazard rate = spread/(1-recovery) • Assuming a constant hazard rate, the term structure of default probabilities can be calculated as: default probability at t = 1 – exp(-hazard rate * t) • A constant correlation will be assumed for every pair of credit names – typically calculated from the market spreads for a similar single tranche (often an index tranche). • The recovery will also be assumed constant, e.g. 20% - 40%.
Pricing the Risk A step-by-step guide to build a pricing model for single tranche synthetic CDO (CPORTS) Step Two: Building a default and time-to-default simulation engine • Cholesky decompose the correlation matrix • Generate uniformly distributed random numbers and generate independent normal random numbers (e.g. Box-Muller algorithm); then the multiplication of these random numbers with the decomposed correlation matrix to get correlated random numbers. • The inverse of the normal distribution function of these random numbers will be used to compare with default rates of each asset to determine if it defaults. • The inverse of the exponential of the normal distribution function is used to compare with the hazard curve to determine the time-to-default.
Pricing the Risk A step-by-step guide to build a pricing model for single tranche synthetic CDO (CPORTS) Step Three: Price Calculation -- Break Even Premium • The forward “risk free” interest rate curve is built and the discount factors are calculated. • For each simulated path of defaults and time-to-defaults, the investor’s premium income is calculated and discounted to get the present value of the investor premium income. • For the same simulated path, the loss of the investor is also calculated and discounted to get the present value. • The break even premium is the annual premium the investor gets paid such that the PV of investor income equals to the PV of the loss for this same simulated path. • After a large enough number of paths are generated and break even premium for each path is averaged, this average (expected break even premium) is the premium the investor should get for this investment – the price of the single tranche.
Pricing the Risk A step-by-step guide to build a pricing model for single tranche synthetic CDO (CPORTS) Example: This path has one default in every year. The PV of the loss is 0.85, and the break even premium is 1089 bps which makes the PV of the premium received equal to 0.85. If all 5 defaults would occur in the first year, the break even premium would be 2140 bps; and if the 5 defaults occur in the last year, the break even premium would be 1028 bps.
Pricing the Risk A different approach: required return on risk capital • For a buy-and-hold investor who may not care about mark-to-market of the investment, the fair market value pricing may not be suitable . • In this case, senior management will determine: • Risk appetite: how much risk is tolerable? • The required return on the tolerable risk. • The portfolio credit risk model will then be used to generate a loss distribution curve. • The risk capital for given risk tolerance level is calculated from the loss distribution curve, and the return on the capital is the risk premium required, which is the price the investor is willing to pay for this investment.
Pricing the Risk A different approach: required return on risk capital Example: Suppose risk tolerance level is 1%. From the loss distribution curve, the loss amount with a probability of 1% occurring is 6%. Suppose the required return on this 6% risk capital is 20%. Then the premium should be 20%*6% = 1.2% Ignoring the time value of the money, the tranche price should be approximately 120 bps.
Pricing the Risk A Sample Checklist for an Equity or Subordinated Note Investor: • Cashflow model – a translation of the Offering Memorandum: • Accurately model the cash payment waterfalls • Model all the financial tests: OC and IC • Par preservation vs. Turbo: • Pro rata amortization vs. sequential amortization: • Pro rata amortization helps to preserve the funding gap • However • Other considerations:: • OC and IC trigger levels • Any other tests • Equity voting rights • Call provisions • Conflict of interest – Manager as co-investor?
Pricing the Risk A Comparison of Par Preservation vs. Turbo