A Collateralised Debt Obligation (CDO) is a type of structured asset-backed security that requires the creation a special purpose vehicle (SPV) that has assets, ...
What is a CDO? A Collateralised Debt Obligation (CDO) is a type of structured asset-backed security that requires the creation a special purpose vehicle (SPV) that has assets, liabilities and a manager (Picone). A CDO is a financial security consisting of a diversified portfolio and risky assets that generate cash flows and restructures this group of assets into different tranches that have different risk profiles and that can be sold separately to different investors. The pooled assets (e.g. loans, bonds, mortgages) serve as collateral for the CDO and give the CDO its value. Of all the tranches, the senior ones are the safest as they have the first claim on assets if some of the underlying assets defaults which makes these tranches significantly less risky than the collateral itself. They therefore have a higher credit rating and lower coupon rates. Junior tranches are riskier and therefore offer higher interest rates to compensate for the higher default risk in order to be able to attract investors. The structure of a CDO is as depicted in Figure 1.
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Figure'1:'CDO'diagram' Source:!Picone,!D.!Collateralised!Debt!Obligations.!City!University!Business!School,!London.!Royal!Bank!of!Scotland.!
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Figure'2:'Expected'losses'across'CDO'tranches' Source:!Picone,!D.!Collateralised!Debt!Obligations.!City!University!Business!School,!London.!Royal!Bank!of!Scotland.'
The SPV would be created such that it is “bankruptcy-remote”. That is, were the originating bank to go bankrupt, its creditors would not be able to claim assets within the SPV. The original bank sells its assets (credit card bonds, corporate bonds, and mortgage bonds) to the SPV. The SPV funds this purchase with the proceeds collected from the senior, mezzanine and junior notes it has sold to investors.
RampDup period Figure'3:'CDO'process'
Reinvestment! period
Unwind! period !
Figure 2 traces the different phases of a CDO. Typically, the CDO goes first through a ramp-up period, where the collateral portfolio is formed. Then, the collateral portfolio is actively managed during the
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reinvestment period. The liabilities are repaid with the collateral principal proceeds during the unwind period.
! Who buys CDOs? It is usually uncommon for consumers (i.e. the public) to directly invest into CDOs. Typically, insurance companies, investment and commercial banks, hedge funds, pension funds and investment managers buy this kind of securities. Pension funds are more interested in the senior tranches as they have a good credit rating whilst hedge funds tend to go more after the riskier tranches. These organisations seek to buy tranches or cash flows that they think will make their fixed income and credit portfolios outperform Treasury bills and notes with the same implied maturity. Who sells CDOs and why? It is usually investment banks that sell CDOs after having bought different securities from commercial banks. CDOs can be separated into two main groups that serve two different purposes. The first class is called the arbitrage CDO and aims to seize any arbitrage opportunity that occurs in the credit-spread differential between the interests the SPV has to pay and receives. The SPV will earn more from risky and therefore high yield collaterals than what it has to pay for its safe and highly rated notes. The second one, the balance sheet cash flows CDO acts as capital relief. It allows to take down securities that require too much regulatory capital from the balance sheet. This enables the organisation to lower funding costs or increase return on equity. In order for the transaction to have an influence on the return on equity, balance sheet CDOs are typically very large. Risky assets such as high yield bonds (CBO) or bank leverage loans (CLO) face illiquidity problems as they are often difficult to analyse and evaluate. This decreases the amount of potential buyers who would be willing to invest in these securities, therefore creating a gap between supply and demand in the economy. This is the reason why corporate bonds face liquidity issues in the secondary market. The structure of CDO enables to take this market inefficiency into account and enables to take advantage of high risk-adjusted returns through active management. What are the main characteristics of the SEQUIL/MINCS deal described in the case? The SEQUILS/MINCS is a structure used to achieve investment-grade rating through securitizing sub-investment-grade loans. It involves two SPVs (SEQUILS and MINCS), one for the funding of the portfolio and the other for the securitization of the credit risk in the loan portfolio. The ratings for the two SPVs are all above the investment-grade rating (BB- or B+) for the loans from RBS. Additionally, the two SPVs are separated from RBS to remove the credit risk that RBS faces. SEQUILS purchases the low-rating loans using the funds obtained from note issuance. Because of the credit swap, which is used to back up the loans, SEQUILS pays a fee periodically in exchange of a payment when one or more loans default. Therefore, the ratings are still high for those newly issued notes. In fact, SEQUILS buys low rated loans (from BB- to B+) and insures them (with Morgan Guarantee Trust in our case study) so as to be able to issue high rates notes (BBB to AAA). In other words, by swapping the credit risk out, SEQUILS pools BB- to B+ securities into less risky notes. As for MINCS, it consists of synthetic CDOs and it is funded by notes whose principals are invested in AAA rated securities, and it also sells credit swap to the insurer (Morgan Guarantee Trust in our
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case study). In spite of the high credit risk of original loan from RBS, the overall investment-grade for MINCS can still reach a BBB rating. In a nutshell, MINCS is used to swap credit risk out of RBS. From a pool of loans « below investment grade (BBB) », the deal promises the creation of investment grade securities (some AAA and the worst is a BBB). Fantastic! How is this possible? First of all, the SEQUILS/MINCS structure and the two SPVs make it possible to transfer the risk from RBS and also separate the funding and the credit risk on the loan portfolio into two pools of investors. The separation allows the institute to reduce the total risk of its portfolio for each group of investors.
Figure'4:'Structure'of'the'SEQUILS/MINCS'transaction'
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SEQUILS buys the loan from RBS using its funding from the issuance of notes. For SEQUILS investors, the notes that they invested in are basically used to fund the risky loans rating BB- or B. In order to have a protection for investors, SEQUILS pays Morgan Guarantee Trust a periodical fee in return for a payment that was contingent on the default of one or more loans purchased from RBS. Because of the existence of the credit swap, it guarantees the investors that they can still get their principal back when one or more loans default. Due to the protection from credit swaps, the investment grades for the notes can still be BBB or even AAA, depending on which tranche the investment belongs to (different tranches represent different payment orders when loans default). On the other hand, MINCS writes the credit swaps for SEQUILS - Morgan Guarantee Trust buys the swaps from MINCS to transfer its own risk. The credit swaps bring high risk as well as high yield to MINCS as the swap is 6 times its capital. After packaging the risky swaps with its other AAA investments, the overall investment-grade for MINCS still can be over BBB. Moreover, Morgan Guarantee Trust plays an essential role in this restructuration of loans by enabling to smooth out cash flows. The trust is able to give to SEQUILS the cash needed should it suffer
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default losses as it will get it back from the other side i.e. the MINCS part of the structure. Additionally, the rating agencies may underestimate the risk of the SPVs. An important lesson learned from the financial crisis in 2008 is that the correlation between any two assets is higher than we initially expected. For example, the correlation between the AAA rating that MINCS holds and the credit swaps are not that low. Therefore, the situation may be worse during recessions, resulting in higher overall risk. Imagine to be a portfolio manager of a large pension fund, would you buy MINCS securities (the BBB ones)? a.! Risks from the perspective of the investor We don’t believe that investing in MINCS securities is a good choice for pension funds in spite of their relatively high investment ratings. Pension funds pursue long-term and less risky investment in order to secure regular payments for retired people. MINCS is too risky and complex for pension funds. Indeed, the complexity of the MINCS structure and the information asymmetry make it hard for pension funds to figure out the exact risk of the investment. Although the rating agencies think that the investment grade for the MINCS notes is BBB, we still doubt about the reliability of the rating. By repackaging assets through this complex structure, below investment grade loans end up with a higher grade although there is nothing in the underlying assets themselves that has improved. The credit risk, first swop out to SEQUIL and then to MINCS indicates that it is likely that MINCS actually invests in notes that are below the BBB rating. In fact, we could say that SEQUIL and RBS are short on the underlying portfolio whereas MINCS is long on it. It is also likely that agencies underestimate the correlation between any two assets which might lead a, important defaults waterfall. Furthermore, once the loans from RBS default, MINCS investors have to bear the ultimate loss as they are the first ones to absorb credit losses. In other words, MINCS provides credit swaps for a portfolio of 852.5 million (SEQUILS), while the total value of the notes of MINCS is just 144 million i.e. it insures a CDS that is 6 times its capital value. Although all the notes are invested in AAA grade assets, the proceeds still may not be able to fully cover the loss if a portion of the loans from RBS defaults. Additionally, MINCS’s fixed-term investments also constrain the ability of covering the loss if and when the default occurs. Based on the above reasons and on the fact that the down side risk relative to the return does not match a large pension fund’s risk profile, we would recommend not to invest in MINCS. b.! Risks from the perspective of RBS RBS incurs reputation but also profitability risks. Although RBS has already sold those risky loans to SEQUILS, it is supposed to disclose the transaction to its shareholders and debt-holders, and prove that the two SPVs are independent from RBS. Otherwise, it will face severe litigation risk. Based on the reference readings, we find that RBS tried to hide the facts about the high risks. When the crisis finally came, some investors sued RBS for covering the risks on purpose. Secondly, both SPVs cannot solve RBS’ fundamental problem: poor profit and costly loans. Additionally, transferring the credit risk and the default risk to the two SPVs will incentivise RBS to keep taking risker loans because they do not need to consider the risk too much. Since RBS still has to hold a portion of CDO (the equity tranche) to show that it will improve the quality of the loans, it still exposes to a certain amount of risk. The equity tranche is risky for RBS based on the requirements for equity tranche – RBS is supposed to absorb the loss first. As long as things go well, profitability ratios
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would indeed be good which enhances the capital adequacy ratio but when the crisis hits and the economic perspectives become gloomy, RBS suffers important losses. Finally, as mentioned by Picone, transferring loans to the SPV in a plain-vanilla CDO necessitates important initial costs. A loan-by-loan evaluation is required to verify whether they comply with the securitisation program and to check that there are no particular clauses that does not allow the loan transfer. Therefore, because the SEQUIL/MINCS structure is a consolidation of a synthetic and a plain vanilla CDP, RBS still needs to spend time on these transactions and take care of its sensitive client relationships.
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References: 1.! Lu, A., & Buraschi, A. (2007). Credit risk management and off-balance sheet engineering at Royal Bank of Scotland: A crisis in the making? IMD. Lausanne: International Institute for Management Development. 2.! Picone, D. Collateralised Debt Obligations. City University Business School, London. Royal Bank of Scotland. 3.! Nick Dunbar, The Hidden Picture of Talent 4.! RBS timeline: where it all went wrong, The Telegraph 5.! RBS 'deceived' Highland Capital over collateralized debt obligation, The Telegraph ! !
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