Getting into CDOs

Skillionaire · Post by **Skillionaire** » Thu Mar 29, 2007 11:42 pm

RRP,

Just got a piece of material regarding CDO equity (see below). In the interest of full disclosure haven't really looked at it (fairly swamped today and I've got an 8:00 dinner), but I did scan it and it seemed to have some interesting points. On a completely different topic, please take a look at the previous thread where I was a D-bag when you get a chance.

[url=/User%20Files/2550/Forward%20Starting%20Equity%2007Mar29.pdf]Attached File: Forward Starting Equity 07Mar29.pdf[/url]

Kr,

We don't give all that much weight to RA around here. We feel that our rating methodology is superior and value bonds based on a combination of many factors. That being said, I'm sure that if we saw a BBB- rated tranche that was undervalued/underrated based on what we judged to be its risk profile, I'm sure that we would buy it.

Johnny,

Not a stupid question, but no, that's not (necessarily) what it means. Every deal is fairly unique in its capital structure and the underlying collateral so it'd be tough to justify a blanket statement such as that. Let me know if you'd like any .pdf's regarding this topic; I have a million but I'd have to think for a minute about which would be truly relevant and my time is scarce for the rest of the day.

rowdyroddypiper · Post by **rowdyroddypiper** » Fri Mar 30, 2007 2:11 am

I appreciate that you've seen the error of your ways and repented. The phorum is always here to help those that are willing to help themselves.

On topic, that paper is referencing trades on the equity from index tranches, which while called CDO equity has very little in common with cash CDO equity (or synthetic for that matter). In fact in most shops the correlation guys and the CDO guys are totally separate and apart from one another. Read it and let me know if you think differently.

rowdyroddypiper · Post by **rowdyroddypiper** » Fri Mar 30, 2007 3:10 am

"This isn't my thing at all, so excuse the possibly stoopid question, but if a CDO has a BBB- equity slice doesn't that mean that not enough risk has been taken out of the higher tranches? i.e. it's not an efficient way of slicing up the risk to have the equity rated so highly."

Johnny, you are not totally incorrect. If you look at the example deal provided by Skillionaire the lowest bond is rated A3 even though the reference pool is 100% AAA rated obligations, some very minimal piece is rated below A3. This is because the pool is tranched and the pool is tranched in order to get the wrap on the AAA (It's unlikely that you could get an insurance company to finance a whole portfolio of AAA's at inside AAA spreads without some minimal credit enhancement, insurance guys are weiners like that).

In fact in these RMBS deals, the enhancement to the AAA guy is more protection against reinvestment risk from prepays than straight credit risk. Whatever. As kr pointed out, it's not a tremendously interesting trade. Just think of it as a way to get off balance sheet non-mark to market financing for massive AAA positions. Same thing gets done through CP conduits and liquidity facilities all day long. Since they reissue somewhat more frequently CP is more mark to market, but can be a bit cheaper.

For all intents and purposes you're just slapping some strucutre on to rent an insurance company BS. So basically the inefficiency you create by tranching the pool and having to issue A3 rated certificates out of an entirely AAA pool is offset by the differential in spread you have to pay for the wrap versus what you'd have to pay for issuing straight AAA cash bonds.

Johnny · Post by **Johnny** » Fri Mar 30, 2007 2:12 pm

Thanks RRP. I agree that this trade isn't interesting. But in general (i.e. for more interesting CDOs) it would be odd to have the equity rated so highly, wouldn't it?

rowdyroddypiper · Post by **rowdyroddypiper** » Fri Mar 30, 2007 4:08 pm

Yes, it would be. I haven't seen a case where the lowest rated piece was not at least a ratings level back of the lowest rated piece of collateral in the pool. When you get a bunch of lower rated stuff together you will tend to end up with at least a little of the structure that is non-rated. That's going to be the equity. If you could get rated bonds all the way down the capital stack, you'd just try and sell those and pull the residual cash flows yourself, 100% leverage.