Friday, June 22, 2007

The CDO Put

In a recent post, I off-handedly mentioned the "CDO Put." Basically, the CDO put, as I'm using it, refers to the fact that wider credit spreads result in making CDO creation easier. Thus a minor widening event will be met with increased CDO issuance, thus creating a back-stop to spreads.

Here's how it works. Let's say that the spread on BB-rated bank loans is LIBOR +250bps. So if I have a $100 million portfolio of these loans, I'm earning LIBOR +$2.5 million every year.

Now let's say that I can build a CDO of these securities with the following traches:

65% AAA (LIBOR +25)
8% AA (LIBOR +50)
8% A (LIBOR +80)
9% BBB (LIBOR +250)
10% Equity

That comes out to annual interest cost of LIBOR +$490,000. So we should have over $2 million left over to cover admin costs, cover defaults, and pay equity holders.

What happens if credit spreads widen? Well, we'd logically assume that the spread between AAA and BBB (or BB) bonds would widen. So let's say that the BB loan market is now +350bps. Let's say that the debt tranches on a new CDO deal widen as well:

65% AAA (LIBOR +35)
8% AA (LIBOR +80)
8% A (LIBOR +120)
9% BBB (LIBOR +350)
10% Equity

So now the annual interest cost is $700,000, a 43% increase. But now interest collected is $3.5 million. Now we have $2.2 million left over for costs, losses, and equity holders. So the net-net is that the CDO deal is more profitable as spreads wider.

If spreads in the loan market track spreads for similar-rated tranches in the CDO market, its a mathematical certainty that wider spreads will improve CDO economics, all else held equal. Thats because the CDO will always be issuing higher-rated debt than the collateral its buying. The basic arbitrage of a CDO is the spread between the lower-rated collateral and the higher-rated debt. Put another way, its the arbitrage of owning a portfolio of weak credits which collectively can garner a higher rating.

The truth is that CDO spreads are wider than generic bond spreads. I mean, a generic FRN with say AA rating and 8 years to maturity (a typical average life for a CDO tranche) would be in the 15-20bps range. But AA CDO tranches are much wider, usually in the 40-50bps area. AAA (and even AA) CDS spreads are usually less than 10bps. But the AAA tranche of CDOs of CDS is far wider, the most recent I saw was around 40bps.

So if investors lose confidence in CDO technology, spreads could widen in CDO tranches beyond where generic collateral spreads are going, destroying the CDO put. So far, the CDO market has held up beautifully in the face of the meltdown in sub-prime. CDO investors should be very encouraged. There shouldn't be any reason why CLOs should widen just because too many mortgage brokers were too aggressive with their credit standards.

Another thing to bear in mind is that the soundness of a CDO is not dependant in any way on the movement in credit spreads. By this I mean, if you buy a CDO today and spread for the collateral widen, and defaults don't actually increase, the cash flow of the CDO is unchanged. If you imagine that credit events, like LBOs, will cause spreads to widen, but actual defaults will remain relatively low, CDOs are probably better investments than traditional bonds.


smurfy said...

Would you write on what the LBO put is as well?

Anonymous said...

i'm sorry, Tom, isn't it the same as saying that if a stock goes down, then everything else being equal, purchasing this stock at a lower price becomes more profitable, so money will flow to this stock and therefore there is a limit how far it can go down?

knzn said...

"if you buy a CDO today and spread for the collateral widen, and defaults don't actually increase, the cash flow of the CDO is unchanged"

Hmmm...the cash flow is unchanged, but the present value of the cash flow (probably) changes (if you discount it at a rate including an appropriate risk spread). Couldn't you say the same thing about a traditional bond -- that the cash flow is unchanged when interest rates rise?

knzn said...

Qualitatively, I don’t think I buy the logic behind the CDO put. If spreads widen, it’s presumably because the price of risk is going up. If the price of risk is going up, then the required return on the very high risk, highly levered equity tranches should go way, way, way up. So the fact that the actual return goes way, way, way up doesn’t necessarily make it a better deal. Quantitatively, it may turn out to be true, given reasonable risk-aversion parameters, etc., that it does become a better deal, but proving that would require a lot of messy math (and a bit of economic theory).

Jay said...

I know this might be slightly elementary for your site, but would you be able to provide a basic over related to swaps.
My primary question, is why fixed rate yeilds are often written as Swaps + 100 bps (Spread). What is the purpose for including 'Swaps' in this equation, why not just say the fixed rate is x%.
My second question is: what does it mean when 5yr swaps are quoted as 54 bps?

Thanks for any insighted you can provide.

TDDG said...

When a fixed-rate instrument is quoted on a spread basis, either swaps + X or 10-year + X etc., its because either the fixed rate isn't set yet, or the bond is being quoted on a yield basis. For example, let's say you are looking at MER 6.05 5/16 bonds. The coupon is 6.05%, so the thing pays you interest equal to 3.025% of the par amount you own semi-annually for as long as Merrill is solvent and the bond is outstanding.

But once the bond is issued, the fixed rate of 6.05% might not be market anymore. So in order to quote the bond, dealers will use a spread to Treasuries. That way the quote can stay the same even though the general rates market is moving. If the spread is changing, its saying that MER is moving differently than the general bond market.

Now when someone quotes fixed rate bonds vs. swaps, they mean the fixed rate side of a swap with a similar maturity. So for a 10-year bond, they'd use 10-year swaps.

When swap spreads are quoted, like your 5-year example, thats the spread between the 5-year swap and the 5-year Treasury.

Anonymous said...

Does anybody have the most recent spreads for Aaa, Aa2, Baa2 and Ba2
rated tranches. Before the subprime problems they were in the following ranges:
Aa2 0,28%
A2 0,55%
Baa2 0,83%
Ba2 2,75%
and now?

TDDG said...

Max, if any CDO deals were getting done, I could tell you. But they aren't so I can't.

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