Cdos, Especially Cdo S of RMBS: Neil D. Pearson

CDOs, Especially CDOs of RMBS
Neil D. Pearson
Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.
Various Types of CDOs

CDOs of corporates:
cash CDOs Collateralized loan obligations (CLOs) Synthetic CDOs Single-tranche synthetic CDOs Tranches of subprime RMBS Tranches of Alt-A or jumbo prime RMBS CMBS Tranches of credit card ABS, auto loan ABS, Tranches of other CDOs
ABS CDOs; collateral can include:
Others
There are also some other kinds, e.g. CDOs of trust preferred securities (TRPS)
CDO of Corporates
Bond Bond Bond 2 3 1 Bond Bond Bond Bond Bond 5 4 7 8 6 Bond Bond Bond Bond 15 17 18 16 Bond Bond 10 9 Bond Bond 20 19
Special Purpose Vehicle CDO Assets CDO Bonds
Bond Bond Bond Bond 14 12 13 11
Bond Bond Bond Bond 24 22 24 31 Bond Bond Bond Bond 34 32 33 31 Bond Bond Bond Bond 44 42 43 41 Bond Bond Bond Bond 54 52 53 51 Bond Bond Bond Bond 74 72 73 71 Bond Bond Bond Bond 84 82 83 81 Bond Bond Bond Bond 94 92 93 91
Bond Bond Bond Bond 25 27 28 26 Bond Bond Bond Bond 35 37 38 36 Bond Bond Bond Bond 45 47 48 46 Bond Bond Bond Bond 55 57 58 56 Bond Bond Bond Bond 75 77 78 76
Bond Bond 30 29 Bond Bond 40 39 Bond Bond 40 49 Bond Bond 60 59 Bond Bond 80 79
AAA Bond
CDO Assets
Bond Bond Bond Bond Bond Bond 90 85 89 87 1298 86 Bond Bond Bond Bond 95 97 98 96 Bond Bond Bond Bond 105 107 106 108 Bond Bond Bond Bond 115 117 118 116 Bond Bond 100 99
AA Bond A Bond BBB Bond BBB- Bond Residual
Bond Bond 110 109
Bond Bond 120 119
In a cash collateralized debt obligation (CDO) based on corporate bonds, the sponsor assembles a portfolio of corporate bonds, which comprise the assets of a special purpose vehicle. The SPV then issues various CDO bonds. The SPV has a set of rules according to which the interest and principal cash flows from the CDO assets are distributed to the various CDO bonds. In this set of rules, the higher-rated CDO bonds will have first claim on the cash flows, while the lower-rated CDO Bonds will bear most of the default risk.
Another name for a CDO bond is a tranche

CDO of Corporates
If a few bonds default, the residual or equity tranche bears the losses
AAA Bond
CDO Assets
Bond Bond 110 109
Bond Bond 120 119
CDO of Corporates
AAA Loan
CDO Assets
AA Bond A Loan BBB Bond BBB- Bond Residual
If a few bonds default, the residual or equity tranche bears the losses. If more bonds default, the BBB- and BBB CDO bonds will suffer losses And if yet more bonds in the collateral pool default, the A and AA CDO bonds might suffer losses
Bond Bond 110 109
Bond Bond 120 119
Collateralized Loan Obligation (CLO)

Loan 1 Loan 11 Loan 31 Loan 31 Loan 41 Loan 51 Loan 71 Loan 81 Loan 91 Loan 101 Loan 111 Loan 2 Loan 12 Loan 22 Loan 32 Loan 42 Loan 52 Loan 72 Loan 82 Loan 92 Loan 102 Loan 112 Loan 3 Loan 13 Loan 24 Loan 33 Loan 43 Loan 53 Loan 73 Loan 83 Loan 93 Loan 103 Loan 113 Loan 4 Loan 14 Loan 24 Loan 34 Loan 44 Loan 54 Loan 74 Loan 84 Loan 94 Loan 104 Loan 114 Loan Loan 5 6 Loan Loan 15 16 Loan 7 Loan 17 Loan 27 Loan 37 Loan 47 Loan 57 Loan 77 Loan 87 Loan 97 Loan 107 Loan 117 Loan 8 Loan 18 Loan 9 Loan 19 Loan 10 Loan 20 Loan 30 Loan 40 Loan 40 Loan 60 Loan 80 Loan 90 Loan 100
Special Purpose Vehicle CLO Assets CLO Bonds
Loan Loan 25 26 Loan Loan 35 36 Loan Loan 45 46 Loan Loan 55 56 Loan Loan 75 76 Loan Loan 85 86 Loan Loan 95 96 Loan Loan 105 106
Loan 28 Loan 38 Loan 48 Loan 58 Loan 78 Loan 1298 Loan 98 Loan 108 Loan 118
Loan 29 Loan 39 Loan 49 Loan 59 Loan 79 Loan 89 Loan 99 Loan 109
AAA Bonds
CLO Assets
A collateralized loan obligation (CLO) has a collateral pool consisting of leveraged loans, not bond. Because leveraged loans amortize relatively quickly, many CLOs will reinvest the amortization in additional leveraged loans for some period of time.
Loan 110 Loan 120
Loan Loan 115 116
Loan 119
Synthetic CDO (of Corporates)

CDS 1 CDS 11 CDS 31 CDS 31 CDS 41 CDS 51 CDS 81 CDS 91 CDS 101 CDS 111 CDS 2 CDS 12 CDS 22 CDS 32 CDS 42 CDS 52 CDS 82 CDS 92 CDS 102 CDS 112 CDS 3 CDS 13 CDS 24 CDS 33 CDS 43 CDS 53 CDS 83 CDS 93 CDS 103 CDS 113 CDS 4 CDS 14 CDS 24 CDS 34 CDS 44 CDS 54 CDS 84 CDS 94 CDS 104 CDS 114 CDS 5 CDS 15 CDS 25 CDS 35 CDS 45 CDS 55 CDS 85 CDS 95 CDS 105 CDS 115 CDS 6 CDS 16 CDS 26 CDS 36 CDS 46 CDS 56 CDS 86 CDS 96 CDS 106 CDS 116 CDS 7 CDS 17 CDS 27 CDS 37 CDS 47 CDS 57 CDS 87 CDS 97 CDS 107 CDS 117 CDS 8 CDS 18 CDS 28 CDS 38 CDS 48 CDS 58 CDS 1298 CDS 98 CDS 108 CDS 118 CDS 9 CDS 19 CDS 29 CDS 39 CDS 49 CDS 59 CDS 89 CDS 99 CDS 109 CDS 119 CDS 10 CDS 20 CDS 30 CDS 40 CDS 40 CDS 60 CDS 90 CDS 100 CDS 110 CDS 120
Special Purpose Vehicle CDO Collateral Pool CDO Liabilities
AAA Bond
CDO collateral pool
In a synthetic CDO the collateral pool consists of a portfolio of CDS, not bonds, and cash often invested in a Guaranteed Investment Contract issued by an insurance company. The CDS and cash together create a synthetic bond portfolio.
Cash
Synthetic CDO (of Corporates)

CDS 1 CDS 11 CDS 31 CDS 31 CDS 41 CDS 51 CDS 71 CDS 81 CDS 91 CDS 101 CDS 111 CDS 2 CDS 12 CDS 22 CDS 32 CDS 42 CDS 52 CDS 72 CDS 82 CDS 92 CDS 102 CDS 112 CDS 3 CDS 13 CDS 24 CDS 33 CDS 43 CDS 53 CDS 73 CDS 83 CDS 93 CDS 103 CDS 113 CDS 4 CDS 14 CDS 24 CDS 34 CDS 44 CDS 54 CDS 74 CDS 84 CDS 94 CDS 104 CDS 114 CDS 5 CDS 15 CDS 25 CDS 35 CDS 45 CDS 55 CDS 75 CDS 85 CDS 95 CDS 105 Loan 115 CDS 6 CDS 16 CDS 26 CDS 36 CDS 46 CDS 56 CDS 76 CDS 86 CDS 96 CDS 106 CDS 116 CDS 7 CDS 17 CDS 27 CDS 37 CDS 47 CDS 57 Loan 77 CDS 87 CDS 97 CDS 107 CDS 117 CDS 8 CDS 18 CDS 28 CDS 38 CDS 48 CDS 58 CDS 78 CDS 1298 CDS 98 CDS 108 CDS 118 CDS 9 CDS 19 CDS 29 CDS 39 CDS 49 CDS 59 CDS 79 CDS 89 CDS 99 CDS 109 CDS 119 CDS 10 CDS 20 CDS 30 CDS 40 CDS 40 CDS 60 CDS 80 CDS 90 CDS 100 CDS 110 CDS 120
CDO CDO Collateral Liabilities Pool
AAA Tranche
The collateral pool need not include any cash---it might consist only of CDS. In this case the CDO is just a complicated credit default swap, and the liabilities are legs of the swap
CDO collateral pool
AA Tranche A Tranche BBB Tranche BBB- Tranche Tranche
Synthetic CDO
Swap Documentation Collateral Pool CDO Tranches
Most senior tranche
CDO tranches pay a portion of the losses on the collateral pool
100+ CDS on corporates
CDO tranches receive premiums
Next tranche Next tranche Next tranche Next tranche

Single-Tranche Synthetic CDO

If it is a swap, then one does not need the full capital structure. In a single-tranche synthetic CDO, the protection seller receives a premium in exchange for covering a portion of the losses on the collateral pool. The protection buyer pays the premium, and receives the protection payments.
CDO tranche pay a portion of the losses on the collateral pool
Protection Buyer
100+ CDS on corporates
Protection Seller
CDO tranche
CDO tranche receive premiums
Synthetic CDO of Corporates

The attachment and detachment points indicate the portions of the losses for which each tranche is responsible
Description of the CDO Tranches Collateral Pool Attachment Detachment Attachment Notional Point (%) Point (%) Point ($) 1,000,000,000 0% 3% 0 1,000,000,000 3% 7% 30,000,000 1,000,000,000 7% 10% 70,000,000 1,000,000,000 10% 15% 100,000,000 1,000,000,000 15% 30% 150,000,000 Detachment Point ($) 30,000,000 70,000,000 100,000,000 150,000,000 300,000,000 Tranche Notional 30,000,000 40,000,000 30,000,000 50,000,000 150,000,000 Coupon (Spread) 15.000% 4.000% 3.000% 1.400% 0.350%
ABS CDOs
Now lets consider CDOs of asset-backed securities, called ABS CDOs. In an ABS CDO,
collateral pool consists of bonds issued by an asset securitization commonly, the ultimate underlying asset are subprime mortgages, and the bonds are subprime residential mortgage-backed securities (subprime RMBS)
First need to consider the lower-level asset securitization
Asset (Mortgage) Securitization

Mrtg 1 Mrtg 11 Mrtg 31 Mrtg 31 Mrtg 41 Mrtg 51 Mrtg 71 Mrtg 81 Mrtg 91 Mrtg 101 Mrtg 2 Mrtg 12 Mrtg 22 Mrtg 32 Mrtg 42 Mrtg 52 Mrtg 72 Mrtg 82 Mrtg 92 Mrtg 102 Mrtg 3 Mrtg 13 Mrtg 24 Mrtg 33 Mrtg 43 Mrtg 53 Mrtg 73 Mrtg 83 Mrtg 93 Mrtg 103 Mrtg 4 Mrtg 14 Mrtg 24 Mrtg 34 Mrtg 44 Mrtg 74 Mrtg 84 Mrtg 94 Mrtg 104 Mrtg 5 Mrtg 15 Mrtg 25 Mrtg 35 Mrtg 45 Mrtg 75 Mrtg 85 Mrtg 95 Mrtg 105 Mrtg 6 Mrtg 16 Mrtg 26 Mrtg 36 Mrtg 46 Mrtg 76 Mrtg 86 Mrtg 96 Mrtg 106 Mrtg 7 Mrtg 17 Mrtg 27 Mrtg 37 Mrtg 47 Mrtg 57 Mrtg 87 Mrtg 97 Mrtg 107 Mrtg 8 Mrtg 18 Mrtg 28 Mrtg 38 Mrtg 48 Mrtg 9 Mrtg 19 Mrtg 29 Mrtg 39 Mrtg 49 Mrtg 59 Mrtg 10 Mrtg 20 Mrtg 30 Mrtg 40 Mrtg 40 Mrtg 60 Mrtg 80 Mrtg 90 Mrtg 100
Special Purpose Vehicle Assets of the SPV Asset-Backed Securities
AAA Bond
Mrtg Mortgage Mrtg 55 54 56
Mrtg 58 Mrtg 1298 Mrtg 98 Mrtg 108
Assets (Mortgages)
Mrtg Mortgage Mrtg 79 77 78 Mrtg 89 Mrtg 99 Mrtg 109
Mrtg 110
Mrtg Motg Mrtg Mrtg 1991 1992 1993 1994
Mrtg Mrtg Mrtg Mrtg 1995 1996 1997 1998
Mrtg Mrtg 1999 2000
In an asset securitization, the sponsor assembles a portfolio of assets, for example 2,000 or 3,000 home mortgages. These mortgages comprise the assets of a special purpose vehicle. The SPV then issues various bonds, called in this case residential mortgagebacked securities. The SPV has a set of rules according to which the interest and principal cash flows from the assets are distributed to the various bonds. In this set of rules, the higher-rated bonds will have first claim on the cash flows, while the lowerrated bonds will bear most of the default risk.
Asset (Mortgage) Securitization

Mrtg 1 Mrtg 11 Mrtg 31 Mrtg 31 Mrtg 41 Mrtg 51 Mrtg 71 Mrtg 81 Mrtg 91 Mrtg 101 Mrtg 2 Mrtg 12 Mrtg 22 Mrtg 32 Mrtg 42 Mrtg 52 Mrtg 72 Mrtg 82 Mrtg 92 Mrtg 102 Mrtg 3 Mrtg 13 Mrtg 24 Mrtg 33 Mrtg 43 Mrtg 53 Mrtg 73 Mrtg 83 Mrtg 93 Mrtg 103 Mrtg 4 Mrtg 14 Mrtg 24 Mrtg 34 Mrtg 44 Mrtg 74 Mrtg 84 Mrtg 94 Mrtg 104 Mrtg 5 Mrtg 15 Mrtg 25 Mrtg 35 Mrtg 45 Mrtg 75 Mrtg 85 Mrtg 95 Mrtg 105 Mrtg 6 Mrtg 16 Mrtg 26 Mrtg 36 Mrtg 46 Mrtg 76 Mrtg 86 Mrtg 96 Mrtg 106 Mrtg 7 Mrtg 17 Mrtg 27 Mrtg 37 Mrtg 47 Mrtg 57 Mrtg 87 Mrtg 97 Mrtg 107 Mrtg 8 Mrtg 18 Mrtg 28 Mrtg 38 Mrtg 48 Mrtg 9 Mrtg 19 Mrtg 29 Mrtg 39 Mrtg 49 Mrtg 59 Mrtg 10 Mrtg 20 Mrtg 30 Mrtg 40 Mrtg 40 Mrtg 60 Mrtg 80 Mrtg 90 Mrtg 100
AAA Bond
Mrtg 58 Mrtg 1298 Mrtg 98 Mrtg 108
Assets (Mortgages)
Mrtg Mortgage Mrtg 79 77 78 Mrtg 89 Mrtg 99 Mrtg 109
Mrtg 110
Mrtg Motg Mrtg Mrtg 1991 1992 1993 1994
Mrtg Mrtg Mrtg Mrtg 1995 1996 1997 1998
Mrtg Mrtg 1999 2000
If the SPV assets are mortgages, we call the bonds issued by the SPV Residential Mortgage-Backed Securities (RMBS). If the SPV assets are subprime mortgages, we call the bond subprime RMBS. If the SPV asset are commercial mortgages, then the bonds are called commercial mortgage-backed securities (CMBS). If the SPV assets are credit card receivables, then the bonds issued by the SPV are called credit card asset-backed securities (ABS). Similarly for other collateral categories, e.g. we can have auto loan ABS
Asset (Mortgage) Securitization and ABS CDOs

Mrtg 1 Mrtg 11 Mrtg 31 Mrtg 31 Mrtg 41 Mrtg 51 Mrtg 71 Mrtg 81 Mrtg 91 Mrtg 101 Mrtg 2 Mrtg 12 Mrtg 22 Mrtg 32 Mrtg 42 Mrtg 52 Mrtg 72 Mrtg 82 Mrtg 92 Mrtg 102 Mrtg 3 Mrtg 13 Mrtg 24 Mrtg 33 Mrtg 43 Mrtg 53 Mrtg 73 Mrtg 83 Mrtg 93 Mrtg 103 Mrtg 4 Mrtg 14 Mrtg 24 Mrtg 34 Mrtg 44 Mrtg 74 Mrtg 84 Mrtg 94 Mrtg 104 Mrtg 114 Mrtg 5 Mrtg 15 Mrtg 25 Mrtg 35 Mrtg 45 Mrtg 75 Mrtg 85 Mrtg 95 Mrtg 105 Mrtg 115 Mrtg 6 Mrtg 16 Mrtg 26 Mrtg 36 Mrtg 46 Mrtg 76 Mrtg 86 Mrtg 96 Mrtg 106 Mrtg 7 Mrtg 17 Mrtg 27 Mrtg 37 Mrtg 47 Mrtg 57 Mrtg 87 Mrtg 97 Mrtg 107 Mrtg 117 Mrtg 8 Mrtg 18 Mrtg 28 Mrtg 38 Mrtg 48 Mrtg 9 Mrtg 19 Mrtg 29 Mrtg 39 Mrtg 49 Mrtg 59 Mrtg 10 Mrtg 20 Mrtg 30 Mrtg 40 Mrtg 40 Mrtg 60 Mrtg 80 Mrtg 90 Mrtg 100
In an ABS CDO, the assets of the CDO SPV are bonds issued by mortgage or other asset securitization
AAA BOND
Mrtg 58 Mrtg 1298 Mrtg 98 Mrtg 108 Mrtg 118
Assets (Mortgages)
Mrtg Mortgage Mrtg 79 77 78 Mrtg 89 Mrtg 99 Mrtg 109 Mrtg 119
For example, this BBBbond might go into the asset pool of an ABS CDO
Mrtg 110 Mrtg 120
Mrtg Motg Mrtg 112 113 111
Mrtg 116
ABS CDO
Mtge Mtge Mtge Mtge 4 2 3 1 Mtge Mtge Mtge Mtge 5 7 8 6 Mtge Mtge Mtge Mtge 195 197 198 196 Mtge Mtge 10 9 Mtge 200
Reference Portfolio Collateral Pool

ABS Tranche 1 ABS Tranche 6 ABS Tranche 11 ABS Tranche 16 ABS Tranche 21 ABS Tranche 2 ABS Tranche 7 ABS Tranche 12 ABS Tranche 17 ABS Tranche 22 ABS Tranche 3 ABS Tranche 8 ABS Tranche 13 ABS Tranche 18 ABS Tranche 23 ABS Tranche 4 ABS Tranche 9 ABS Tranche 14 ABS Tranche 19 ABS Tranche 24
Mtge Mtge Mtge Mtge 194 192 193 191 591 791
ABS Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Tranche 5 392 393 394 395 396 397 398 399 400 391

ABS Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Tranche 10592 593 594 595 596 597 598 599 600

ABS Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Tranche 15
792 793 794 795 796 797 798 799 800
Bond Coupons ABS (L + Mtge Mtge Mtge Mtge Mtge bps) Mtge Mtge Mtge Mtge Tranche 20 995 994 997 Special 999 998 992 993 996 991 ABS Purpose Tranche 25 Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Vehicle Proceeds 1191 1192 1193 1194 1195 1196 1197 1198 1199 ($)

CDO Mtge Trust199
Assets RMBS Structure (Mortgages) Bonds
CDO
Note Coupon (L + bps)
AAA RMBS AAA Tranche
Mtge 1000 Mtge 1200
Proceeds Special ($)Purpose Vehicle
ABS Tranche 86
ABSCDO Tranche 1 ABSCDO Tranche 6
ABS Tranche 87 ABSCDO Tranche 2 ABSCDO Tranche 7
ABS Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge 1391 Tranche 901392 1393 1394 1395 1396 1397 1298 1399 1400

AA RMBS A RMBS AA BBB Tranche RMBS A BBB- Tranche RMBS Residual BBB Tranche Equity Tranche
ABSCDOMtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge 1591 Tranche 5 1592 1593 1594 1595 1596 1597 1598 1599 1600

ABSCDO Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Tranche 10 1791 1792 1793 1794 1795 1796 1797 1798 1799 1800
Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge Mtge 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
CDO Collateral Pool Can Include Tranches of Other CDOs

ABS Tranche 1 ABS Tranche 6 ABS Tranche 11 ABS Tranche 16 ABS Tranche 21 ABS Tranche 2 ABS Tranche 7 ABS Tranche 12 ABS Tranche 17 ABS Tranche 22 ABS Tranche 3 ABS Tranche 8 ABS Tranche 13 ABS Tranche 18 ABS Tranche 23 ABS Tranche 4 ABS Tranche 9 ABS Tranche 14 ABS Tranche 19 ABS Tranche 24 ABS Tranche 5 ABS Tranche 10 ABS Tranche 15 ABS Tranche 20 ABS Tranche 25 Bond Coupons (L + bps) Special Purpose Vehicle AA Tranche A Tranche BBB Tranche Equity Tranche
CDO Trust
CDO Structure
Note Coupon (L + bps)
AAA Tranche
Proceeds ($)
Proceeds ($)
ABS Tranche 86
17
Tranches (bonds) issued by other CDOs
Why Is It Difficult to Estimate the Value of an ABS CDO?

There is a collateral pool underlying each ABS tranche
ABS Tranche 1 ABS Tranche 6 ABS Tranche 11 ABS Tranche 16 ABS Tranche 21 ABS Tranche 2 ABS Tranche 7 ABS Tranche 12 ABS Tranche 17 ABS Tranche 22 ABS Tranche 3 ABS Tranche 8 ABS Tranche 13 ABS Tranche 18 ABS Tranche 23 ABS Tranche 4 ABS Tranche 9 ABS Tranche 14 ABS Tranche 19 ABS Tranche 24 ABS Tranche 5 ABS Tranche 10 ABS Tranche 15 ABS Tranche 20 ABS Tranche 25
ABS Tranche 86
(1) If the CDO collateral pool includes say 90 ABS tranches, you need to model the probability distributions of the cash flows of the 90 different collateral pools. These collateral pools can consist of many different asset classes, e.g. subprime mortgages from different regions, Alt-A mortgages, jumbo prime mortgages, commercial mortgages, credit card receivables, auto loans, student loans, airplane leases, etc. (2) For most asset classes, limited liquidity in underlying ABS makes it difficult to calibrate the models to market prices
19

Each underlying deal has a waterfall that must be coded
ABS Tranche 86
(1) Also need to code the rules for allocating the cash flows to the tranches issued by the 90 underlying securitizations. (These are called the deal waterfalls.) This is conceptually straightforward, but the rules can be complicated, and this step can be time-consuming and burdensome. (2) Plus you need to code the waterfall of the CDO itself. (3) In practice, often need to rely on a vendor who has already done this, e.g. Intex. But Intex does not cover the entire universe of securitizations.
20

The valuation problem can become orders of magnitude more complicated if the collateral pool includes tranches of other ABS CDOs
ABS Tranche 86
21
Tranches (bonds) issued by other CDOs
As an example, lets consider the cashflow model for a single asset class, subprime mortgages
Approaches that have been used to value RMBS

Net Asset ValueValue based on current net liquidation value of assets. Equity Tranche: Market value of reference assets (net of debt and other liabilities) divided by notional amount of equity issued. Debt tranches: Use debt coverage ratio as an indicator of risk ComparablesFind priced security with similar characteristics to security being valued (coupon, structure, rating, manager, ) Cash Flow Analysis Model securitization and tranche of interest (collateral pool, waterfalls, and triggers) Create scenarios for default, recovery and prepayment to generate cash flows from tranche over time Discount cash flows to obtain present value of security The cash flow approach can use fundamental or market-implied future default rates, and can use deterministic or stochastic (Monte Carlo) scenarios
Neil D. Pearson
23
Components of a cash flow model

Recovery model HPA model delinquency/default /prepayment model
The delinquency/default/prepayment model is the central component
cash flow model
valuation model
Term structure model
Neil D. Pearson
24
Mortgage Transitions
Month t Month t+1 Month t+2 Month t+3
pre-paid current 30-days 60-days 90-days default
If a loan transitions to become 60-days delinquent, in the next month it can either prepay, return to being current, transition to 30-days delinquent, remain 60-days delinquent, or become 90-days delinquent. Need models of the transition probabilities, or roll rates. For example, need a model of the probability that a loan becomes 30-days delinquent given that it is 60-days delinquent, that is we need P(30-day | 60-day)
Neil D. Pearson 25
Output of the HPA model consists of scenarios of simulated future house price appreciation rates, passed to the delinquency /default/prepayment and recovery models
Model Components
Recovery model
Output of the recovery model consists of simulated recoveries on foreclosed houses, which are passed to the cash flow model
HPA model delinquency/default /prepayment model
cash flow model
valuation model
Term structure model

Output of the delinquency/default Output of the term structure model /prepayment model consists of consists of scenarios of simulated scenarios of monthly prepayments, future short and long-term interest defaults, and delinquencies, which rates, which are passed to the are passed to the cash flow model delinquency/default/prepayment and D. Pearson Neil cash flow models
26

Cdos, Especially Cdo S of RMBS: Neil D. Pearson

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CDOs, Especially CDOs of RMBS

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

Various Types of CDOs

ABS CDOs; collateral can include:

Special Purpose Vehicle CDO Assets CDO Bonds

Bond Bond Bond Bond 14 12 13 11

AA Bond A Bond BBB Bond BBB- Bond Residual

Bond Bond Bond Bond 104 102 103 101

Bond Bond 110 109

Bond Bond Bond Bond 114 112 113 111

Bond Bond 120 119

Another name for a CDO bond is a tranche

Special Purpose Vehicle CDO Assets CDO Bonds

Bond Bond Bond Bond 14 12 13 11

AA Bond A Bond BBB Bond BBB- Bond Residual

Bond Bond Bond Bond 104 102 103 101

Bond Bond 110 109

Bond Bond Bond Bond 114 112 113 111

Bond Bond 120 119

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

Special Purpose Vehicle CDO Assets CDO Bonds

Bond Bond Bond Bond 14 12 13 11

AA Bond A Loan BBB Bond BBB- Bond Residual

Bond Bond Bond Bond 104 102 103 101

Bond Bond 110 109

Bond Bond Bond Bond 114 112 113 111

Bond Bond 120 119

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

Collateralized Loan Obligation (CLO)

Special Purpose Vehicle CLO Assets CLO Bonds

Loan 29 Loan 39 Loan 49 Loan 59 Loan 79 Loan 89 Loan 99 Loan 109

AA Bond A Bond BBB Bond BBB- Bond Residual

Loan 110 Loan 120

Loan Loan 115 116

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

Synthetic CDO (of Corporates)

Special Purpose Vehicle CDO Collateral Pool CDO Liabilities

CDO collateral pool

AA Bond A Bond BBB Bond BBB- Bond Residual

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

Synthetic CDO (of Corporates)

CDO CDO Collateral Liabilities Pool

CDO collateral pool

AA Tranche A Tranche BBB Tranche BBB- Tranche Tranche

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

100+ CDS on corporates

CDO tranches receive premiums

Next tranche Next tranche Next tranche Next tranche

Single-Tranche Synthetic CDO

100+ CDS on corporates

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

Synthetic CDO of Corporates

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

First need to consider the lower-level asset securitization

Copyright 2010, 2011 by Neil D. Pearson. All rights reserved.

Asset (Mortgage) Securitization

Special Purpose Vehicle Assets of the SPV Asset-Backed Securities

Mrtg Mortgage Mrtg 55 54 56

Mrtg 58 Mrtg 1298 Mrtg 98 Mrtg 108

Mrtg Mortgage Mrtg 79 77 78 Mrtg 89 Mrtg 99 Mrtg 109

AA Bond A Bond BBB Bond BBB- Bond Residual

Mrtg Motg Mrtg Mrtg 1991 1992 1993 1994

Mrtg Mrtg Mrtg Mrtg 1995 1996 1997 1998