Structural and collateral considerations.

This section highlights the credit support and payment features of CDOs, and their effect on the CDO transactions.

I. CREDIT SUPPORT AND PAYMENT STRUCTURES

1. SUBORDINATION

One of the most common forms of credit enhancement in CDOs is subordination of junior tranches. In the multi-tranche or senior/subordinated CDO the subordinated or junior tranches support the senior tranches. The issuance proceeds from debt and equity are used to purchase collateral (assets) generally with a principal balance equal to the rated debt amounts (liabilities) plus the equity share. Since the equity is not typically rated, the asset pool supporting the rated liabilities is greater than the rated liability amounts. Thus, there is a loss amount that the assets can sustain without immediately affecting any of the rated liabilities.

The payment priority waterfall in the transaction prioritizes the payments to each class of debt holders. In CDO payments are typically paid sequentially for the senior to the more subordinated tranches. Thus, holders of the senior debt tranche have priority of payment over the holders of any junior debt tranche. As a result of their subordinated status, the junior debt tranches generally are rated lower than the senior debt. However, the junior debt holders are compensated for the additional risk by being paid a higher interest rate.

2. OVERCOLLATERIZATION

Instead of using subordination, the senior liability class in the structure can also be supported by overcollateralization. In this structure, the rated class is supported by an excess of assets. The overcollateralization amount covers the estimated level of credit losses that the structure is expected to withstand without causing a loss to the holders of the rated senior tranche, in accordance with the risk expectations of the senior tranche rating.

Consider, for example, a cash flow transaction involving the issuance of $80 million of rated senior debt supported by a collateral pool with a total par value of $100 million. This "80/20" liability structure consists of 80% rated senior debt, and 20% unrated supporting debt or equity. The senior overcollateralization ratio (O/C ratio) equals 125% (100/80), which is defined as the ratio of assets over rated liabilities. The funds used for the purchase of surplus assets ($20 million in this example) are typically raised by the issuance of unrated equity.

The same level of credit protection for the senior class could have been provided through subordination by issuing $80 million of senior notes, $10 million of class B subordinated notes, $5 million of class C subordinated notes, and $5 million of unrated equity. If the transaction allocated losses from the equity tranche up, in all likelihood the class B and class C notes could have been given some rating lower than the rating of the senior class. This would likely lower the interest rate needed for payment on these tranches to less than if they were all part of the $20 million unrated equity. The rate would be lower because the class B is protected from losses by class C, and class C is protected from losses by the equity. If they were all part of the $20 million unrated equity, all investors would have faced a loss after the first default. Hence, creating different tranches in a structure with different payment priorities allows the issuer to create different risk/reward profiles. This is the concept behind CDOs, where the lowest class in the structure takes the first loss. By segregating the risk/reward profile of the portfolio, the senior tranches of the CDO can be rated higher than the average rating of the pool. However, because the equity investors take on the first loss risk, they demand high rates of return.

3. PAYMENT ALLOCATIONS

The manner in which collateral principal payments and losses are allocated among classes has a large impact on the level of credit support each tranche has over time. All payment structures represent different trade-offs between paydown and support of the senior class, versus return of cash to the junior debt and equity holders. There are several types of payment structures, of which the most commonly used are sequential pay, pro rata, and fast pay/ slow pay. It is worth noting that though this discussion mentions three different payment structures, the sequential payment structure with fast pay features is by far the most common structure used in CDOs.

4. SEQUENTIAL PAY

These structures require payment of senior debt in full before the payment of junior debt. In the 80/20 example discussed earlier, the $20 million subordinated class would remain outstanding until the entire $80 million senior class was retired. Clearly, as the $80 million senior notes pay down, the effective senior O/C ratio builds to well above 125%. In such structures that pay senior debt first, senior debt holders benefit from an increase in credit enhancement as the portion of subordinated debt grows in relation to total debt.

5. PRO RATA PAYDOWN

In this structure, available funds are allocated to pay down principal on the rated debt in proportion to the size of each tranche. Thus, the degree of overcollateralization is maintained at the same percentage, until retirement of the senior class. In the example above, the overcollateralization would be maintained at the 80%/ 20% level, assuming no losses occur. Subordinated investors will be paid out at the same time as the senior investors assuming no losses occur and there are no credit support floors in the deal. Thus the hard dollar amount of credit support to senior noteholders decreases as time goes on. If losses are incurred, the loss amount is allocated to the lowest tranche first. Thus in the example, the lowest tranche would receive less than 20% of the principal collections.

Given that collateral pools are lumpy and defaults can occur at any time, the pro rata paydown does not protect senior noteholders as well as sequential paydown. Assume in the previous example that there were only $20 million in assets outstanding with no defaults having occur. At that point, 80% of the debt would be senior ($16M), and 20% would be subordinated ($4M), the same proportions as at the start of the transaction. If at that point the transaction would incur a $5 million dollar loss, only $4 million would be allocated to the subordinated tranche, and the senior tranche would lose $1 million. If the transaction had paid down scquentially, however, the senior class would have been retired once only $20 million of assets were outstanding, and would have not suffered any loss. For this reason, pro rata structures are not optimal for CDOs and typically must have hard dollar floors of credit support.

6. FAST PAY/SLOW PAY STRUCTURES

This structure pays down both classes, but pays down senior debt faster than the junior debt and at a higher rate than pro rata. Like sequential pay structures, these structures typically require a "minimum par value overcollateralization ratio," in which the ratio of assets over liabilities must be maintained at a minimum level, for example, of at least 125%. If this test is breached due to defaults or trading losses, a higher percentage or all of the collateral cash flow will be used to pay senior debt until compliance is restored. If excess funds are available after meeting senior and junior debt service and coverage requirements, they may be used to pay down junior debt, even before senior debt maturity.

A variation on the fast pay structure is a turbo paydown of junior notes with excess interest proceeds when the coverage tests for the senior notes are satisfied and the coverage tests for the junior notes are not satisfied. In this structure, excess interest is used to pay down the most costly debt, and in effect substitutes overcollateralization for subordination, since the par amount of assets does not decrease as the subordinate class is paid down. While these structures do provide some benefits, in general they may be harder to model since transition between triggers is difficult to accurately predict.

II. OTHER CREDIT SUPPORT

1. CASH COLLATERAL OR RESERVE ACCOUNTS

Cash collateral or reserve accounts are another form of credit enhancement. Excess cash is held in highly rated and liquid investments that provide security to the debt holders, generally in an account under the control of a trustee or custodian. Cash reserves are often used in the ramp-up phase of a cash flow transaction. During this phase, cash proceeds from the sale of CDO securities can be used to purchase the underlying collateral and to fund reserve accounts.

Cash reserves may not be the most efficient form of credit support because of the relatively low assumed interest rate earned on the eligible investments held in the reserve account. As interest owed on the CDO securities is typically higher than the interest earned on these reserves, allocation of cash to reserve accounts can result in "negative carry". The benefits of accumulating cash balances in the structure somewhat offset the lower interest earnings.

2. EXCESS SPREAD OR INTEREST

When the all-in interest rate earned on the assets is higher than the all-in interest and fees paid on the rated CDO securities, excess spread or interest is generated. The difference, commonly seen in arbitrage structures, occurs because the bond and loan assets are rated lower, on average, than the rated debt, and thus earns higher coupon or spread. Under normal circumstances when credit loss is low, the excess interest is typically distributed to equity holders and is not needed to support debt holders. When credit loss exceeds a certain predetermined level, excess interest can be redirected to either sequentially pay down notes or be used to purchase additional assets. Either way, overcollateralization increases credit support to noteholders.

3. DEFAULTED OBLIGATIONS

Unless the transaction is a Distressed CDO (see the "Distressed Debt CDOs" section in "Spccial Topics") collateral generally should not, on inclusion in the portfolio, be a defaulted obligation. This requirement is very analogous to the now ubiquitous asset eligibility parameter specifying that an asset, upon inclusion in the portfolio, not be a credit risk obligation, or an asset which, after the date of purchase, has a significant risk of declining in credit quality and, in the subjective judgment of the collateral manager, has a significant risk of becoming a defaulted obligation with a lapse of time.

A defaulted obligation is defined solely flora the perspective of the CDO transaction as specified under the definition of defaulted obligation. The collateral asset in question may not actually be in default under the terms of the underlying instrument. Nonetheless, the asset is highly unlikely to provide the ongoing interest and/or principal payments necessary to fund the CDO's liabilities.

Defaulted obligations are fundamentally securities for which there has been a failure in the payment of principal and/or interest that has occurred, and is continuing, with respect to that debt obligation (i.e., a default). Such failures are without regard to any credit-related grace period or waivers permitted under the terms of the security.

In connection with this CDO-focused definition of default, it is important to highlight that for corporate/ sovereign obligations, in the majority of circumstances Standard & Poor's requires the use of the issuer credit ratings (ICR) in lieu of asset's individual rating to assess the credit worthiness and default probabilities of the collateral pool. Accordingly, even where the securities arc current on their payment, a defaulted obligation is generally defined broadly so as to include those assets for which:

* A default in the payment of principal and/or interest has occurred and is continuing on another debt obligation of the same issuer which is senior or pari passu in right of payment to that debt obligation (the relevance is obvious where both debt obligations are full recourse obligations);

* The issuer or others have instituted proceedings to have the issuer adjudicated as bankrupt or insolvent or placed into receivership and such proceedings have not been stayed or dismissed or such issuer has filed for bankruptcy protection; or

* Standard & Poor's has assigned an issuer credit rating of "D" or "SD" to the issuer. The collateral manager is also afforded the flexibility to deem any security a defaulted obligation for reasons other than those specified.

Application of defaults to synthetic securities in CDOs is the same as for synthetic CDO structure and includes publicly documented rescheduling. A synthetic security is deemed a defaulted obligation where either the counterparty of the synthetic security is in default under the terms of the security, or the reference obligation of the synthetic security would be a deemed a defaulted security. If the counterparty defaults in synthetic CDOs, this most likely is deemed a transaction event of default and not an event of default for the reference obligation.

Standard & Poor's allows two "carve outs" for performing securities while the issuer carries an ICR of 'D' or 'SD'. One such carve out is debtor-in-possessing (DIP) financing. These facilities are set up after the obligor has filed for bankruptcy and are senior to the other obligations. DIP financing allows companies to operate during bankruptcies and is approved by the bankruptcy court. As such, DIP securities are not defaulted obligations even if the issuer had an ICR of 'D' or 'SD'. To the extent that DIP financings are included in collateral pools, they are included in limited concentrations, are carried at par value, and must have a Standard & Poor's rating which typically is higher than D.

The other carve out is where collateral assets are technically defaulted obligations but currently paying interest and principal nonetheless. Limited (5% or less) "current pay" buckets may be used in transactions if such buckets include the following defaulted obligations:

* Obligations that have paid in cash the most recent interest payment and principal payment due;

* The collateral manager subjectively expects that the next interest and/or principal payment due will be paid in cash;

* The obligations have a market value greater than a threshold amount (e.g., 80% of par); and

* If the issuer of such a security is subject to a bankruptcy proceeding, a bankruptcy court has authorized the payment of interest due and payable on the collateral obligation.

Obligations that display these characteristics are not very common. For the purposes of the CDO Evaluator, such obligations are deemed to be 'CCC-' unless a different instrument rating is assigned by Standard & Poor's.

The primary impact of deeming assets as non-current pay defaulted obligations is to the overcollateralization tests of the transaction. Defaulted obligations are afforded more onerous treatment since they are carried at the lesser of the Standard & Poor's-assigned recovery rate and fair market value in lieu of par. Current pay bucketed securities are generally treated at the lesser of fair market value and the par amount or some haircut of par, for so long as they continue to satisfy the definitional requirements of such buckets.

Although not generally defined as defaulted obligations, collateral obligations which by the terms of the underlying instruments permit the deferral of payment of accrued, unpaid interest (often referred to as PIK assets) are often grouped together with defaulted obligations by market participants. The association is attributed to the similarity in treatment.

PIK assets for which interest has been deferred and capitalized for each consecutive payment date occurring over a period of 12 months are afforded the same onerous treatment in overcollateralization tests as defaulted obligations. Until such time as payment of interest is resumed and all capitalized and deferred interest is paid in cash in accordance with the terms of the underlying instruments, deferring PIK assets are carried at the lesser of fair market value and the assigned recovery rate. While PIK assets are treated as defaulted for the purposes of the O/C and I/C tests, Standard & Poor's puts no requirement that the collateral manager follow the recovery process as for defaulted securities, unless the manager deems them defaulted.

The market value treatment of defaulted obligations mad deferring PIK assets is of significant focus in a down credit cycle. Negative ratings migration and credit deterioration manifest into the greater potential failure of overcollateralization test triggers. De-levering of liabilities may occur with increased frequency mad severity. It is important to note however that there is no requirement by Standard & Poor's to sell defaulted obligations and/or deferring PIK assets. Such a forced liquidation of collateral exposes transactions to the obvious risks associated with fire sales, thus Standard & Poor's would rather have the collateral manager use best judgment in such cases.

IV. LIQUIDITY CONSIDERATIONS IN CDOS

CDO rating analysis addresses credit and liquidity considerations to determine whether asset cash flows will assure timely payment of interest of the rated liabilities. Liquidity is a paramount concern in cash flow CDOs because the timely payment of a CDO's liabilities depends on the timely payment of the underlying assets. Assets which do not pay timely interest in cash may lead to a shortfall of cash within a particular due period and create a liquidity problem for the rated liabilities. In general, Standard & Poor's encourages each CDO transaction to include an aggregate percentage limitation on the type of assets that do not pay timely interest in cash. However, once the aggregate percentage limitation is specified within a specific CDO transaction, Standard & Poor's goal is to evaluate and analyze the impact of these types of assets on the rated liabilities.

There are several types of assets, which appear in cash-flow CDO transactions, that do not pay timely interest in cash: zero-coupon securities, securities with a mismatch in payment frequency in comparison to the rated liabilities (i.e. a semi-annual paying asset in a quarterly-paying liabilities CDO transaction), and PIK securities. Each of these assets is treated generally in the following sections.

ZERO-COUPON SECURITIES

A zero-coupon security is a security that makes no scheduled interest payment but instead is sold at a discount from its par value. A CDO transaction that purchases a zero-coupon security cannot rely on a periodic stream of interest payments in cash from this type of security. As a result, zero-coupon securities must be treated for the purpose of the interest coverage tests and the par value tests, as follows:

* For the purpose of the interest coverage test, zero-coupon securities are excluded from the calculation of interest coverage because the security is not generating a predictable stream of interest in cash.

* For the purpose of the par value test, zero-coupon securities are included at their accreted value instead of par value to capture the discounted value of a security that does not make periodic interest payments.

* For the purpose of eligibility criteria and the inclusion of zero-coupon securities in a CDO transaction, Standard & Poor's has traditionally accepted a 5% limitation on such inclusion without imposing special modeling requirements, provided that a specific CDO transaction can demonstrate that it can make timely interest payments on the rated liabilities with a 5% allocation to zero-coupon securities.

V. MISMATCH IN PAYMENT FREQUENCIES

1. DIFFERENCES IN PERIODICITY 

This risk arises when the frequency with which payment is received on assets differs from the frequency with which payments must be made on the rated securities. The risk is compounded when payments on different assets are received with different frequencies. For example, some of the assets may pay interest quarterly, while others may pay semiannually. If the assets pay interest more frequently than the liabilities, then the transaction is subject to negative carry. If the assets pay interest less frequently than the liabilities, then the transaction is subject to liquidity risk.

These mismatch risks can be addressed in various ways. One example is a hedge agreement, such as a total return swap, with an 'AAA' rated counterparty that will pay the interest deficiency. Another example is a set of collateral and portfolio guidelines designed to limit the risks, such as a maximum limit on assets paying interest less frequently than liabilities (as well as coverage calculations to properly track this). In addition, a reserve can be funded for differences between the interest coverage ratio for different due periods.

2. DIFFERENCES IN PAYMENT DATES

This risk arises when the dates on which payments are received on assets are different from the dates on which payments must be made on the rated securities. This risk may partly be a result of differences in periodicity, or simply a result of differences in payment dates without any differences in periodicity. For example, in a transaction in which all the assets pay quarterly interest, some assets may pay in January, April, July, and October, while other assets may pay in February, May, August, and November.

3. PAYMENT-IN-KIND

Payment-in-kind (PIK) securities are those securities that have the ability to defer and capitalize current interest without triggering an event of default under their terms of issuance. PIK securities pose an interesting concern for a CDO transaction because there is no guarantee that these assets will resume current interest payments in cash or will repay the interest that has been deferred and capitalized and the interest due on such deferred interest. As such, PIK securities must be treated in a special manner as discussed below, for the purpose of the interest coverage tests and the par value tests.

For the purpose of the interest coverage test, the interest due on PIK securities is excluded from the interest coverage test once a payment of interest has been deferred. Once the PIK security resumes paying current interest in cash, the cash flow is once again included in the interest coverage test.

For the purpose of the par value test, the PIK securities are treated in a special manner. If a PIK security is current on its interest, and if it is not included at a lesser value for some other unrelated reason, it is included in the par value test at its par value. However, if a PIK security misses current payment of interest for a year, such PIK security is treated in a manner similar to a defaulted security and is included in the par value test at the recovery value assigned to this type of security. In order for a PIK security to be included at its par value in the par value test once again, it would have to resume its current payment of interest in cash and repay the interest that has been previously deferred and capitalized.

In addition, if the percentage of PIK securities within a CDO transaction exceeds 5%, it is likely that Standard & Poor's will request that the excess of the 5% of these securities be subjected to additional liquidity stresses to demonstrate the transaction's ability to pay timely interest on the rated liabilities.

A special consideration is given to PIK securities within a CDO of CDOs transaetion, where a great percentage (up to 100%) of the underlying assets may pay ha kind. PIK securities may pay in kind indefinitely without triggering an event of default until maturity, in accordance with their terms of issuance. As a result, liquidity within a CDO transaction with underlying CDO assets may be severely compromised by a large number of noncurrent-pay assets. The special treatment accorded to these assets for the purpose of the interest coverage tests and the par value tests becomes especially important to monitor the potential liquidity risk to the rated liabilities.

In addition, third-party liquidity providers are often engaged to provide payments of timely interest on the rated liabilities. The third-party liquidity providers covenant will pay the interest shortfall due on the rated liabilities that are caused by underlying assets that go into payment-in-kind mode. Third-party liquidity providers should stop advancing monies when the PIK securities are deemed defaulted for the purposes of the par value test in order to avoid becoming de facto credit support and financing underlying assets that may not come back into compliance.

VI. INTEREST RATE HEDGING

As previously mentioned, most cash flow CDO transactions have interest-rate hedges to mitigate the risks between fixed-rate assets and generally floating-rate liabilities. Synthetic CDOs also use interest-rate hedges in a variety of ways to insure sufficient interest will be available to pay investors and mitigate interest rate movement risks. Such hedges are generally structured under ISDA documentation following Standard & Poor's criteria presented in the "Hedging Considerations" section.

In cash-flow transactions, a variety of swaps and caps are typically employed. When testing cash flows, Standard & Poor's uses different interest paths to test the sensitivity of the transaction to movements in interest rates. Since each transaction is different, there is no ideal hedging structure and Standard & Poor's does not require any particular hedging strategy. All Standard & Poor's requires is that the transaction is hedged to pass Standard & Poor's interest-rate stresses and that hedge termination payments due to any counterparty in cases where assets default or the counterparty defaults, do not jeopardize payments to noteholders.

The majority of arbitrage cash-flow transactions use a combination of swaps and caps to achieve this goal. Typically the transaction has one general swap at a set notional amount covering the entire reinvestment period. Then the notional of the swap is reduced based on the anticipated maturity profile of the assets. Typically in the amortization period, the swap notional amortizes rapidly, and additional caps are used to mitigate the risk of a high interest-rate environment. The caps also typically have an amortizing notional.

The amount of swap/cap required is a function of the fixed and floating percentages in the asset pool and the fixed to floating amounts of rated liabilities. Since in most transactions, the percent of fixed and floating assets may vary over time, Standard & Poor's stresses cash flows assuming the minimum and maximum amount of fixed and floating assets. In certain cases Standard & Poor's also biases the defaults between fixed and floating assets to see if the transaction is sufficiently robust.

The hedges are generally independent of the asset's defaults, and do not change notional amounts based on the levels of defaults occurring. The notionals may however be changed during the life of the transaction if the collateral manager wishes to do so, and with rating agency affirmation. Since the cash flows are modeled with the asset pool balance decreasing due to defaults, while the swap notional stays as contracted, there must be sufficient liquidity in the deal to allow ongoing hedge payments to the counterparty under even the most stressful rating scenarios. There must also be sufficient liquidity in the deal to pay senior interest on all non-PIK tranches.

The strategy of using a number of hedges to cover the entire asset pool is employed in most arbitrage transactions. In certain cases, however, the sponsor proposes to use asset-specific swaps to cover interest-rate risks. If properly structured, such swaps may be used, as long as the default of the asset does not trigger a termination payment payable to the swap counterparty high in the waterfall. The risk is that if an asset with an asset-specific swap defaults while the SPE is out of the money, the SPE might not have sufficient money to pay the termination payment while meeting the timely payment of interest requirements. Standard & Poor's rating methodology can establish the level of default expected in the asset pool at different rating levels, but it is difficult to identify which particular assets will default, and when. Thus if an asset has an asset specific swap that must be terminated with any payment due, it is extremely difficult to predict what the termination payment will be and when. This makes cash-flow modeling almost impossible.

For these reasons, Standard & Poor's allows asset-specific swaps in transactions only if they are structured with no termination costs due from the SPE to the counterparty, or if such termination payments are subordinated below the rated noteholders.

Asset-specific swaps in CDOs also make trading and reinvestment more difficult. The collateral manager must either sell the swap with the asset, or find an asset that matches the payment characteristics of the old asset under the swap. Even if they succeed in selling the asset and the swap, then they either have to buy an asset that does not need a swap or find an asset and a corresponding swap. Because of all these considerations, asset-specific swaps are not widely used in hedging interest rate risks in CDOs. Nevertheless, they may be employed for assets that have unique payment characteristics and requirements

VII. FOREIGN-EXCHANGE HEDGING

As CDO transactions are increasingly becoming global products, naturally the need to incorporate foreign-currency hedges has also grown. This is driven both by the desire to broaden the asset pool as well as the need to broaden the number of investors. For example, European euro-denominated transactions may want to diversify the asset pool by including some U.S. dollar-denominated assets. At the same time, an Asian bank that has noneuro loans may want to increase the investor universe for its CDOs by offering euro-denominated notes.

Ideally, the FX swap would take currency as received on the asset and would convert it at the set rate. This swap would be outstanding for the lift: of the asset or until a recovery is achieved on a defaulted asset. The swap would then terminate with no termination payments. Unfortunately, such swaps rarely exist and are expensive since the swap counterparties must balance their positions though other swaps.

To achieve effective foreign-currency hedging, a number of different strategies, as outlined below, have been employed. There is not a single best strategy that can be used, but rather the most appropriate strategy depends on the specifics of the transaction and the level of foreign currency mismatch between the assets and liabilities. Standard & Poor's does not recommend any one particular strategy over the other, hut rather will analyze each deal on its merits and work with the sponsor in evaluating different solutions. Some of the possible strategies to mitigate FX risk are described below.

1. MODEL THE RISK

Standard & Poor's has developed a foreign-exchange model that uses the extreme value theorem to generate foreign-exchange appreciation and depreciation curves between any number of major currencies, under different rating scenarios. Using these curves, it is possible to model the results of a transaction that uses no foreign-currency hedges. While this is possible, it has not proven practical on a large scale since the depreciation risks are somewhat large and render the transaction uneconomical. For example, in a 'AAA' rating scenario, the American dollar-British pound depreciation exceeds 40% over 12 years. Thus the transactions must have large amounts of overcollateralization to support such foreign-exchange movements. Nevertheless, such curves are very useful to model transactions that have some levels of foreign-exchange hedges but are not perfectly hedged.

2. ASSET-SPECIFIC SWAPS

A number of transactions have incorporated asset-specific swaps to broaden the asset universe for the collateral manager. These are most commonly seen in European transactions denominated in euros that purchase a number of U.S. dollar assets to diversify the asset pool. Such swaps typically have no termination payments due should the asset default. The same asset specific hedge considerations as outlined in the Interest rate hedge section above apply to these swaps.

3. SINGLE FX SWAP FOR THE ENTIRE POOL OF ASSETS

As in the case of interest rate swaps, it is possible to use a single swap to cover a pool of assets that pay in a different currency. The swap would have a set notional schedule and pay the corresponding amount in the other currency based on the set exchange rate. Such swaps work best if all the asset pool is in one currency and the rated liabilities in another. For such swaps, the cash flow modeling stresses would principally focus on making sure that sufficient currency is generated by the assets while defaulting and recovering to make sure the SPE can meet the payment due under the swap.

4. SINGLE FX SWAP FOR PART OF THE ASSET POOL

In this case only some of the assets are in a different currency (say, 30% of the pool) and the rest are in the same currency as the liabilities. In such a case, it is possible to get one swap that would cover the entire FX exposure as outlined in the paragraph above, but the analyses becomes more complicated.

The complication arises for the fact that if defaults were sized based on the entire pool, it is very difficult to predict how much of the defaults would occur in each currency. It is possible to bias default in one currency or the other and model accordingly, but often this produces inefficient transactions.

To get around these problems, it is possible to model the transaction as consisting of two different asset pools, with one pool being in a different currency and having a FX swap. The default rate on each pool would be set separately by running each individual pool through the CDO Evaluator. Then separate cash flow runs would be run under the usual stresses on each pool, and the payments would be combined to pay the noteholders. Because the pools are independent, the cash flows must also stress the entire possible combinations of default timings mad patterns that may occur between the two pools.

This type of analysis is more stressful, because in general the asset pools are smaller, hence there is less diversification and the default rates are generally higher. In addition, tighter eligibility and reinvestment criteria may be imposed on each pool to keep it within the needed parameters. Thus there is a higher risk that the collateral manager may not be able to find the right investments. Because of the constraints, this structure may be best suited for static pools, but nevertheless, a number of both static pool and revolving transactions have been done this way.

5. OPTIONS ON HEDGE NOTIONAL

One other strategy to deal with the FX risk is to hedge the FX pool of assets; then purchase a number of options to reduce the notional amount of the hedges should assets defaults. Such options should be purchased upfront and be available to be exercised without the SPE incurring additional termination costs. If a FX asset defaults, then the collateral manager can exercise part of the options to reduced the hedge in line with the estimated loss and still have sufficient hedges to also cover expected recoveries.

Standard & Poor's would analyze the respective asset pools and establish default and recovery parameters, then see if the proposed level of options is sufficient. The cash flow would then be modeled assuming such options are exercised as needed. Obviously this places additional requirements on the collateral managers since they must be able to demonstrate that they have the ability to manage and properly exercise the swap reduction strategy. While options are generally expensive, a good number of transactions have successfully closed using this strategy.

6. COMBINATION OF STRATEGIES

A handful of deals have been done employing a combination of all of the above FX risk management strategies. Such deals generally have employed a combination of asset specific and pool asset swaps. Then they also purchased a number of different options to adjusting the notional of the swaps, but they left a small part of the structure unhedged. Needless to say, such deals are much more difficult to model, and the collateral manager must demonstrate that they have knowledge of hedging.

VIII. SYNTHETIC SECURITIES IN CASH FLOW CDOS

Many traditional cash flow CDO structures allow for the purchase of synthetic securities as eligible collateral. Typically, the amount of collateral that may be purchased in synthetic form is approximately 20% of the total portfolio, based on investor requirements. Synthetic securities are commonly defined as derivative structures that expose the holder of such securities to the credit risk of two or more entities. As a result, these securities are classified as bivariate or multivariate risk instruments that contain risks that are not fully measured by the single jurisdiction CDO Evaluator model. Consequently, these instruments require additional review to measure the ultimate default probability of the instruments as well as any expected recovery value. Examples of synthetics include credit-linked notes and credit default swaps. Most CDO structures will require rating confirmation prior to the purchase of such instruments.

Standard & Poor's rating confirmation will be contingent upon review of all documentation related to the structure of the synthetic instrument, including any SPE documents, trust agreements, and hedges. Furthermore, all relevant ISDA documentation including schedules and confirmations will be reviewed. Once the confirmation process is completed, Standard & Poor's will assign a default probability to the instrument as well as an estimated recovery value for Standard & Poor's modeling purposes.

The default probability assigned will reflect a number of factors including the issuer credit rating of a reference entity, the risk which is being transferred by the counterparties, as well as any counterparty's rating to the extent that the CDO is relying on payments (i.e. premiums) to be received from such counterparty on an ongoing basis. Recovery assumptions will reflect the CDO manager's expertise, the level of security supporting the reference obligation as well as the settlement provisions provided for in the derivative contract. To the extent that the derivative provides for physical settlement of the contract upon a credit event, recovery levels should approximate the assumptions normally afforded to the respective reference obligation.

However, if the derivative contract requires cash settlement, recovery assumptions will be significantly lower since the CDO may be exposed to a depressed price on the reference obligation since most market price calculations would occur relatively shortly after the credit event occurred with respect to the reference obligor.

As an alternative to obtaining rating confirmation prior to the purchase of each synthetic instrument, CDO managers may obtain approval for a template for future synthetic transactions, also known as a "form-approved synthetic." The "form-approved synthetic" will be a defined term in the CDO indenture and will reference a specific derivative template that will be an appendix to the CDO indenture. The template will be reviewed by Standard & Poor's prior to execution and may serve as a basis for future trades that conform in all material respects to the approved template, alleviating the need for rating confirmation prior to each individual trade. Although rating confirmation will not be required prior to the execution of individual trades, Standard & Poor's will still require, on a post-closing basis, notification of the trade as well as receipt of all relevant documentation in order to assign the appropriate default probabilities and recovery assumptions related to each derivative contract.

HENRY C. ALBULESCU is a director in Standard & Poor's CDO Ratings group. He is currently responsible for Standard & Poor's global CDO criteria development and analyzing new CDO structures. Before joining the CDO group, Henry rated asset-backed securities supported by various asset types, including automobile loans and leases, student loans, and export receivables.

Prior to joining Standard & Poor's in 1995, Henry was CFO of a manufacturing company. He also managed the Business Analysis and Consulting group of Skadden, Arps, Slate, Meagher & Flom and worked in strategic planning for Mellon Bank.

Henry holds an M.B.A in finance and accounting from Columbia University Graduate School of Business and a B.S. in chemical engineering from Lehigh University.

Henry C. Albulescu

Standard & Poor's