You are on page 1of 59

CDO training program

CONFIDENTIAL

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

CDO Technology Overview

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

CDOs

Concept is derived from securitisation Pool, tranches Pool with a very minimum of 10 to 20 assets Below 10 / 20 assets => Exotic Credit Derivatives area Usually the minimum is 50 (optimal number = 100 to 120 assets) Tranches = debt securities format Senior (super-senior = AAA tranche) Mezzanine (upper, lower) Equity (most junior debt) Also called first loss tranche

Less risk SENIOR MEZZ. EQTY.

More risk

CDO training program

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

CDOs (contd)
Senior: 80 Mezz : 15 Eqty : 5

Mecanism Lets assume the following tranching

Pool 100

and 3 different senarios: If over the CDO life, the cumulative losses of the pool = 3
Senior tranche is not hit Mezz tranche is not hit

Increasing number of defaults

Equity tranche is hit by 3

Eqty tranche investors partially lose their investment

If over the CDO life, the cumulative losses of the pool = 10


Senior tranche is not hit Mezz tranche is hit by 5 Mezz tranche investors partially lose their investment EQTY tranche investors lose all their investment

Equity tranche is totally hit (by 5)

If over the CDO life, the cumulative losses of the pool = 25


Senior tranche is hit by 5 Senior tranche investors partially lose their investment Mezz tranche investors lose all their investment EQTY tranche investors lose all their investment
4

Mezz tranche is totally hit (by 15) Equity tranche is totally hit (by 5)

CDO training program

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Different Asset Classes

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Different Asset Classes


Corporate risks High Grade High Yield Mix of both Asset Backed Securities (ABS) 2 main caracteristics: Default rate < to those of corporate assets class Relatively higher stability of ratings (more resilient to economic downturns) SME Loans (small & medium companies) CDO tranches ( CDO-squared)

CDO training program

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Different Structures

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Different types of structures: 4 criteria

Objective

Balance Sheet vs Arbitrage CDO

Balance sheet = credit portfolio management, reglementary issues, capital optimization, Arbitrage = taking advantage of the difference between the average return on the reference portfolio and the payments made to the tranches investors (= excess spread) Transfer mode Cash vs Synthetic

Cash = True sale of the underlying credit assets portfolio Synthetic = risk transfert via CDS Cash Flow CDO vs Market value CDO Cash flow = CDO revenues driven by those of the underlying credit assets portfolio + revenues allocation to investors according to note seniority (= cash flow waterfall) Market value (CDS based technology) = CDO performance linked to the variation of the underlying credit assets market value Static vs Managed CDO Static = Credit assets reference pool is defined at implementation and remain unchanged during all the life of the transaction Managed = Credit assets reference pool can fluctuate over time according to CDO manager trading decisions

CDO training program

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Flurry of innovations wont be discussed


CDO^2 CPPI (Constant Proportion Portfolio Insurance) CPDO CDO with equity buckets Mix between debt and Eqty in order to enhance the CDO return profile L/S (Long / Short structure) Hedging vs market spreads variations Etc

CDO training program

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Lets focus on 3 cases


Funded Loan Securitisation Partially Funded Synthetic CDO Single-tranche synthetic CDO

CDO training program

10

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Cash CDO / Funded Loan Securitisation

Bank = Transaction Sponsor / Manager


Borrower 1 Borrower 2 Borrower 3
Loan agreement Loan agreement Loan agreement Management Agreement

SPV
Assets Liabilities Senior Debt AAA
Face value = 66.5% EURIBOR + 45bp Notes

Investors = protection providers


Senior exposure

Reference pool Assets face value = 100% True sale

Pool of credit assets Assets face value = 100%

Mezzanine BB
Face value = 20% EURIBOR + 90bp

Notes

Intermediary exposure

Cash Borrower 4
Loan agreement

(=Notes proceeds)

Equity
Face value = 13.5%

Notes

First loss exposure

The bank selects a pool of loans to be securitized


Notes proceeds

CDO training program

11

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Funded Loan Securitisation (contd)


Named Cash CLO (Collateralised Loan Obligation) True sale to an SPV for the full amount of the CLO The SPV can already exist, but in most cases, it is created for the sole purpose of the CDO SPV issues rated securities (with various tranches from AAA/Aaa to BB/Ba3 in general) that are all placed to Investors Securities rated by rating agencies (S&P, Moodys, Fitch, ) Rating based on Default statistics (historical data) Sponsors commitment = Equity retention Bank commits itself to keep the first losses unhedged in order to prove its good faith to investors vs any arbitrage temptation Many drawbacks (= heavy structure) but some advantages in terms of funding stability (vs synthetic CDO that are non-funded structures) Good for banks with weakening rating interest level (swap rate + spread) defined the day the structure is implemented and remains unchanged through the life of the deal (=usually 5 years) In terms of rating

CDO training program

12

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Partially Funded Synthetic CDO


Bank A

AAA: 90% Reference potfolio of credit assets

Super senior CDS Premium (20bppa)

Bank B
(20% BIS weighted)

Non funded part


2. Pledge Collateral

Portfolio tranching
AAA: 3% A: 3% BBB: 3% EQTY : 1%

SPV Subordinated CDS Premium Treasuries


(0% BIS weighted)

CLN : 9%
EQTY: 1%

Cash

Intermediary exposure

Funded part
First loss exposure

1. Pledge Collateral

Collateral (Treasuries)

Notes proceeds

Cash

Market
Eqty tranche can be kept by the bank in order to enhance the risk profile of the structure
1. Pledge collateral to Bank A:

Neutralizes bank A exposure towards SPV Enables bank A to benefit from a 0% BIS weighted treatment
2. Pledge collateral to investors:

Neutralizes investors exposure towards Bank A credit risk Enables Bank A to issue AAA rated notes though itself rated AA (or below)

CDO training program

13

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Partially Funded Synthetic CDO (contd)

Focus on reg. Cap. Optimization (Basle I)


RWA & Capital before securitization of the pool (H): Pool = fully drawn corp. credit assets for a total amount of 100MEUR RWA = 100MEUR Reg cap RWA * 8% = 8MEUR RWA & Capital after securitization of the pool Super senior tranche RWA = 90MEUR * 20% = 18MEUR Reg Cap = 18MEUR * 8% = 1,44MEUR Mezz tranche RWA = 9MEUR * 0% = 0MEUR Reg Cap = 0MEUR * 8% = 0MEUR Eqty tranche Reg Cap = 1MEUR (1:1 ratio)

New total RWA = 18MEUR

Such synthetic CDO deal : Enables the bank to reduce its RWA from 100MEUR to 18MEUR Leaves Tier 1 component of Reg cap unchanged (pre and post securitization) Enables a huge benefit on the [Core Reg Cap / RWA] ratio that is dramatically increased Eqty tranche nominal deducted from Tier3 component on a 1:1 basis

CDO training program

14

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Single tranche Synthetic CDO

Bank A

AAA: 90% Reference potfolio of credit assets

Portfolio tranching
AAA: 3% A: 3% A: 3% BBB: 3% EQTY : 1%

Subordinated CDS Premium (45bppa)

Protection provider

Correlation desk Delta hedging Position dynamically managed vs long & hold strategy type

CDS Market

CDO training program

15

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Single-tranche Synthetic CDO (contd)

Only one tranche is created and sold to an investor. The capital structure is not entirely distributed Single-tranche synthetic CDOs are also called Bespoke tranches Indeed, the investor can customize various caracteristics (= portfolio composition, term, rating,tranche size, subordination, ) Structure that can be self managed or externally managed Bilateral instrument (= no distribution) Non publicly rated structure Correlation desks are the natural counterparties Correlation desk traders Delta-hedge their position in the CDS markets Tranche underlying names need to be liquid Pricing & rating of single tranches will now be examined in part 2

CDO training program

16

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Base Case Loss distribution characteristics

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Base Case CDORom use

Let our base case be an homogeneous portfolio with 200 names with a nominal of 100M each Equally weighted, 0.5% each With the same 3-year bullet tenor for all the names With the same 1.71%- PD for all names (typically they are all Baa3) With the same 30% recovery rate for all names The key parameter discussed is correlation In our base case, we assume a level of correlation at 10% Correlation is supposed to be the same across the portfolio Pool total nominal = 20.000M

CDO training program

18

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Base Case - Portfolio Loss distribution graph

Loss Distribution 20.00% 18.00% 16.00% 14.00% % of portfolio loss 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 0.0% 1.5% 3.0% 4.5% 6.0% 7.5% 9.0% 10.5% 12.0% 13.5% 15.0% 16.5% 18.0% 19.5% 21.0% 22.5% 24.0% 25.5% 27.0% 28.5% 30.0% 31.5% 33.0% 34.5% 36.0% 37.5% 39.0%

Probabilities

CDO training program

19

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Base Case Zoom on [0%-3%] and [8%-11%] tranches


[0%-3%] Tranche
Loss Rate Probabilities 0.0% 14.76% 0.1% 0.04% 0.2% 0.06% 0.3% 0.05% 0.4% 17.66% 0.5% 0.23% 0.6% 0.10% 0.7% 0.21% 0.8% 15.44% 0.9% 0.25% 1.0% 0.12% 1.1% 12.14% 1.2% 0.40% 1.3% 0.15% 1.4% 0.12% 1.5% 9.23% 1.6% 0.31% 1.7% 0.11% 1.8% 5.94% 1.9% 1.13% 2.0% 0.17% 2.1% 0.10% 2.2% 4.98% 2.3% 0.28% 2.4% 0.09% 2.5% 1.49% 2.6% 2.33% 2.7% 0.16% 2.8% 0.07% 2.9% 2.64% 3.0% 0.22% Cum Prob 0.147581667 0.147986833 0.148552667 0.149101167 0.325696 0.328024 0.329017667 0.331104167 0.485512167 0.487974667 0.489143333 0.610565333 0.614605167 0.616134833 0.617369167 0.709715833 0.7128165 0.713940667 0.773310167 0.784625667 0.786371333 0.787376333 0.837185167 0.839991667 0.840908167 0.855773167 0.87903 0.880650667 0.881380667 0.907799833 0.909956167

[8%-11%] Tranche
Loss Rate Probabilities Cum Prob 8.0% 0.01% 99.77% 8.1% 0.00% 99.77% 8.2% 0.01% 99.78% 8.3% 0.03% 99.81% 8.4% 0.01% 99.82% 8.5% 0.00% 99.82% 8.6% 0.02% 99.84% 8.7% 0.01% 99.86% 8.8% 0.00% 99.86% 8.9% 0.00% 99.86% 9.0% 0.02% 99.88% 9.1% 0.00% 99.89% 9.2% 0.00% 99.89% 9.3% 0.01% 99.90% 9.4% 0.01% 99.91% 9.5% 0.00% 99.91% 9.6% 0.00% 99.91% 9.7% 0.01% 99.93% 9.8% 0.00% 99.93% 9.9% 0.00% 99.93% 10.0% 0.00% 99.94% 10.1% 0.01% 99.94% 10.2% 0.00% 99.95% 10.3% 0.00% 99.95% 10.4% 0.01% 99.95% 10.5% 0.00% 99.96% 10.6% 0.00% 99.96% 10.7% 0.00% 99.96% 10.8% 0.01% 99.96% 10.9% 0.00% 99.97% 11.0% 0.00% 99.97%

Prob = 1
CDO training program 20

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Base Case - El & Ec. Cap. inferred from Distribution

Capital Economique Cum. Prob. Port. Cum. Loss 50.00% 265 90.00% 574 95.00% 781 99.00% 1,202 99.90% 1,861 99.98% 2,359

EL

256

Expected Loss equals 256 million which represents 1.28% of the pool nominal (= 256,29M / 20.000M) An 1.28% EL over a 3-year period roughly corresponds to a 42 bppa spread, which is consistent with a Baa3 pool Ec Cap 99.8% equals 12% of the pool nominal (= 2.359M / 20.000M) Ec Cap = 9 times EL The capital buffer amount is very important

CDO training program

21

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Main drivers of Cum Loss Distribution

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Portfolio Loss distribution


What are the main drivers of the loss distribution? Key 1 factor = Default rate of each entity The higher the PD rate of the portfolio, the more important the cumulative losses

Impact level on the cumloss curve

Key 2 factor = Correlation The higher the correlation, the more fat tailed the cumloss distribution Key 3 factor = Tenor The higher the CDO maturity, the more important the cumulative losses Other parameters of lesser impact Diversification (# of names) LGD

Default Prob Tenor

EL Increase Increase

Impacts on Cum Loss Distribution Ec Cap Fat Tail Increase Increase Increase Increase

Rating Deteriorate Deteriorate Increase on Senior tranche Decrease on Eqty tranche Neutral on Mezz. Tranche

Spread Increase Increase Increase on Senior tranche Decrease on Eqty tranche Neutral on Mezz. Tranche

Correlation

Neutral

Increase

Increase

CDO training program

23

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Tenor impact on portfolio loss distribution

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Tenor impact on EL & Ec Capital

Expected Loss & Capital @ 99.98%


7000

Tenor (in year) 1 3 6 9 x2.2 12

EL (MEUR) 63 256 554 845 x1.2 1,282

Ec. Cap. 99.98 (en MEUR) 991 2,359 3,738 4,762 6,035

6000 5000 Million 4000 3000 2000 1000 0 0 5 10 15 Tenor (year) EL EC99.98

The longer the tenor, the bigger the EL and the Ec. Cap. In other words, the longer the tranche maturity, the lower its rating

CDO training program

25

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

DP Impact on portfolio loss distribution

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Loss Rate (Default Probability) impact on EL & EC. Cap.

Probability

- 1% loss rate curve - 1.5% loss Rate curve

1%

1,5%

Portfolio losses in % of pool nominal

The higher the DP, the bigger the EL and the Ec. Cap. In other words, you have higher probabilities to have big losses with low rated pool.

CDO training program

27

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Correlation impact on portfolio loss distribution

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

In theory

two correlation extreme cases


No correlation No link between the various default

Binomial case
25% Probability of each situation 20% 15% Binomial 10% 5% 0% 0 8 16 24 32 40 48 56 64 72 80 88 Number of defaults amongst 100 96

Binomial calculation Sample with (n) elements, probability of default (p) each. Proba of having (k) defaults is P(X=k) = C(n,k) * p^k * (1-p) ^(n-k)

With X being the number of defaults, and K [0;n ] BINOMDIST(3, 200, 1.71%, FALSE) And of course, the sum of the probabilities for k= 0, 1, 2 etc is 100%

Maximum correlation Bimodal distribution Either no loan default or all the loans of the pool default
Probability of each situation 70% 60% 50% 40% 30% 20% 10% 0% 0 8 16

100% Correlation case

Full Correl

24

32

40

48

56

64

72

80

88

Number of defaults amongst 100

96

CDO training program

29

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

In real life

Intermediate cases

40.00% 35.00% Probabilities 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

Correl = 10%

Correl = 20%

Correl = 30%

The intermediate cases with correl 10% or correl 20% etc are a kind of blend between correl = 0% and correl 100% The higher the correlation, the more fat tailed the distribution looks like. The higher the correlation, the more important the impact of the 100% correlation bimodal distribution ( situations) Greater probability to have no loss at all the curve moves to the left the curve moves to the right Higher probabilities for extreme

Greater probability to have all the underlyings defaulting at the same time

CDO training program

30

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Correlation @ 10% vs Correlation @ 20%

CumProb = 88.29%

CumProb = 90.78% CumProb = 8.59% CumProb = 8.19% CumProb = 3.12% CumProb = 1.05%

Probability

-10% correlation -20% correlation

2.8% 3% Same mean 6%

Portfolio losses in % of pool nominal

The pricing of the tranche is proportional to the sub area Below the curve

CDO training program

31

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Correlation @ 10% vs Correlation @ 20% (Contd)

The two distributions have the same mean ( = 2.8%) Correlation impacts the standard deviation of the cumloss distribution Correlation increases the sub area of senior tranches ( Loss distribution attracted to the right)

For the correlation @10%, there is a 1.05% probability that cumulative losses over 3 year will fall in the [6% - 100%] interval of pool size For the correlation @20%, there is a 3.12% probability that cumulative losses over 3 year will fall in the [6% - 100%] interval of pool size

Naturally those expected losses will drive the tranche pricings The larger the area of the tranche below the curve, the higher the spread Correlation increases Senior tranche price Correlation decreases Eqty tranche price Correlation has a relatively neutral impact on Mezz tranche Note: such statement is no longer true for very high correlation levels (impact of the 100% correlation bimodal distribution)

CDO training program

32

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Pricing in theory: only one correlation

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Conversion of CumLoss into bppa of pool nominal

(Approximate calculations*)

Mezz Senior Eqty [0% - 3%] [3% - 6%] [6% - 100%] 36.31 35.32 3.28 3.43 0.41 1.25

Global Pool [0% - 100%] 40

Correlation @ 10% Correlation @ 20%

x3

40

* Duration concept not taken into account

Most sensitive tranche in terms of correlation


In the base case, we assume an average CDS spread for the pool @40 bppa of pool nominal For a 10% correlation The [0%-3%] loss tranche having a cumulative probability of 90.78% (see p.4), the corresponding tranche pricing is 36.31bppa of pool nominal (= 40bpba * 90.78%)

CDO training program

34

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Translation into tranche pricings

(Approximate calculations*)

Eqty Mezz Senior [0% - 3%] [3% - 6%] [6% - 100%] 1,210 1,177 109 115 0.44 1.33

For 10% correlation, equity tranche


The [0%-3%] cumloss tranche size being 3% of pool nominal, the corresponding tranche pricing is 1210 bppa of tranche nominal (= 36.31bppa / 3%)

Correlation @ 10% Correlation @ 20%

Same type of calculations apply to mezzanine and senior tranches


Mezzanine 3.28bppa of pool nominal (= 8.19% * 40 bppa) 109bppa of tranche nominal (=3.28bppa /3%)

* Duration concept not taken into account

Return carried by the Eqty tranche = 12% of the pool nominal

Senior tranche 0.42bppa of pool nominal (= 1.05% * 40 bppa) 0.44bppa of tranche nominal (=0.42bppa /94%)

Key point : pricing of upper tranches are quiete close to 0 bppa

CDO training program

35

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Pricing in real life: not only one correlation!

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Compound correlation model limits

Theory

single correlation model

Real life

various correlation levels

Step 1 : tranche pricing calculated from a unique correl Correl Pricing bppa Tranche [0% - 3%] [3% - 6%] [6% - 9%] [9% - 12%] [12% - 22%] 6% 6% 6% 6% 6% 1 610 140 10 0.6 0.02

Step 2: Correls calculated by the market Market Spread Correl Deducted 1 046 86 33 12 6 20% 6% 30% 40% 50%

Pricing not so close to 0

Step 1: Determination of the spread of each tranch of a portfolio using the historical unique correlation @ 6% (used by rating agencies) via the Normal Copula Model Step 2: Calculation of correlations using market spread Market spread are not deducted from one level of correlation but various levels of correlation according to tranche attachment and detachment points

CDO training program

37

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Real market pricings are not so close to zero!

Determining tranche pricings through a CumLoss approach with a unique correlation figure is indeed possible around the equity zone But when applying the same approach to upper mezz and senior tranches, you find spread levels extremely low (near to zero bp) Whereas the market quotes hardly fall below 1 or more bppa Who would sell protection at 0.1 bppa? The law of supply and demand leads to higher market spreads,and hence higher correlation levels Such a market practice explains the correlation smile (same as for the options markets) The more senior the tranche, the higher the level of correlation induced by the market

CDO training program

38

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Correlation Smile: Theory vs market prices


Though only one correlation figure should prevail for the entire portfolio & tranche pattern Indeed, when a default occurs, only one correlation will apply to the whole portfolio market quotations cannot be derived from a model with only 1 correlation Correlation varies according to the tranch seniority Market needs to ensure liquidity for upper tranches The smile reflects the fact that market does not believe in a single correlation model

Europe [0% - 3%] [3% - 6%] [6% - 9%] [9% - 12%] [12% - 22%] [3% - 100%]

Bid/Ask 28.25/33.25 + 500 235/275 95/115 50/65 18/26 13.5/17.5

Mid-market implied correlation 19.9% 7.3% 18.8% 24.8% 30.4% 20.9%

Smile de corrlation

CDO training program

39

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Bootstrapping method

Base correlation related to x% is the correlation of the [0, x%] equity tranche on a standardised portfolio Recursive calculation of the base correlation curve [0%-3%] tranche spread known from mkt BaseCorrrel (3%) then calculated f-1(Spread [0% - 3%]) = compound Correlation

[3% - 6%] tranche spread known from mkt Given that [3% - 6%] tranche pricing depends on BaseCorrel (3%) and BaseCorrel (6%),

Spread [0% - 6%] = Spread [0% - 3%] + Spread [3% - 6%]

BaseCorrrel (6%) then calculated

f-1(Spread [0% - 6%])

6%- 9% tranche spread known from mkt BaseCorrrel (9%) then calculated etc. Bootstrapping is a calculation method that derives the BaseCorrel of a senior tranche from a more junior tranche

CDO training program

40

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Base Correlation curve after bootstrapping calc

Skew measures the steepness of the BaseCorrel curve

In other words, the skew is the slope of the BaseCorrel curve with a proportionality factor in the definition)
A steepening of the skew conveys a spread increase of the upper tranches

Smile Effect

The skew level is ruled by the law of supply and demand

Smile effect

CDO training program

41

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Mezzanine tranche pricing is sensitive to skew

Base Correlation Skew


90%

Parallel shift in the correlation


Correlation

80% 70% 60% 50% 40% 30% 20% 10% 0% 0% 5% 10% 15% 20% 25%

level does not impact Mezz tranche spread level

(H): Portfolio spread = 54bppa [15% - 25%] 228bppa [15% - 26%] 211bppa

Detachem ent Level Initial Correlation Parallel Shift

[16% - 25%]

248bppa

[16% - 26%]

231bppa

Base Correlation Skew


90% 80% 70% Correlation 60% 50% 40% 30% 20% 10% 0%

whereas skew changes Mezz tranche spread level

0%

5%

10%

15%

20%

25%

Detachem ent Level Initial Correlation Skew Mouvement

CDO training program

42

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Mezzanine tranche pricing is sensitive to skew (Contd)

Impact of changing correlation @ attachment point All things being equal, the higher the correlation at attachment point, the bigger the tranche spread The slope of the base correlation curve decreases Impact of changing correlation @ detachment point All things being equal , the higher the correlation at detachment point, the lesser the tranche spread The slope of the base correlation curve increases Its the slope of the base correlation curve that affects tranche pricing Note: A parallel shift of the base correlation curve only impacts the spread levels of Eqty and Senior tranches Neutral impact on Mezz. tranche

CDO training program

43

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Mark-to-Market

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Base case
Closing Pool @ 25 bppa Tenor 5 year 14 days Correlation_Attach 15% Correlation_Detach 23.8% Tranche [3% - 6%] Nominal Tranche 3 billion Nominal pool 100 billion After 1 year Pool @ 40 bppa Tenor 4 year 14 days Corelation _Attach 12% Correlation_Detach 22% Tranche [3% - 6%] Nominal Tranche 3 billion Nominal pool 100 billion

CDO Tranche (Unfunded transaction)


Amount Tranche Value Market Spread Bp Value 641,753 % of Invested Notional 0.02% 0.56% 4.71

CDO Tranche (Unfunded transaction)


Amount Tranche Value Market Spread Bp Value -35,225,919 % of Invested Notional -1.17% 0.87% 3.83

CDS Portfolio
Amount Number of Names Outstanding Portfolio Notional Portfolio Expected Loss % of Outstanding Portfolio 125 100,000,000,000 -1.26%

CDS Portfolio
Amount Number of Names Outstanding Portfolio Notional Portfolio Expected Loss % of Outstanding Portfolio 125 100,000,000,000 -1.62%

-1,263,720,256

-1,615,837,376

CDO training program

45

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Explanation of MtM in order of magnitude


At Closing, Portfolio spread = 25 bppa ( Tranche spread = 56 bppa ( CDS cost of the whole pool) CDS cost for the tranche)

Thus, my tranche represents 6.7% of the portfolio global cost of carry Cost of carry of the tranche related to pool nominal = 56 bppa * 3% = 1.68bppa This cost related to the global cost of carry of the pool = 1.68bppa / 25 bppa = 6.7% It can be noted that the lower the tranche seniority, the higher its relative cost of carry, and thus the more important its Delta In other words, the delta of the tranche is 6.7%. It means that the tranche behaves like 6.7% of the portfolio in terms of MtM Delta-hedging (by a correlation desk) will thus be done on a nominal of 6.7% * 100 billion = 6.7 billion MtM (for the investor) = - 6.7% * [0.40% - 0.25%] * [3.7 year] * 100 billion

Tranche converted into pool

Duration Variation in Underlyings spread

Pool nominal

MtM (for the investor) = - 37 million Calculation looks like the MtM of a Bond

CDO training program

46

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Greeks or portfolio sensitivity to risk factor shifts

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Greeks or portfolio sensitivity to risk factor shifts


Delta

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Delta: Volumetry

Bank A

Reference potfolio of credit Assets 1 GEUR

Portfolio tranching

[9% - 100%] 910MEUR

[6% - 9%]: 30MEUR [3% -- 6%] :: 30MEUR [3% 6%] 30MEUR [0% - 3%]: 30MEUR

Subordinated CDS Premium

Protection provider

Correlation desk
Delta hedging (H): Delta = 5.7 * tranche notional CDS Market

In this example, the correlation desk must realise its delta hedge on a nominal equal to almost 6 times the tranche notional 5.7 * 30MEUR = 171MEUR or 17.1% of the pool nominal

CDO training program

49

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Delta: generals
Tranche Delta is used: By investors (correl desk) to hedge their exposure to movements in the CDS spread of the underlying credits Delta = definition of the CDS underlying nominal that needs to be sold / bought to hedge a short/long synthetic CDO tranche position By CDO sponsors to manage the transactions Delta = indication of the cost of substituting underlying credits. Delta main features Tranche delta range from 0% to 100% of pool nominal Tranche delta are usually quoted in terms of notional amount needed to hedge the tranche against spread movements of the particular underlyings. Delta = (Tranche spread var. / CDS on the specific underlying spread var.) * Tranche notional Tranche Delta depends on: Attachment point (= subordination) Tranche thickness Pool spread Time to maturity Default correlation

CDO training program

50

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Delta: Tranche attachment point impact

70.00%

Tranche size Tranche [0% - 3%] 3% [3% -6%] 3% [6% - 9%] 3% 3% [9% - 12%]

Tranche spread with portf. spread @ 25 bppa 648.07 51.28 16.33 6.18

Tranche spread with portf. spread Delta in % Base Correl @ 26 bppa of pool AP / DP 668.80 15% / 15% 62.19% 55.46 15% / 23.8% 12.54% 17.33 23.8% / 30.7% 3.00% 7.04 30.7% / 36.9% 2.58%

60.00% 50.00% Delta 40.00% 30.00% 20.00% 10.00% 0.00% [0% - 3%] [3% -6% ] [6% - 9% ] [9% - 12% ] Tr anche Delta in % of pool

The more junior the tranche, the higher its delta Tranches that are lower in the capital structure are more risky as there is less protection against default risk

CDO training program

51

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Delta: Tranche detachment impact

Tranche [3% - 6%] [3% - 7%] [3% - 8%] [3% - 9%]

Tranche spread Tranche spread Tranche with portf. spread with portf. spread Delta in % @ 26 bppa of pool @ 25 bppa size 51.28 55.46 3% 12.54% 43.98 47.46 4% 13.92% 38.62 41.73 5% 15.55% 33.8 36.4 6% 15.60%

18.00% 16.00% 14.00% Base Correl 12.00% AP / DP 10.00% 15% / 23.8% 8.00% 15% / 26.1% 6.00% 15% / 28.4% 4.00% 15% / 30.7% 2.00% 0.00% Delta [3% - 6% ] [3% - 7%] [3% - 8%] [3% - 9% ] Tr anche Delta in % of pool

The larger the tranche, the higher delta For a fixed level of subordination (here = 3%), a wider tranche is exposed to a larger band of losses, and is therefore more risky Note that the increase in tranche delta flattens out once the limit of possible losses is reached

CDO training program

52

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Delta: other factors impacts

Pool spread: Tranche deltas are linked to the risk profile of the pool. The riskier the pool, the greater the delta of the Eqty tranche the lower the delta of the senior tranche Time to maturity: As the time to maturity tends to 0, defaults becomes less likely to occur, the delta of the Eqty tranche converges to 100% of the pool nominal, and the deltas of all other tranches converge to 0% : Default correlation As correlation level increases,the risk is shifted to the senior tranche (= higher probability of joint default), the delta of the Eqty tranche decreases and the delta of the senior tranche increases

CDO training program

53

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Greeks or portfolio sensitivity to risk factor shifts


Time to maturity

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Variation of MtM with the time to maturity

-0.02%

MtM

Point of time Issuance + 1Year + 2Years + 3Years + 4 Years + 5 Years (Residual maturity = 14 days)

GCPM MtM in % of tranche nominal -0.02% -0.37% -0.70% -0.70% -0.54%

Ye ar s 0.00% -0.10% -0.20% -0.30% -0.40% -0.50% 0 1 2 3 4 5

Source: SG CDO Pricer tool

-0.60% -0.70% -0.80%

All parameters being equal We look at the [3% - 6%] tranche We make strong assumptions: Portfolio spread (= 25bppa) remains unchanged all along the life of the CDO Correlation curve remains unchanged (Attachment point = 15% / Detachment point = 23.8%) To explain the curve shape, lets simplify the MtM formula by ignoring the Delta impact (negligible since moving into a relatively narrow corridor)

MtM (for the investor) =

- [Tranche spread variation * Duration * tranche nominal]


Tranche less risky

As time to maturity decreases, the MtM deteriorates (there is less time for defaults to hit the [3% - 6%] mezzanine tranche Tranche spread decreases)

up until a certain point of time when MtM increases again until reaching 0 at maturity ( time decay impact on tranche MtM superior to spread reduction impact)

CDO training program

55

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Greeks or portfolio sensitivity to risk factor shifts


Spread parallel move test

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Spread parallel move test

[0%- 3%]

Portfolio spread (bppa) 25 50 x2 75 100 125 Portfolio spread (bppa) 25 50 x2 75 100 125

Tranche spread (bppa) 872 1,727 x2 2,556 3,372 4,179 Tranche spread (bppa) 56 216 x4 436 686 942

Duration (year) 3.84 3.18 2.68 2.3 2 Duration (year) 4.71 4.58 4.4 4.18 3.97

[3% - 6%]

4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 25 45 65 85 105 125 145 Portfolio spread (bppa) [0% - 3%] spread (bppa) [3% - 6%] spread (bppa)

All parameters being equal We look at the [0% - 3%] tranche and the [3% - 6%] tranche Maturity = 5 years We make strong assumptions:

Correlation curve remains unchanged: 15% /15% for the tranche [0%-3%] and 15% / 23.8% for the tranche [3% - 6%]
We move the portfolio spread from 25bppa to 50 bppa [0% - 3%] tranche spread moves from 872 bppa (core) to 1727 bppa [3% - 6%] tranche spread moves from 56 bppa (core) to 216 bppa The ratio 34.2/1 is the leverage of that tranche The ratio 6.4/1 is the leverage of that tranche

Eqty tranche is the most sensitive to portfolio (and single-name) wide spread moves Note that tranche spread vs pool spread curve is sligthly convex

Tranche spread (bppa)

CDO training program

57

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Greeks or portfolio sensitivity to risk factor shifts


Duration

- C:\USERS\Stephane DELAINE\STR - CDO CWA & investissement\presenations\post asian seminar slides - 30/03/2007 17:07:02

Duration

[0%- 3%]

Duration (years)

Portfolio spread (bppa) 25 50 75 100 125 Portfolio spread (bppa) 25 50 75 100 125

Tranche spread (bppa) 872 1,727 2,556 3,372 4,179 Tranche spread (bppa) 56 216 436 686 942

Duration (year) 3.84 3.18 2.68 2.3 2 Duration (year) 4.71 4.58 4.4 4.18 3.97

5 4.5 4 3.5 3 2.5 2 1.5 0 50 100 150 Portfolio spread (bppa) [0% - 3%] Duration [3% - 6%] Duration

[3% - 6%]

All parameters being equal


We look at the [0% - 3%] tranche and the [3% - 6%] tranche Maturity = 5 years We make strong assumptions:

Correlation curve remains unchanged: 15% /15% for the tranche [0%-3%] and 15% / 23.8% for the tranche [3% - 6%] Duration can be defined as a kind of discounted average life time The riskier (= more junior) the tranche The higher the portfolio spread the higher the number of default the smaller the duration

the higher the number of default

the smaller the duration

Note that American priced tranche will always have a smaller duration than European priced tranche

CDO training program

59