CDO Equity Structures: Where the Real Money Lives

Book: Structured Finance and Collateralized Debt Obligations | Author: Janet M. Tavakoli | Publisher: John Wiley & Sons (2008) | ISBN: 978-0-470-44344-6

Chapter 10 opens with a warning: “If you don’t understand what is going on with your cash flows, you are in serious trouble.”

Then it spends the next several pages showing that many market professionals did not understand their cash flows. And it was not because the math was hard.

Accruing Errors: Simple Math, Big Consequences

Before getting to equity structures, Tavakoli walks through some deceptively simple errors that appear repeatedly in structured finance.

The first example: if you borrow $500 million and pay it back at $46 million per month for a year, what is your interest rate? You are paying back $552 million, which is 10.4% more than you borrowed. Most smart people would guess around 10.4%.

They would be wrong. The actual rate is about 20.35%, because you do not have full use of the money for the entire year. Each payment reduces your balance. The IRR on a monthly stream of $46 million payments over 12 months is about 1.556% per month. Annualized: just over 20%.

This is not an obscure corner case. Lenders used exactly this kind of framing on American consumers for decades until the law required disclosure of effective annual rates.

A related real-world example from the book: an investment banker at a top-five US bank agreed to pay bonds at a semiannual BEY of 8.806%. When some investors asked for quarterly coupons, he divided the semiannual rate in half and told them they would get 2.2015% quarterly. The economics were not the same. The correct quarterly rate to match the original agreement was 2.1775%. On a $250 million, 12-year deal, the error cost $60,000 per quarter. Every quarter. For 12 years.

One bond basis point is not equal to a LIBOR or money market basis point. These are not nitpicks. Errors in day count conventions, frequency conversions, and forward price calculations affect CDO warehousing, portfolio cash flow calculations, and structured product pricing.

Probability of Receipt

The timing, frequency, magnitude, and probability of receipt of cash flows are the four factors that determine value.

Probability of receipt is the one that trips up CDO equity investors most. The expected value of a bet is not the only thing that matters. If the downside risk is catastrophic, you should decline even a positive expected value bet. This is basic decision theory, but CDO equity investors routinely ignored it.

Tavakoli frames it sharply: suppose you are a hedge fund that wants to buy equity exposure but does not want to put up any money up front. You want a bank to fund any losses as they occur, via a credit default swap, and you want to repay only at maturity five years out. What could go wrong?

Plenty. The bank now has uncollateralized credit exposure to you. You are earning income now without setting aside reserves. If personnel turnover means nobody at your fund knows or cares about this exposure in year three, the problem compounds. These “investors” often refused to disclose how many similar deals they had already done, or how they were being compensated.

Best and Worst Equity Investments

Not all equity tranches are created equal. The structure of the equity cash flows matters as much as the portfolio. Here is the spectrum:

Worst for equity investors: The equity investor gets a fixed return of original principal plus a fixed coupon (say 15 to 25%), calculated only on the remaining equity balance after losses. All remaining excess cash flows go to the bank arranger. You absorb first-loss risk and give up all the upside.

Slightly better: Same fixed coupon structure, but all residual cash flows are available to pay the principal and coupon first. Once the preset amount is satisfied, the rest still goes to the bank arranger. You get paid but the arranger pockets the true upside.

Middle ground: The equity investor gets a portion of residual cash flows, but the bank arranger retains a strip.

Good: The equity investor gets all residual cash flows, but only up to a loss threshold (usually 50 to 100% of the initial equity investment). Above that threshold, excess spread diverts to a reserve account for benefit of AAA and AA investors. Unused reserve reverts to equity at maturity.

Best for equity investors: The investor gets maximum leverage and exclusive rights to all residual cash flows. Loss is strictly limited to the original investment. This is also the worst for rated tranche investors, and it creates the highest moral hazard risk when the portfolio is managed.

The Best Equity Earns All Residuals

In many managed CDOs, the equity investor claims all residual cash flows and absorbs losses only up to the initial equity investment. Once losses exceed that amount, all ongoing cash flow still goes to the equity investor. It is only the principal that is gone.

This structure creates a moral hazard. Once losses exceed the equity investment, the manager is playing with house money on the loss side. Any further defaults reduce the balances of more senior noteholders. The manager, especially if they are the bank arranger holding equity, now has an incentive to stuff deteriorating credits into the portfolio to chase higher spreads. Those higher spreads flow to the equity. Additional losses above the equity attachment point are someone else’s problem.

The only protections are trading restrictions and cash flow triggers. If those are weak, the situation can deteriorate badly.

Tavakoli documents a real case where this happened. A large Yankee Bank invested in a single-A tranche of a deal brought by a major investment bank. The deal manager actively traded the portfolio down in credit quality until it became a junk portfolio. The Yankee Bank contacted the relevant rating agency, which said it was statistically impossible for an investment-grade portfolio to reach junk status that quickly. The rating agency was wrong. The manager was not randomly sampling from the investment-grade universe. They were deliberately hunting for high-spread, deteriorating credits.

The Yankee Bank considered going to the press but ultimately did not. Tavakoli notes dryly that the bank might have asked itself why it did not demand better structural protections in the first place. It was enticed by a slightly higher original coupon and ignored structural risk.

Overcollateralization and Rated Equity

In some structures, the equity investor’s cash goes in as overcollateralization rather than as a first-loss tranche in the traditional sense. The equity cash flows are usually unrated, but Fitch or Moody’s may rate a segment of the equity cash flows if they have the same probability of loss as an investment-grade security. The rating covers return of principal and ultimate (not timely) payment of a modest coupon.

In 2002, base-case equity IRRs on investment-grade corporate synthetic CDOs ranged from 10-15% at the low end in early 2002 to 50-60% in the fall of 2002 when CDS spreads gapped out. That was exceptional, but it illustrates the leverage in equity tranches.

A specific example from the book: a principal-protected Schuldschein structured from a static synthetic CDO with a 2.5% equity tranche on a EUR 500 million portfolio had a base-case equity IRR of 50%. The principal-protected Schuldschein (PPS) itself had a base-case IRR of 16%. In spring 2001, investors were content with 6.5% to 8% on the PPS. By fall 2002, 16% was available.

German insurance companies bought many of these PPS structures because they did not have to mark a Schuldschein to market. The attraction of accounting treatment over economic reality is a theme that shows up repeatedly in structured finance history.

Equity That Is Not Really First Loss

Some structures let equity investors pay a coupon calculated only on the original investment amount rather than the remaining balance. As defaults occur, the equity notional is written down, but coupon is calculated off the original amount. Higher stated coupon. But once losses occur, the investor has no claim to further residuals beyond the remaining balance.

The stated coupon is higher than for structures where equity gets all residuals. But it does not reflect all potential residual cash flows. The equity investor gets paid more up front but misses the big upside from good performance.

The bank arranger or structurer keeps those excess residuals if neither the rated tranche investors nor the equity investors are entitled to them. Tavakoli is clear: equity investors should not give away residuals to arrangers or managers who do not have either first-loss risk or trading-loss risk.

Moral Hazard: Four Conditions That Signal Trouble

Four structural conditions together create a dangerous moral hazard:

1. Losses are allocated in reverse order of seniority, limited to each tranche’s initial investment.
2. Excess spread does not accrue to benefit any noteholders and is not available to absorb losses.
3. The manager has inadequate restraints on trading, allowing portfolio quality to deteriorate.
4. The manager has a claim on the excess spread.

When all four are present, once equity losses exceed the initial investment, the manager is incentivized to trade down in credit quality. Higher-spread, riskier names generate more excess spread, which goes to the manager. New losses fall on the next tranche in line.

Unfunded Equity: Ultimate Leverage

Equity risk can be transferred synthetically just like any other CDO risk. An unfunded equity investor as credit protection provider receives a premium but does not pay any losses until a credit event occurs.

The investors who choose this structure are typically hedge funds or offshore subsidiaries of reinsurance companies. They want leverage. Sky-high returns and no money upfront. Income in the interim. No loss payments for five years.

Some of these investors asked for even more leverage: they wanted the bank arranger to fund any losses as they occurred. The bank would essentially give them a credit line. The investor would use CDS premium income to pay interest on that loan. Payment of the full loss amount would only come at maturity.

Tavakoli raises a question that nobody likes to answer: how are these people compensated? If personnel are paid on current revenue with no charge for future liabilities, the incentive is to max out the deals, collect the fee, and be gone before the losses mature. The CDO bank arranger would have no idea whether this entity was already up to its eyeballs in similar exposure.

Some structurers eager to earn fees rammed these deals through. Some banks had trouble finding mainstream equity investors and turned to these willing counterparties instead. Tavakoli notes the cynical but rational counter-strategy: buy credit default protection on the equity investor itself. Fold that cost into deal economics. If they eventually default on their obligation, you are covered.

But that makes the deal less attractive to the very investors you are trying to bring in, since it reduces their net premium. Market dynamics pushed against doing the responsible thing.

The next post covers the second half of Chapter 10: actively traded synthetic CDOs, interest subparticipations, participation notes, combination notes, first-to-default basket swaps, and where the real edge in equity investing lies.

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