Project Finance CDOs: When Infrastructure Debt Meets Securitization

Book: Structured Finance and Insurance: The ART of Managing Capital and Risk Author: Christopher L. Culp Publisher: Wiley Finance, 2006 ISBN: 978-0-471-70631-1

Chapter 32 is by J. Paul Forrester, a partner at Mayer Brown Rowe & Maw, and it’s structured around three simple questions: What are project finance CDOs? Why do they exist? And why now? It’s a clean, well-organized chapter that makes a pretty compelling case for why project finance debt is a natural fit for securitization.

What: The CDO Basics

If you’ve been following this series, you’ve seen CDOs come up before. But Forrester gives a good refresher. CDOs evolved from the techniques originally developed for collateralized mortgage-backed securities during the savings and loan crisis in the 1980s. By 2004, over $220 billion worth of CDOs were issued, making them the second largest type of asset-backed security after home equity products.

The basic concept: take a pool of financial assets that behave predictably enough to forecast default rates, loss severity, and recovery periods. Apply credit enhancement (subordination, overcollateralization). Issue tranched securities against that pool. Each tranche has a different risk/return profile. Senior tranches get paid first and carry higher ratings. Junior tranches absorb losses first and offer higher yields.

The pool is managed by a collateral manager who picks assets, monitors them, and sometimes trades a portion of the portfolio to capture arbitrage opportunities. CDOs come in two broad flavors: balance-sheet CDOs (used by banks for regulatory capital efficiency) and arbitrage CDOs (motivated by the spread between asset yields and securities costs).

The CDO issuer is usually set up offshore, often in the Cayman Islands, to avoid U.S. taxation. There’s a whole stack of legal requirements around perfecting collateral liens, securities law exemptions, Investment Company Act registration, and ERISA compliance. Forrester mentions these but wisely says they’re “beyond the scope of this article.”

Why: Project Finance Is a Perfect Fit

Here’s the interesting part. Project finance loans have higher assumed recovery rates and shorter recovery periods than comparably rated corporate debt. Why? Because project finance documentation has much tighter covenants and events of default. When a project loan goes bad, the participants are few in number and highly motivated to resolve things quickly and consensually.

This matters a lot for CDOs. Higher recovery rates mean less credit enhancement is needed to get the same rating on the CDO securities. Less credit enhancement means lower cost of issuance. Lower cost means a bigger arbitrage opportunity. The math works better.

Four major project finance banks (ABN Amro, Citibank, Deutsche Bank, and Societe Generale) pooled their default and recovery data and hired S&P Risk Solutions to analyze it. The results showed lower expected losses and lower loss-given-default for project finance compared to corporate debt with the same ratings. So this wasn’t just intuition. There was data behind it.

By the early 2000s, rated project finance debt issuance exceeded $100 billion annually. The rating agencies had extensive experience and elaborate methodologies for rating project finance. S&P alone had rated more than 500 projects in 35 countries.

For commercial banks, project finance CDOs solved a specific problem. Banks are great at originating project finance loans. They can handle flexible funding during construction phases when draws might speed up or slow down. But projects are capital intensive with long useful lives, requiring long-term financing. And banks fund themselves with short-term deposits. This creates an asset-liability mismatch.

CDOs let banks keep doing what they’re good at (originating and monitoring project loans) while offloading the long-duration risk to capital markets investors who actually want long-dated assets. Everybody wins. In theory.

For investors, project finance CDOs offered portfolio diversification with low correlation to typical corporate bond holdings. And the tranched structure let each investor pick their preferred risk/return position.

Now: Early Transactions

Forrester walks through the pioneering deals:

Project Funding I (December 1998): Credit Suisse First Boston’s first attempt. 40 loans, primarily to U.S. projects.

Project Funding II (January 2000): CSFB’s international version. 42 loans across multiple countries.

Project Securitization Company I (July 2001): Citibank’s entry. International project finance portfolio.

EPIC (October 2004): Depfa Bank’s synthetic infrastructure CDO referencing UK public infrastructure loans.

There were earlier precedents too. Energy Investors Fund Funding (July 1994) monetized equity interests in 13 power projects. The IFC’s Latin America and Asia Loan Trust (June 1995) securitized 73 loans across 11 countries.

But international project finance CDOs were hard to structure. Diversification requirements were tricky. Are loans to power projects in Brazil and Argentina really diversified, given how interconnected their energy sectors are? That’s a judgment call, not a math problem. Withholding tax issues across multiple jurisdictions added complexity. Some deals used participation interests to avoid transfer consent requirements, but that introduced the credit risk of the participation seller.

My Take

This chapter is a good example of smart financial engineering applied to a real problem. Commercial banks had a genuine asset-liability mismatch. Project finance investors wanted access to infrastructure debt but couldn’t easily get it. CDOs created a bridge.

But a few things stand out with hindsight. Forrester notes that the market “may still be more art than science.” The diversity assumptions were based on educated judgments rather than empirical evidence. And Basel II’s proposed treatment of project finance as requiring higher capital than corporate exposure was creating regulatory incentives to move this stuff off bank balance sheets.

That phrase “art than science” keeps echoing when you think about how CDO markets in general performed a few years later. The project finance CDO market was much smaller and more specialized than the mortgage CDO market. But the same basic tension was there: sophisticated models, limited historical data, and structures that depended on assumptions about correlation and recovery that hadn’t been stress-tested through a real crisis.

S&P was optimistic, expecting project finance CDOs to expand participation of portfolio investors in infrastructure debt markets. Whether the “substantial promise” was fully realized is debatable. But the core logic, that well-structured project finance debt with tight covenants and high recovery rates makes good CDO collateral, was sound. The execution and the broader CDO ecosystem were where things got complicated.

This post is part of a series retelling “Structured Finance and Insurance” by Christopher Culp. Previous: Credit Derivatives and CDOs After Enron | Next: Insurance Securitization Trends 2004