Let me get this straight: There are 2 sections, a junior and a senior one. Only the junior section is funded. Now the return on the junior section is comprised of 1) income from the debt securities 2)and insurance premium on the CDSwap. But oddly enough, the return on the senior section is also the premium on the CDS. Is that because when the manager of the CDO sells the CDS, he allocates a certain portion of the CDS sale proceeds to the junior section (majority) and some to the senior section?
shit shit shit… does the asset manager buy the CDswap or does he sell it? Do the senior and junior notes recieve the premium of the CDS because they sell it, through the SPV, and it is payed by the asset manager (i.e: manager is long the CDS, and SPV is short)??? If the asset manger does indeed pay for the CDS, where does th money come from? Is it from the spread betwee the coupon rate payed by the borrowers of the underlying securities and the coupon rate given to investors through the CDO? fuck…who makes money on this shit…?? cheers sometimes trying to visualize this wizardry can simply make you mad…!!!
The terminology is that when you buy protection you’re long the CDS (i.e. you’re short the credit and make periodic premium payments to the counterparty) and when you’re short the CDS you’re long the credit and receive the insurance premiums from the counterparty(and ofcourse any losses occur on the reference bond you make protection payments to the protection buyer. Your description of how a partially funded(hybrid) synthetic in your first post is basically correct. Basically on the asset side the SPV sells protection on a bunch of different bonds (i.e. sells say 100 CDS) to whoever desires the protection. Now the SPV is entitled to premium payments from the buyers of protection. On the liability side the SPV issues 4 tranches, of varying senieroty/rating/coupon, and sells those to investors. Now the bottom three tranches (the equity, junior, and mezzanine tranches) are funded. What this means is that the investors who purchase hose tranches of the CDO (SPV) buy them like any other bond, where you give $100’s with the hope of getting it back at maturity. Those proceeds are used to purchase a variety of very safe and liquid AAA bonds. Those bonds have two purposes, the first being to serving as the “collateral” for the protection buyer (the one making the premium payments). This is because if there is ever a loss/defaulton any of the bonds referenced by the CDS, the CDO has to compensate the protection buyer for any loss he incurs. Where does the money come from? Through the sale of the safe AAA assets. Ofocurse if those assets are sold then the lower tranches take a loss, since they will now not be getting principle back at maturity. The second purpose of the AAA asstes is to provide the first source of coupon income to the tranche holders. Usually this would be approximately “LIBOR” Now ofcourse in reality if you buy a an equity piece of this hybrid CDO or a BBB subordinate tranche, you expect to get more then LIBOR on your investment, since you have the first loss exposure to any defaults on the referenced bonds. Hence the margin,the x in the the Libor + x bps comes from the credit premiums received each period. Now the last part of all this is to address the question of how is the money made in all this? Where’s the arbitrage for the CDO Manager (who often holds the equity portion). If you recall I mentioned there were 4 tranches issued on the liability side, three funded (the quity, subordinate, and mezzanine bonds) and one unfunded super senior tranche, which is the key to all this. The investor who buys the AAA SS tranche does not put up any principle to buy the bond. Rather, he enters into a CDS with the CDO. He sells protection to the top of the capital structure. Effectively in the extremely unlikely(well as we have seen over the last few months not so quite unlikely) case that losses on the referenced bonds exceed the principle balance put up by the lower 3 tranches, the SS will be on the hook to the protection buyer. Because this was deemed unlikely, the SS is not required to put up any collateral or principle like a normal bond holder, and thus makes this a partially synthetic structure. The coupon for the SS is extremely low, on the order of just 20-30 bps (that’s not margin either, that’s the TOTAL coupon) and this coupon also comes from the protection premium payments that the protection buyer makes on the underlying bonds. Because the SS is so large (over 70% of the capital structure) and required such a low return, the end result is that after the coupon’s of it and the mezz and junior tranches are paid, there is a lot of excess money left over(assuming low defaults). This excess get’s sent to the equity piece, resulting in high IRR’s and the logic behind the arbitrage,
Nice job alex.
no problem…feel free to throw any other CDO/MBS/ structured products questions my way…