Full Capital Structures versus Single Tranches

Cash-flow CDOs tend to be full capital structure deals.  This means that the issuer (or SPE) will sell a similar amount of liabilities to pay for the assets that it purchases.  This is in contrast to the synthetic CDO (or CSO), where only tranches representing a small fraction of the capital structure are sold, typically the middle (or mezzanine) tranches which are often rated from AA to BBB.  The underwriting investment bank will often retain the more subordinated unrated (or equity) notes and the most senior tranches (commonly referred to as the “super senior” liabilities). 

 

Cash-flow (asset-liability matched) or Market Value

Most cash-flow CDOs issue debt which matches the longest maturity of the assets so there is no refinancing risk for the CDO.  An alternative approach is to deliberately mismatch the maturity between assets and liabilities by using short term debt instruments such as commercial paper or repurchase agreements. These short term debt instruments allow for additional yield pickup by issuing debt lower on the yield curve than the assets.

The mismatch between the assets and liabilities can be typically addressed by using a combination of a liquidity provider and through market value covenants. If the assets are not particularly liquid then a liquidity provider is needed to purchase the commercial paper or provide alternative means of financing either short term or long term if the short term debt cannot be funded in the market.  If the underlying assets have a sufficiently liquid market then funding can be advanced against the market value less a suitable haircut for price volatility. This is sometimes called the “advance rate”: the percentage of the market value against which funds are lent. This is often only used for the most senior portion of the transaction’s liabilities.

The issuer may fund the rest of the asset purchases by issuing term funded mezzanine notes and equity or capital notes. The issuer will covenant to maintain a minimum value of the portfolio with regard to the short term debt.  In the event of a breach of these covenants, then, several remedies can be enforced. These include (a) directing cash flows to the senior notes, (b) preventing the issuance of more short term debt and (c) liquidating some or all of the assets to repay some of all of the short term debt.