Collateral portfolio

The waterfall process for interest payments is shown at Exhibit 15.7. Before paying the next priority of the waterfall, the vehicle must pass a number of compliance tests designed to measure the overall robustness of cash flow being generated by the collateral portfolio. These metrics include tests such as interest coverage and principal (par) coverage, which is similar in concept to bank loan covenants and explained more fully later. 

As a matter of CDO surveillance, the quality of a CDO s collateral portfolio is monitored regularly and reported on by the portfolio administrator by way of a Trustee Report. This report details the results of various compliance tests, which are performed on an asset-by-asset level as well as on an aggregate portfolio level. Compliance tests are designed to monitor ... 

Recovery rates for individual obligors differ by issuer and industry classification. Rating agencies publish data on the average prices of all defaulted bonds, and generally analysts will construct a database of recovery rates by industry and credit rating for use in modelling the expected recovery rates of assets in the collateral portfolio. 

Many securitisations by regular issuers of MBS will have a relatively low average seasoning on their collateral pool at launch. Loans that have been originated relatively recently will have had little opportunity to fall behind with their payments so this pool is likely to have low arrears. Experience suggests that arrears tend to increase over the first two years and then stabilise as the collections process and, if necessary, repossessions take effect. Therefore, when comparing the arrears within collateral pools, it is important to also consider the age of the loans in the portfolios. 

Analysing the collateral characteristics of a credit card portfolio is essential because it tells us how the transaction is likely to perform. The major characteristics we focus on are ... 

The composition of a credit card portfolio by account age tells us how the seasoning of the collateral can vary significantly across varions portfolios. Exhibit 13.13 shows the initial composition of two credit card portfolios by account age. 

Advanced seasoning is a positive attribute for a trust as the portfolio is more likely to exhibit stable collateral performance than a relatively unseasoned portfolio. This is because a pool of new receivables usually experiences increasing losses for the first 18 months after which the losses usually decline and then level out. Over time, positive selection occurs as the lower quality and riskier accounts become charged-off and removed from the pool, leaving the higher quality accounts which should demonstrate more stable performance. 

We will discuss portfolio yield, monthly payment rate (MPR), delinquencies, charge-offs, and excess spread as well as excess spread efficiency (ESE) and charge-off coverage (COC) the latter two are combinations of the first five performance indicators. The various performance indicators will be shown for European and US credit card collateral. We will use our BECCI for European collateral and Standard Poor s Credit Card Quality Indexes (S P Index) for US collateral. 

As Exhibit 13.14 shows, yields have fluctuated on a month-on-month basis, both in Europe and in the United States, owing to the different number of days available for collection each month. For example, there was an extra bank holiday in June 2002 in the United Kingdom for the Queen s Jubilee Celebration. As more than 90% of European credit card trusts hold solely UK collateral, the reduced number of collection days in June had a significant impact on our European performance indicators. Cash collections for the master trusts fell by more than a fifth in June with a direct knock-on effect of reducing portfolio yield by almost 20%. 

Excess spread is a particularly important measure of the health of a credit card portfolio and negative excess spread will usually trigger early amortisation. Excess spread is portfolio yield less servicing fees, note coupon, charge-offs, and other costs. Exhibit 13.20 shows 3-month average excess spread for European and US credit card collateral. 

Excess spread for European credit card collateral has traditionally been higher than excess spread for US collateral. This is due both to higher portfolio yield and significantly lower charge-offs in Europe. 

The ESE ratio is defined as excess spread divided by portfolio yield it measures the ability of the servicer to turn yield into excess spread. The greater the ratio, the smaller the predicted impact of a slowing economy on the performance of the collateral. As Exhibit 13.21 shows, the prime issuer (issuer 1) has a much higher ESE ratio than the subprime issuer. The September 2002 ratios for European and US credit card portfolios are 44% and 39%, respectively. 

Strictly speaking, the FIAT 1 transaction does not generate excess spread. This explains the high level of credit enhancement from the unrated class M notes (usually, unrated tranches are either privately sold or kept as an equity tranche by the originator). On the closing date, an amount of notes was issued which was equal to the net present value of all future cash payments due from the collateral (as opposed to the principal balance of the collateral). The discount rate used was the fixed rate payable to the swap counterparty (swap rate plus coupon on the class A notes and all fees associated with the transaction). Structured this way, the receivables always yield the discount rate, leaving no excess spread in the transaction. However, losses on the FIAT 1 portfolio can be covered to a certain degree from interest collections because the structure provides for delinquent principal and defaults to be covered before interest is paid on the class M notes. 

A pool of collateral should be well diversified geographically to minimise the effect on the pool in the event of a rise in unemployment or recession in any one region. Exhibit 14.13 shows the initial Globaldrive B portfolio, which is geographically well diversified among nine major German regions. 

Market valne transactions aggressively nse ramp-up periods to acquire assets when accumulating the collateral pool. There is typically a liquidity facility, which is in place prior to the closing of the transaction, to help bridge the acquisition of assets. The principal repayment of liabilities are extinguished when the nnderlying assets are sold (traded) out of the portfolio, rather than when they matnre. 

CDO equity is not a straightforward instrument and must be assessed carefully by investors due to their complexity and limited liquidity. The asset manager, the quality of the collateral pool and the amount of leverage are very important issues for consideration. In addition, potential investors must consider how the equity investment fits with his or her broader portfolio. 

Moreover, the ability to rapidly source, or ramp up, collateral for deals means that investors can sometimes avoid the costly but usually unquantified cost of holding commitments firm until closing. If a deal is held firm at agreed levels for several weeks or months until the required cash collateral has been sourced, the short option granted by the investor is significant. In contrast, the ramp-up for a pool of synthetic CDS can happen very quickly in some cases in a single afternoon. For this, the overall value to the portfolio of the ramp-up benefit would depend heavily on the volatility of the underlying assets. 

The diversity score takes a pool of different assets which have some actual correlation and reduces them to a smaller pool of assets that are assumed to be homogeneous and uncorrelated. It is hoped that the mean and standard deviation of this model portfolio s performance will match the actual performance of the collateral. 

Another one of the easier methods of gaining leverage is through the subordinated tranches of ABS transactions with underlying credit collateral. The major drawback of nsing these instruments is the relative lack of liquidity that can hamper active management of the portfolio s leverage. 

Equation (27.2) describes a line with slope k starting from point Q in the risk/return diagram (Exhibit 27.2)7 Maximization of the expected portfolio return in equation (27.1) in compliance with equation (27.2) exactly describes the investor s risk aversion. Additionally, the following collateral conditions are set ... 

Further collateral conditions such as restrictions of portfolio restructuring may be set but are not considered here. 

One of the most time consuming tasks which is usually conducted in-house is the review of the documentation for the collateral to be put into the portfolio. Points to pay attention to are whether or not the assets are properly secured, transfer provisions, which will be very important when the rating agencies look into the portfolio to determine the sale and insolvency clawback risks, governing law, and acceleration clauses. 

The Collateral Debt Securities will have to satisfy certain asset and portfolio criteria (the Asset Criteria and the Portfolio Criteria respectively and together known as the Eligibility Criteria ). For example, the Asset Criteria will provide that the Collateral Debt Security will need to have a maturity shorter than the Einal Notes. The Portfolio Criteria, will provide that the portfolio, as a whole, will not contain more than 5% of assets rated below BBB+. 

The Collateral Manager and the Collateral Advisor are entitled to an annual fee to be paid on the Final Closing Date and on each anniversary thereafter. For US consolidation reasons, it is usually advisable to make sure that the payment of fees to the Collateral Manager and Collateral Advisor are not linked to the performance of the portfolio and rank senior to the Junior Noteholders. 

Amongst other things, the Collateral Administrator is responsible for calculating certain amounts that are payable to the Noteholders, preparing the periodic reports (in this case, monthly reports) and carrying out any other duties in respect of the portfolio as instructed by the Collat-... 

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