Liabilities tranches

On the liability side, the structure will have tranches whose allocations of income and loss are predefined. From most junior to most senior, the tranches include equity, mezzanine, senior, and super-senior. Equity, or first loss, is analogous to the equity in a company s balance sheet, and represents the residual interest remaining after other liabilities are paid off. The mezzanine, or middle tier of risk, typically represents low-rated tranches all the way up to AA risk. Senior usually refers to AA and AAA risk. Super-senior represents a level of risk that is deeply subordinated (usually by at least 10%) to AAA, and as its name implies is regarded as extremely safe. In a structure that is not uncommon, we will assume all of the liability tranches are unfunded except for the equity. ... 

In fact, the position of the 5% funded equity holder is exactly equivalent to an investor that has purchased 1 billion of assets with 20 times the nonrecourse leverage. The implied borrowing rate of such leverage is equivalent to the blended spread of the tranches that are senior to the equity. In our case the premiums due to the three tranches above the equity total 4.75 million, and the total tranches of risk that they represent equal 950 million. The annual spread due is 0.50% of the notional on these liability tranches and, thus, in this case the equity holder has borrowed 950 million at a blended borrowing cost of 50 bps. 

Step 5 Rate and Price Tranches. Evaluate the probability-weighted losses in each scenario to generate an overall expected loss for each tranche, and from this expected loss calculate an implied rating for the tranche. Price the tranche based on spreads for comparably rated investments. Having determined the cost of each ratable liability tranche, estimate the available excess spread applicable to the (unrated) equity tranche. 

Of the total spread of the assets available to fund the tranches of liabilities in this example, fully 68.33% goes to the first loss piece even though this piece only represents 5% of the total potential loss. Meanwhile, a mere 7% of the available 15 million asset spread accrues to the most senior 70% of the capital structure. As with all CDOs, in this synthetic deal the senior tranches are providing leverage to the junior tranches in exchange for safety. 

With this analysis, the synthetic CDO looks much like any operating company, as shown in Exhibit 22.7. The equity holders have purchased assets of 1 billion. Those assets are predicted to generate a return of 15 million (the asset spread ). To purchase those assets, the equity holders have put up 50 million, and borrowed 950 million. They must pay 4.75 million per year in a regate (the liability spread ) to service their debt, and if it all goes bad they will not lose any more than the 50 million that has been put up. Any losses in excess of this amount will begin to accrue to other tranches according to predetermined rules, which are discussed below. 

The cumulative benefits to synthetic CDO structures versus cash structures, if they are all in play, amount to dramatically improved economics. For instance, if all of the asset side (flexibility, ramp-up, basis) benefits sum to only 10 bps, and the liability benefit is 40 bps on 70% of the capital structure, the savings would amount to 38 bps (= 40 x 0.7 + 10) on a 1 billion transaction. For a 5-year synthetic CDO, the PV of those 38 bps amounts to over 17 million. In a leveraged structure, of course, these benefits will primarily accrue to the equity and their impact will be magnified as shown in Exhibit 22.8. Clearly, the synthetic CDO may be an efficient vehicle for investors to use in accessing diversified tranches of risk. 

Because the SPV now owns the assets, it has an asset-and-liability profile that must be managed during the term of the CDO. The typical liability structure includes a senior tranche rated Aaa/Aa, a junior tranche rated Ba, and an unrated equity tranche. The equity tranche is the riskiest, since it is the first to absorb any losses in the underlying portfolio. For this reason, it is often referred to as t c first-loss tranche. 

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