P1:a/b P2:c/d QC:e/f T1:g FM JWBK237-Tavakoli July29,2008 7:31 Printer:Yettocome Structured Finance and Collateralized Debt Obligations New Developments in Cash and Synthetic Securitization Second Edition JANET M. TAVAKOLI John Wiley & Sons, Inc. iii P1:a/b P2:c/d QC:e/f T1:g FM JWBK237-Tavakoli July29,2008 7:31 Printer:Yettocome iii P1:a/b P2:c/d QC:e/f T1:g FM JWBK237-Tavakoli July29,2008 7:31 Printer:Yettocome Structured Finance and Collateralized Debt Obligations i P1:a/b P2:c/d QC:e/f T1:g FM JWBK237-Tavakoli July29,2008 7:31 Printer:Yettocome Founded in 1807, John Wiley & Sons is the oldest independent publish- ing company in the United States. With offices in North America, Europe, Australia,andAsia,Wileyisgloballycommittedtodevelopingandmarket- ingprintandelectronicproductsandservicesforourcustomers’professional andpersonalknowledgeandunderstanding. 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HG4028.A84T382008 332.63(cid:2)2044—dc22 2008008483 PrintedintheUnitedStatesofAmerica. 10 9 8 7 6 5 4 3 2 1 iv P1:a/b P2:c/d QC:e/f T1:g FM JWBK237-Tavakoli July29,2008 7:31 Printer:Yettocome Contents Preface xiii AcronymKey xix CHAPTER1 SecuritizationTerminology 1 SimplifiedCashCDO 4 TheCDOArbitrage 5 CHAPTER2 StructuredFinanceandSpecialPurposeEntities 7 SPCsandHistoricalAbuse 10 SPEsandSPVs 16 Documentation 18 SetupCosts 19 ExampleofaMultipleIssuanceEntity 19 Cayman-DomiciledSPEs 22 RepackagingstoSatisfyInvestorDemand 24 Credit-LinkedNotesandFundingCosts 25 StructuredFloaters 27 Principal-ProtectedNotes 27 LoanRepackagings 28 Liquidity 29 MismatchedMaturities 29 UnwindTriggersLinkedtoDerivativesTransactions 30 DAX-LinkedNotewithTriggers 32 Ratings 34 MasterTrusts 34 OwnerTrusts 35 GrantorTrusts 36 RealEstateMortgageInvestmentConduits 36 MultisellerandSingle-SellerConduits 37 v P1:a/b P2:c/d QC:e/f T1:g FM JWBK237-Tavakoli July29,2008 7:31 Printer:Yettocome vi CONTENTS DomesticallyDomiciledCorporations 39 Bankruptcy-Remote? 40 Enron,JPMorganChase,andSureties 43 CHAPTER3 CreditDerivativesandTotalRateofReturnSwaps 45 RisktoPortfolioValue 45 CreditDerivativesandCreditDefaultSwaps 47 NegotiatedLanguage 49 BasisRisk:PersistentCDSLanguageIssues 49 PhysicalSettlementandCashSettlementNegotiations 50 Digital,Binary,Zero-One,All-or-Nothing,or FixedRecoveryCashSettlement 52 InitialValue×(Par−MarketValue) 53 NormalizedPriceMethod—AlternateTerminationPayment 54 HedgeCostsinCashandSyntheticCDOs 55 Deliverables:CDOsandtheCheapest-to-DeliverOption 55 ConvertibleBondsandAssetSwaps 56 NegativeBasisTrades 62 DefaultandRecoveryRate 62 TheDefaultProtectionSeller:CounterpartyCredit andCorrelation 65 DefaultLanguageforSovereignDebt 65 DefaultLanguageforNonsovereignDebt:Controversy andCDOs 66 CDSPricingIssues 69 SyntheticCDOs 70 TotalRateofReturnSwaps(TotalReturnSwaps) 72 PricingTRORSonLeveredCDOTranches 74 TRORSversusRepos 75 EquityTRORS:CorporateLoansDisguisedas CapitalInjections 76 InformationAsymmetryandMoralHazard 78 CDSversusTRORS 78 Pay-as-You-Go 79 Indexes 81 CHAPTER4 CDOsandtheGlobalCapitalMarkets 83 EvolutionoftheCDOMarket 84 P1:a/b P2:c/d QC:e/f T1:g FM JWBK237-Tavakoli July29,2008 7:31 Printer:Yettocome Contents vii CHAPTER5 RiskandValuationIssues 91 ThePortfolioDiversificationMyth 91 ModernPortfolioTheory:BaneofCDOs 92 AbnormalIsNormal 96 Mark-to-MarketHazard 98 CashFlowHazard 99 GlobalDerivativesRisk 100 LoansandLeveragedLoans 101 TheLeverageParadox 103 NewStructuredFinanceDeals 104 Fraud 104 HedgeFunds:ANewInvestorClass 107 Tavakoli’sLaw,HedgeFunds,andtheGreatUnwind 110 BrainDamageTheory 112 DeadMan’sCurveandLeveragedFunds 113 MarginofSafetyversusOne-SidedIlliquidLeveragedBets 114 CHAPTER6 EarlyCDOTechnology 117 TrueSaleHybridandSyntheticStructures 117 CreditEnhancement 119 MonolineandMultilineInsurance 119 CDOClassification 121 MarketValueCDOs 124 CashFlowCDOs 124 TheOriginsofU.S.Securitization 126 CollateralizedMortgageObligations 135 CHAPTER7 EarlyWarningCommercialFinancialServices 143 RatingAgencies’FailedModels 143 AnatomyofaFlawedProcess 144 Terminology 145 EarlyRedFlags 147 CFSGetsCreative 149 SellingOuttheFuture 149 IgnoringanAuditReport 150 LessonstoBeLearned 151 FalloutfromCFS’sBankruptcy 153
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