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Collateralized Debt Obligations structures and analysis by Laurie S Goodman and Frank J Fabozzi2

7-Market Value CDOs Page 173 Monday, August 12, 2002 9:32 AMCHAPTER7Market Value CDOss explained in Chapter 1, there are cash flow and market.value collateralized debt obligations. Many investors look.suspiciously at the senior and mezzanine tranches of market.value CDOs. Their concern is that this deal structure gives.the manager the same latitude to manage a portfolio as a.hedge fund manager. That view is wrong. It is based on a misconception about how market value CDOs are really structured and the protection they provide investorsWhile market value deals are a distinct minority of CDOs,.they are the structure of choice for certain types of collateral,.where the cash flows are not predictable. It is very difficult to.use unpredictable cash flows within the confines of a cash.flow structure. Moreover, market value structures may also.appeal to managers and equity buyers who like the greater.trading flexibility inherent in these deals. Finally, market.value transactions also facilitate the purchase of assets that.mature beyond the life of the transaction, because the price.volatility associated with the forced sale of these assets is.explicitly consideredThis chapter provides an overview of the differences.between cash flow and market value structures. It also examines the mechanics of market value CDOs, focusing on the.advance rates (i.e., the percentage of a particular asset that.may be issued as rated debt)—the key to protecting the debtA173.7-Market Value CDOs Page 174 Monday, August 12, 2002 9:32 AM174COLLATERALIZED DEBT OBLIGATIONS: STRUCTURES AND ANALYSISholders. Then we look at some volatility numbers, which.indicate how conservative the advance rates used by the rating agencies are.CASH FLOW VERSUS MARKET VALUE DEALS.Cash flow deals are dependent on the ability of the collateral.to generate sufficient current cash flow to pay interest and.principal on rated notes issued by the CDO. The ratings are.based on the effect of collateral defaults and recoveries on the.receipt of timely interest and principal payments from the.collateral. The manager focuses on controlling defaults and.recoveries. Overcollateralization, as measured on the basis of.the par value of the portfolio, provides important structural.protection for the bondholders. If overcollateralization tests.are not met, then cash flow is diverted from mezzanine and.subordinated classes to pay down senior notes, or cash flow.is trapped in a reserve account. There are no forced collateral.liquidationsMarket value transactions depend upon the ability of the.fund manager to maintain and improve the market value of.the collateral. Funds to be used for liability principal payments are obtained from liquidating the collateral. Liability.interest payments can be made from collateral interest.receipts, as well as collateral liquidation proceeds. Ratings.are based on collateral price volatility, liquidity, and market.value. The manager focuses on maximizing total return while.minimizing volatilityMarket overcollateralization tests are conducted regularly. These require that the market value of assets multiplied.by the advance rates (discussed later) must be greater than or.equal to debt outstanding. If that is not the case, collateral.sales and liability redemptions may be required to bring overcollateralization ratios back into compliance. Market value.deals have diversity, concentration and other portfolio constraints, albeit less than cash flow transactions. For example,.7-Market Value CDOs Page 175 Monday, August 12, 2002 9:32 AMMarket Value CDOs175in a cash flow transaction if there is a constraint that the asset.manager may not hold more than $20 million par value in a.particular industry, then if $15 million is currently in the.portfolio and the manager would like to invest in $10 million.more in that industry, that cannot be done. The manager may.only invest in an additional $5 million. In contrast, in a market value transaction, the same ma