The Lehman Lesson

The sad fate of Lehman Brothers is a cautionary tale of what's gone wrong with Wall Street. Lehman ended up on the financial scrapheap because it played - and ultimately lost - a dangerous game involving high-stakes bets and huge borrowings. The firm's reported profits grew nicely through last year. But to keep its profits growing, Lehman was taking on more and more risk.

Lehman (LEH, Fortune 500) borrowed too much money, put too much of it into deals of dubious quality, and then insisted for months that all was well when it was apparent that all wasn't well. Monday's bankruptcy filing is a sad end for a firm once regarded as prudent and well managed.

The saddest thing of all is that decades ago Dick Fuld, now Lehman's CEO, bitterly opposed having the firm do big, aggressive deals with its own capital. But as we said in July, during one of Lehman's recurring crises, Fuld's decision to do the risky things that he opposed in the 1980s hurt Lehman badly.

Back then, Fuld's trading faction from the old Lehman Brothers was struggling against the firm's banker faction, led by Steve Schwarzman and Pete Peterson. The bankers wanted the firm to use its own capital to do deals. The traders opposed it. The trader-banker war so weakened Lehman that it sold out to American Express (AXP, Fortune 500) in 1984. Fuld, a Lehman lifer, stayed on, while Schwarzman and Peterson went off to found the Blackstone Group (BX) and become billionaires.

In 1994, AmEx, giving up its "financial supermarket" strategy, spun off a small, undercapitalized firm called Lehman Brothers, with Fuld as CEO. (That's why, despite what you read, Lehman wasn't a 158-year-old firm; it was a 14-year-old firm with a 158-year-old name.) Lehman's leverage - borrowings relative to capital - grew and grew, even as other firms were cutting back as the credit crunch worsened.

For example, last October, with the real estate collapse well underway, Lehman (in partnership with the Tishman Speyer real estate firm) paid a whopping $22.2 billion to do a leveraged buyout of a big apartment developer, Archstone. Losses on the deal began to surface almost immediately. Alas, we can't give you Fuld's take on all this; he's declined to talk with us for months. Lehman looked as if it would be able to survive more or less intact after the Federal Reserve Board announced in March that it would make huge loans available to eligible investment banks. This came shortly after the Fed and the Treasury forced a fire sale of Bear Stearns, and let it be known that the timing was no coincidence.

But Lehman never fully regained the market's confidence, Fed and Treasury support notwithstanding.

That leads us to a second Wall Street lesson from Lehman: that the Fed and Treasury can no longer control events as they once could.

Infrastructure funds

Project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure where project debt and equity are used to finance the project. Usually, a project financing scheme involves a number of equity investors, known as sponsors, as well as a syndicate of banks which provide loans to the operation. The loans are most commonly non-recourse loans, which are secured by the project itself and paid entirely from its cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets, and are able to assume control of a project if the project company has difficulties complying with the loan terms.

Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of a project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound. Project finance is often more complicated than alternative financing methods. Traditionally, project financing has been most commonly used in the mining, transportation, telecommunication and public utility industries. More recently, particularly in the world , project financing principles have been applied to quasi-privatizations of publicly-held infrastructure (e.g., hospitals, light rail, , Harbor , Water Supply , Power Pkant, etc.) under so-called public-private partnerships (PPP).

Risk identification and allocation is a key component of project finance. A project may be subject to a number of technical, environmental, economic and political risks, particularly in developing countries and emerging markets. Financial institutions and project sponsors may conclude that the risks inherent in project development and operation are unacceptable (unfinanceable). To cope with these risks, project sponsors in these industries (such as power plants or railway lines) are generally completed by a number of specialist companies operating in a contractual network with each other that allocates risk in a way that allows financing to take place.

The various patterns of implementation are sometimes referred to as "project delivery methods." The financing of these projects must also be distributed among multiple parties, so as to distribute the risk associated with the project while simultaneously ensuring profits for each party involved.

A riskier or more expensive project may require limited recourse financing secured by a surety from sponsors. A complex project finance scheme may incorporate corporate finance, securitization, options, insurance provisions or other further measures to mitigate risk.

Project finance shares many characteristics with maritime finance and aircraft finance; however, the latter two are more specialized fields.The main challenges of financing large-scale projects.Projects like power plants, toll roads or airports share a number of characteristics that make their financing particularly challenging.

First, they require large indivisible investments in a single-purpose asset. In most industrial sectors where project finance is used, such as oil and gas and petrochemicals, over 50% of the total value of projects consists of investments exceeding $1 billion.

Second, projects usually undergo two main phases (construction and operation) characterised by quite different risks and cash flow patterns. Construction primarily involves technological and environmental risks, whereas operation is exposed to market risk (fluctuations in the prices of inputs or outputs) and political risk, among other factors. Most of the capital expenditures are concentrated in the initial construction phase, with revenues instead starting to accrue only after the project has begun operation.

Third, the success of large projects depends on the joint effort of several related parties (from the construction company to the input supplier, from the host government to the off-taker)so that coordination failures, conflicts of interest and free-riding of any project participant can have significant costs. Moreover, managers have substantial discretion in allocating the usually large free cash flows generated by the project operation, which can potentially lead to opportunistic behaviour and inefficient investments.

The key characteristics of project financing structures

A number of typical characteristics of project financing structures are designed to handle the risks illustrated above. In project finance, several long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures, are used to align incentives and deter opportunistic behaviour by any party involved in the project. The project company operates at the centre of an extensive network of contractual relationships, which attempt to allocate a variety of project risks to those parties best suited to appraise and control them:

for example, construction risk is borne by the contractor and the risk of insufficient demand for the project output by the off-taker (Graph 3). Project finance aims to strike a balance between the need for sharing the risk of sizeable investments among multiple investors and, at the same time, the importance of effectively monitoring managerial actions and ensuring a coordinated effort by all project-related parties.

Large-scale projects might be too big for any single company to finance on its own. On the other hand, widely fragmented equity or debt financing in the capital markets would help to diversify risks among a larger investors’ base, but might make it difficult to control managerial discretion in the allocation of free cash flows, avoiding wasteful expenditures. In project finance, instead, equity is held by a small number of “sponsors” and debt is usually provided by a syndicate of a limited number of banks. Concentrated debt and equity ownership enhances project monitoring by capital providers and makes it easier to enforce projectspecific governance rules for the purpose of avoiding conflicts of interest or suboptimal investments.

The use of non-recourse debt in project finance further contributes to limiting managerial discretion by tying project revenues to large debt repayments, which reduces the amount of free cash flows. Moreover, non-recourse debt and separate incorporation of the project company make it possible to achieve much higher leverage ratios than sponsors could otherwise sustain on their own balance sheets. In fact, despite some variability across sectors, the mean and median debt-to-total capitalization ratios.

for all project-financed investments in currently were around 70%. Nonrecourse debt can generally be deconsolidated, and therefore does not increase the sponsors’ on-balance sheet leverage or cost of funding. From the perspective of the sponsors, non-recourse debt can also reduce the potential for risk contamination. In fact, even if the project were to fail, this would not jeopardise the financial integrity of the sponsors’ core businesses. One drawback of non-recourse debt, however, is that it exposes lenders to project-specific risks that are difficult to diversify. In order to cope with the asset specificity of credit risk in project finance, lenders are making increasing use of innovative risk-sharing structures, alternative sources of credit protection and new capital market instruments to broaden the investors’ base.

Hybrid structures between project and corporate finance are being developed, where lenders do not have recourse to the sponsors, but the idiosyncratic risks specific to individual projects are diversified away by financing a portfolio of assets as opposed to single ventures. Public-private partnerships are becoming more and more common as hybrid structures, with private financiers taking on construction and operating risks while host governments cover market risks.

There is also increasing interest in various forms of credit protection. These include explicit or implicit political risk guarantees,6 credit derivatives and new insurance products against macroeconomic risks such as currency devaluations. Likewise, the use of real options in project finance has been growing across various industries.7 Examples include: refineries changing the mix of outputs among heating oil, diesel, unleaded gasoline and petrochemicals depending on their individual sale prices; real estate developers focusing on multipurpose buildings that can be easily reconfigured to benefit from changes in real estate prices.

Finally, in order to share the risk of project financing among a larger pool of participants, banks have recently started to securitise project loans, thereby creating a new asset class for institutional investors. Collateralised debt obligations as well as open-ended funds have been launched to attract higher liquidity to project finance.

The term structure of credit spreads in project finance

The specific risks involved in funding large-scale projects and the key characteristics of project financing structures illustrated in the previous sections (in particular high leverage and non-recourse debt) have important implications for the term structure of credit spreads for this asset class.

First, based on the widely used framework for pricing risky debt originally proposed by Merton (1974), we should expect to observe a hump-shaped term structure of credit spreads for highly leveraged obligors. In this approach, the default risk underlying credit spreads is primarily driven by two components:
(1) the degree of firm indebtedness or leverage and
(2) the uncertainty about the value of the firm’s assets at maturity.

Given Merton’ s assumption of decreasing leverage ratios over time, postponing the maturity date reduces the probability that the value of the assets will be below the default boundary when repayment is due. On the other hand, a longer maturity also increases the uncertainty about the future value of the firm’s assets. For obligors that already start with low leverage levels, this second component dominates, so that the observed term structure is monotonically upward-sloping.

For highly leveraged obligors, instead, the increase in default risk due to higher asset volatility will be strongly felt by debt holders at short maturities, but as maturity further increases, the first component will rapidly take over, thanks to the greater margin for risk reduction due to declining leverage. This leads to a hump-shaped term structure of credit spreads for highly leveraged obligors.

Second, despite the extensive network of security arrangements, the credit risk of non-recourse debt remains ultimately tied to the timing of project cash flows. In fact, projects which are financially viable in the long run might face cash shortages in the short term. Ceteris paribus, obtaining credit at longer maturities implies smaller amortising debt repayments due in the early stages of the project. This would help to relax the project company’s liquidity constraints, thus reducing the risk of default. As a consequence, longterm project finance loans should be perceived as being less risky than shorterterm credits.

Third, the credit risk of non-recourse debt might be affected not only by the timing but also by the uncertainty of project cash flows and how the latter evolves over the project’s advancement stages. In fact, successful completion of the construction and setup phases can significantly reduce residual sources of uncertainty for a project’s financial viability. Arguably, extending loan maturities for any additional year after the scheduled time for the project to be completely operational might drive up ex ante risk premia but only at a decreasing rate.

Finally, the term structure of credit spreads observed in project finance is likely to be affected by the higher exposure of large infrastructure projects to political risk and by the availability of political risk insurance for long-term project finance loans. While long maturities and political risk represent in principle separate sources of uncertainty, commercial lenders are often willing to commit for longer maturities in emerging economies only if they obtain explicit or implicit guarantees from multilateral development banks or export credit agencies. As political risk guarantees are most often associated with longer maturities, lenders should not necessarily perceive political-risk-insured long-term loans as being riskier than uninsured short-term loans, ceteris paribus

After bailout...

As we all know, Fannie Mae and Freddie Mac were being nationalised a couple of days ago. The US government has put in $US1 billion of new capital (in the form of preferred shares) and says it might put in up to $US200 billion more. At the same time, it will take over the management of these two companies. Consequently, the stock market all over the world cheered this news in exuberance.

This is a farce.

There is a cost to this nationalization, which as we said two months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?,

“The collapse of Freddie Mac and Fannie Mae will result in a colossal deflation. Can the US allow such an unthinkable to happen? If the answer is no, then inflation is the only path out of it, in which the road to hyperinflation hell begins. This is also unthinkable. Which road will the US take? If the US takes the latter route, all of us will be paying for their bailout via inflation.”

Now consider the situation of the US government budget as reported in ‘Frannie’ bailout heavy with irony:

“ According to the US Government’s Accountability Office the national debt stood at $US4.4 trillion early this year. Unless the habit of deficit spending is arrested quickly this figure will double in the next ten years. Meanwhile, the social security system faces an unfunded liability estimated by the Government Accountability Office at $US6.7 trillion and the unfunded liability of Medicare is $US34 trillion.”

If the US government has to bail out more and more blow-ups in the financial system, there is only one way the level of national debt can go: up and up to the sky. It has come to a stage that the word “billion” is not enough to describe the magnitude of the debt- “trillion” has used instead. That level of debt is approximately $150,000 for every man, woman and children in the United States.

Is the US government going to pay all these debt by raising taxes? With rising unemployment, record levels of private debt and wobbly economy, do you think this idea can ever be entertained? If it is politically impossible to raise taxes, what else can be done? Default or print money?

Strangely, the market reacted to this news by bidding up the US dollar

CDOs

Collateralized debt obligations (CDOs) are an unregulated type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided by the ratings firms that assess their value into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. CDOs serve as an important funding vehicle for fixed-income assets.

Some news and media commentary blame the financial woes of the 2007 credit crunch on the complexity of CDO products, and the failure of risk and recovery models used by credit rating agencies to value these products. Some institutions buying CDOs lacked the competency to monitor credit performance and/or estimate expected cash flows. On the other hand, some academics maintain that because the products are not priced by an open market, the risk associated with the securities is not priced into its cost and is not indicative of the extent of the risk to potential purchasers.As many CDO products are held on a mark to market basis, the paralysis in the credit markets and the collapse of liquidity in these products led to substantial write-downs in 2007. Major loss of confidence occurred in the validity of process used by ratings agencies to assign credit ratings to CDO tranches and persists into 2008.

Market history and growth

The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation on June 22, 1990. A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles. It may also reflect the greater profit margins that CDOs provide to their manufacturers.

A major factor in the growth of CDOs was the 2001 introduction by David X. Li of Gaussian copula models, which allowed for the rapid pricing of CDOs. According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$ 503 billion in 2007. Research firm Celent estimates the size of the CDO global market to close to $2 trillion by the end of 2006.

Concept
CDOs vary in structure and underlying assets, but the basic principle is the same. Essentially a CDO is a corporate entity constructed to hold assets as collateral and to sell packages of cash flows to investors. A CDO is constructed as follows:
A special purpose entity (SPV) acquires a portfolio of credit (finance). Common assets held include mortgage-backed securities, Commercial Real Estate (CRE) debt, and high-yield corporate loans.

The SPV issues different classes of bonds and equity and the proceeds are used to purchase the portfolio of credits. The bonds and equity are entitled to the cash flows from the portfolio of credits, in accordance with the Priority of Payments set forth in the transaction documents. The senior notes are paid from the cash flows before the junior notes and equity notes. In this way, losses are first borne by the equity notes, next by the junior notes, and finally by the senior notes. In this way, the senior notes, junior notes, and equity notes offer distinctly different combinations of risk and return, while each reference the same portfolio of debt securities.

A CDO investor takes a position in an entity that has defined risk and reward, not directly in the underlying assets. Therefore, the investment is dependent on the quality of the metrics and assumptions used for defining the risk and reward of the tranches. The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. An investment in a CDO is therefore an investment in the cash flows of the assets, and the promises and mathematical models of this intermediary, rather than a direct investment in the underlying collateral. This differentiates a CDO from a mortgage or a mortgage-backed security (MBS).

The loss of an investor's principal is applied in reverse order of seniority (i.e., highest credit risk tranches to lowest). The senior tranche is protected by the subordinated security structure; thus, it is the most highly rated tranche. The equity tranche (also known as the first-loss tranche or "toxic waste") is most vulnerable, and has to offer higher coupons to compensate for the higher risk.

Structures
CDO is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follows:
Source of funds -- cash flow vs. market value 

Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDO's assets. Cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio. Market value CDOs attempt to enhance investor returns through the more frequent trading and profitable sale of collateral assets. The CDO asset manager seeks to realize capital gains on the assets in the CDO's portfolio. There is greater focus on the changes in market value of the CDO's assets. Market value CDOs are longer-established, but less common than cash flow CDOs.

Motivation -- arbitrage vs. balance sheet
Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. The majority, 86%, of CDOs are arbitrage-motivated.
Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A bank may wish to offload the credit risk in order to reduce its balance sheet's credit risk.

Funding -- cash vs. synthetic
Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a special purpose vehicle) issuing the CDO's tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006.

Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swaps, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss on a specific asset in the event that asset experiences a default or other credit event.) Like a cash CDO, the risk of loss on the CDO's portfolio is divided into tranches. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche receives a periodic payment (the swap premium), with the junior tranches offering higher premiums.

A synthetic CDO tranche may be either funded or unfunded. Under the swap agreements, the CDO could have to pay up to a certain amount of money in the event of a credit event on the reference obligations in the CDO's reference portfolio. Some of this credit exposure is funded at the time of investment by the investors in funded tranches. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in high-quality, liquid assets or placed in a GIC (Guaranteed Investment Contract) account that offers a return that is a few basis points below LIBOR. The return from these investments plus the premium from the swap counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit event occurs and a payout to the swap counterparty is required, the required payment is made from the GIC or reserve account that holds the liquid investments. In contrast, senior tranches are usually unfunded since the risk of loss is much lower. Unlike a cash CDO, investors in a senior tranche receive periodic payments but do not place any capital in the CDO when entering into the investment. Instead, the investors retain continuing funding exposure and may have to make a payment to the CDO in the event the portfolio's losses reach the senior tranche. Funded synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time to create. Cash assets do not have to be purchased and managed, and the CDO's tranches can be precisely structured.

Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional assets. A portion of the proceeds from the funded tranches is invested in cash assets and the remainder is held in reserve to cover payments that may be required under the credit default swaps. The CDO receives payments from three sources: the return from the cash assets, the GIC or reserve account investments, and the CDS premiums.

Single-tranche CDOs
The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke CDOs) where the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches are never sold but held by the dealer based on valuations from internal models. Residual risk is delta-hedged by the dealer.

Variants
Unlike CDOs, which are terminating structures that typically wind-down or refinance at the end of their financing term, Structured Operating Companies are permanently capitalized variants of CDOs, with an active management team and infrastructure. They often issue term notes, commercial paper, and/or auction rate securities, depending upon the structural and portfolio characteristics of the company. Credit Derivative Products Companies (CDPC) and Structured Investment Vehicles (SIV) are examples, with CDPC taking risk synthetically and SIV with predominantly 'cash' exposure.

Taxation of CDOs
CDOs are bonds issued by special purpose vehicles that are backed by pools of bonds, loans or other debt instruments. CDOs are typically issued in classes or “tranches” with some being senior to others in the event of a shortfall in the cash available to make payments on the bonds. The issuer of a CDO typically is a corporation established outside the United States to avoid being subject to U.S. federal income taxation on its global income. These corporations must restrict their activities to avoid U.S. tax; corporations that are deemed to engage in trade or business in the U.S. will be subject to federal taxation. However, the U.S. government will not tax foreign corporations that only invest in and hold portfolios of U.S. stock and debt securities because investing, unlike trading or dealing, is not considered to be a trade or business, regardless of its volume or frequency.

In addition, a safe harbor protects CDO issuers that do actively trade in securities, even though trading in securities technically is a business, provided the issuer’s activities do not cause it to be viewed as a dealer in securities or engaged in a banking, lending or similar business.

CDOs are generally taxable as debt instruments except for the most junior class of CDOs which are treated as equity and are subject to special rules.

Types of CDOs
A) Based on the underlying asset:
Collateralized loan obligations (CLOs) -- CDOs backed primarily by leveraged bank loans.
Collateralized bond obligations (CBOs) -- CDOs backed primarily by leveraged fixed income securities.
Collateralized synthetic obligations (CSOs) -- CDOs backed primarily by credit derivatives.
Structured finance CDOs (SFCDOs) -- CDOs backed primarily by structured products (such as asset-backed securities and mortgage-backed securities).
Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans, and only less than 10% of CDOs were backed by fixed income securities.
B) Other types of CDOs include:
Commercial Real Estate CDOs (CRE CDOs) -- backed primarily by commercial real estate assets
Collateralized bond obligations (CBOs) -- CDOs backed primarily by corporate bonds
Collateralized Insurance Obligations (CIOs) -- backed by insurance or, more usually, reinsurance contracts
CDO-Squared -- CDOs backed primarily by the tranches issued by other CDOs.
CDO^n -- Generic term for CDO^3 (CDO cubed) and higher, where the CDO is backed by other CDOs/CDO^2/CDO^3. These are particularly difficult vehicles to model due to the possible repetition of exposures in the underlying CDO.

Types of Collateral
The collateral for cash CDOs include:
Structured finance securities (mortgage-backed securities, home equity asset-backed securities, commercial mortgage-backed securities)
Leveraged loans
Corporate bonds
Real estate investment trust (REIT) debt
Commercial real estate mortgage debt (including whole loans, B notes, and Mezzanine debt)
Emerging-market sovereign debt
Project finance debt
Trust Preferred securities

Transaction Participants
Participants in a CDO transaction include investors, the underwriter, the asset manager, the trustee and collateral administrator, accountants and attorneys.

Investors
Investors have different motivations for purchasing CDO securities depending on which tranche they select. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities (e.g. corporate bonds) of a similar rating. In some cases, investors utilize leverage and hope to profit from the excess of the spread offered by the senior tranche and their cost of borrowing. This is because senior tranches pay a spread above LIBOR despite their AAA-ratings. Investors also benefit from the diversification of the CDO portfolio, the expertise of the asset manager, and the credit support built into the transaction. Investors include banks and insurance companies as well as investment funds.

Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Mezzanine notes and equity notes offer yields that are not available in most other fixed income securities. Investors include hedge funds, banks, and wealthy individuals.

Underwriter

The underwriter, typically an investment bank, acts as the structurer and arranger of the CDO. Working with the asset management firm that selects the CDO's portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche.

The key economic consideration for an underwriter that is considering bringing a new deal to market is whether the transaction can offer a sufficient return to the equity noteholders. Such a determination requires estimating the after-default return offered by the portfolio of debt securities and comparing it to the cost of funding the CDO's rated notes. The excess spread must be large enough to offer the potential of attractive IRRs to the equityholders.

Other underwriter responsibilities include working with a law firm and creating the special purpose legal vehicle (typically a trust incorporated in the Cayman Islands) that will purchase the assets and issue the CDO's tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading restrictions that will be included in the CDO's transaction documents and other files.

The final step is to price the CDO (e.g. set the coupons for each debt tranche) and place the tranches with investors. The priority in placement is finding investors for the risky equity tranche and junior debt tranches of the CDO. It is common for the asset manager to retain a piece of the equity tranche. In addition, the underwriter was generally expected to provide some type of secondary market liquidity for the CDO, especially its more senior tranches.

According to Thomson Financial, the top underwriters are Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America Securities. CDOs are more profitable for underwriters than conventional bond underwriting due to the complexity involved. The underwriter is paid a fee when the CDO is issued.

The Asset Manager
The asset manager plays a key role in each CDO transaction, even after the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDO's portfolio. The manager can maintain the credit quality of a CDO's portfolio through trades as well as maximize recovery rates when defaults on CDO assets occur.
The asset manager's role begins before the CDO is issued. Months before a CDO is issued, a bank will usually provide financing to enable the manager to purchase some of the collateral assets that may be used in the forthcoming CDO in a process called warehousing.

Even by the issuance date, the asset manager often will not have completed the construction of the CDO's portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend for several months after the CDO is issued. For this reason, some senior CDO notes are structured as delayed drawdown notes, allowing the asset manager to drawdown cash from investors as collateral purchases are made. When a transaction is fully ramped, its initial portfolio of credits has been selected by the asset manager.

However, the asset manager's role continues even after the ramp-up period ends, albeit in a less active role. During the CDO's "reinvestment period", which usually extends several years past the issuance date of the CDO, the asset manager is authorized to reinvest principal proceeds by purchasing additional debt securities. Within the confines of the trading restrictions specified in the CDO's transaction documents, the asset manager can also make trades to maintain the credit quality of the CDO's portfolio. The manager also has a role in the redemption of a CDO's notes by auction call.

The manager's prominent role throughout the life of a CDO underscores the importance of the manager and his or her staff. There are approximately 300 asset managers in the marketplace. Some collateral managers are active whilst some are nothing more than placebos where the investor will be at risk to the underlying portfolio. Asset Managers make money by virtue of the senior fee (which is paid before any of the CDO investors are paid) and subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative business for asset managers. These fees, together with underwriting fees, administration{approx 1.5 - 2%} by virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.
See also: List of CDO Managers

The Trustee and Collateral Administrator
The trustee holds title to the assets of the CDO for the benefit of the noteholders (i.e. the Investor). In the CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and distributes noteholder reports, performs various compliance tests regarding the composition and liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall models. Two notable exceptions to this are Virtus Partners and Wilmington Trust Conduit Services, a subsidiary of Wilmington Trust, which offer collateral administration services, but are not trustee banks. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:

Bank of New York Mellon (note: the Bank of New York Mellon recently also acquired the corporate trust unit of JP Morgan which is the market share leader)
HSBC
LaSalle Bank (Recently acquired by Bank of America)
Wells Fargo
Deutsche Bank
US Bank (note: US Bank recently also acquired the corporate trust unit of Wachovia)
Fortis Intertrust (note: was formerly known as MeesPierson Intertrust)
BNP Paribas Securities Services (note: currently serves the European market only)
Wilmington Trust Company
Sanne Trust
State Street Corporation

Accountants

The underwriter typically will hire an accounting firm to perform due diligence on the CDO's portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread, of each collateral security. Source documents or public sources will typically be used to tie-out the collateral pool information. In addition, the accountants typically calculate certain collateral tests and determine whether the portfolio is in compliance with such tests.

The firm may also perform a cash flow tie-out in which the transaction's waterfall is modeled per the priority of payments set forth in the transaction documents. The yield and weighted average life of the bonds or equity notes being issued is then calculated based on the modeling assumptions provided by the underwriter. On each payment date, an accounting firm may work with the trustee to verify the distributions that are scheduled to be made to the noteholders.

Attorneys
Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction documents. Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory requirements to disclose certain information to investors. This will be circulated to investors. It is common for multiple counsels to be involved in a single deal due to the number of parties to a single CDO from asset management firms to underwriters.

IMF and World bank ?

The World Bank and International Monetary Fund (IMF) have wielded great power over developing countries for the past three decades. Yet it is now widely acknowledged that the neoliberal policies forced on the global South by these two institutions were responsible for increasing poverty and causing economic stagnation across the developing world during the 1980s and 1990s - the two 'lost decades' of development. The Bank and Fund have tried a public relations makeover, rebranding themselves as fellow combatants in the 21st century fight against global poverty. Yet mired in scandal and with their policies largely unchanged, the two institutions now face a crisis of legitimacy.

The World Bank and IMF have attracted intense criticism for the damage caused by their policy prescriptions to developing countries. The World Bank's own internal evaluations have acknowledged the failures of these policies over the 1980s and 1990s. In country after country, the privatization and trade liberalization programmes of the Bank and Fund led to structural dislocation and economic stagnation, with dramatic increases in poverty as a result.

Yet even today the Bank and Fund continue to force these same failed policies on developing countries as a condition of receiving their loans or debt relief. Despite suggesting that they have changed their approach to allow for greater participation by civil society groups in the South, both institutions continue to impose damaging economic conditions on developing countries, including the privatisation of public services. The World Bank's private sector arm, the International Finance Corporation, also continues to promote an unreconstructed privatization programmed, despite all the evidence against it.

The World Bank and IMF also face a crisis of legitimacy in respect of their own anti-democratic governance procedures. Set up at the Bretton Woods conference in 1944, both institutions provide rich countries with in-built control over their programmes. As a result of their 'one dollar, one vote' system, the US, Japan and EU dictate the terms of development to developing countries which rely on finance from the Bank and Fund. Similarly, a long-standing pact allows the US to choose each new head of the World Bank and the EU to appoint each head of the IMF, without any reference to the wishes of the broader membership. Following the scandal surrounding the appointment and subsequent resignation of Paul Wolfowitz as president of the Bank, an international outcry demanded fairer procedures for future appointments. Yet the EU and US refuse to countenance any democratic reforms which might see a challenge to their power.

In frustration at this continuing travesty, developing countries are now trying to break free from the Bank and Fund so as to be able to determine for themselves the development policies best suited to their own needs. Several Latin American states have chosen to sever links with the IMF and World Bank, and some have announced the creation of a rival development bank - the Bank of the South - which would be run on democratic principles. Even developed countries have begun to voice their discontent with the Bank and Fund's approach to development, with the UK government withholding funds in protest and others withdrawing their support from key World Bank projects. In the face of such unprecedented challenge, the World Bank and IMF have a genuine crisis on their hands.

OTC

Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.

OTC-traded stocks

In the U.S., over-the-counter trading in stocks is carried out by market makers that make markets in OTCBB and Pink Sheets securities using inter-dealer quotation services such as Pink Quote (operated by Pink OTC Markets) and the OTC Bulletin Board (OTCBB). OTC stocks are not listed or traded on any stock exchange. Although stocks quoted on the OTCBB must comply with SEC reporting requirements, other OTC stocks, such as those stocks categorized as Pink Sheets securities, have no reporting requirements, while those stocks categorized as OTCQX have met alternative disclosure guidelines through Pink OTC Markets.

The OTC market presents investment opportunities for informed investors, but also has a high degree of risk. Many OTC issuers are small companies with limited operating histories or are economically distressed. Investments in legitimate OTC companies can often lead to the complete loss of the investment. Investors should avoid the OTC market unless they can afford a complete loss of their investment. Investors should never purchase any security without first evaluating the fundamentals of the company and carefully reviewing the financial statements, management background and other data. Investors who purchase securities based on a "hot tip" or the advice of chat room touts may often be disappointed.

OTC market statistics

Data provided by Pink Sheets:

Securities quoted exclusively on Pink Sheets - 5,019

Securities dually quoted on Pink Sheets and OTCBB - 3,445

Securities quoted exclusively on OTCBB - 130

Total OTC securities - 5,149

OTC contracts

An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly. Forwards and swaps are prime examples of such contracts. It is mostly done via the computer or the telephone. For derivatives, these agreements are usually governed by an International Swaps and Derivatives Association agreement.

This segment of the OTC market is occasionally referred to as the "Fourth Market."

The NYMEX has created a clearing mechanism for a slate of commonly traded OTC energy derivatives which allows counterparties of many bilateral OTC transactions to mutually agree to transfer the trade to ClearPort, the exchange's clearing house, thus eliminating credit and performance risk of the initial OTC transaction counterparts.