Event of Default Provisions and the Valuation of ABS CDO Tranches

Abstract

In early October 2007, Moody's downgraded 2,506 first lien subprime bonds issued in 2006. Most of these were rated from A1 to Baa3. An additional 323 bonds rated A1 to Baa3 were kept on watch for further downgrade, and 529 Aaa and Aa subprime bonds were put on watch for downgrade. As a result of these massive downgrades and future rating agency downgrades, investors have become concerned that Event of Default (EoD) provisions in ABS CDOs will be tripped, allowing controlling investors to accelerate many CDOs that own subprime bonds. This would result in diversion of cash flows from lower rated CDO tranches until principal and interest were paid in full on the highest rated tranches. In this article, the authors briefly review EoD provisions, explain how EoD provisions have reshaped the landscape for many distressed collateralized debt obligations backed by subprime mortgage bonds, and show that while many CDOs share basic EoD features, the substantive effect on the cash flows to CDO tranches varies widely. Two decision trees, one to show the diversity of ABS CDO cash flow acceleration features and another to rank different structures by the length of interest flow to subordinate tranches, are presented to show how the most important factors affect cash flows.