• In analyzing the credit risk and other features of the pool, in retail ABS, the common approach is to use a top-down approach; that is, to treat the pool as homogenous and apply characteristic features such as default rate, delinquency rate, prepayment rates, and so on to the entire pool. In other words, the pool-level characteristics are applied to the individual loans in the pool. In the case of corporate loan pools, the pool cannot be taken to be homogenous—so, the analyst studies the distinctive features of each loan in the pool, and aggregating the information about each loan, the pool-level characteristics are derived. We will call this a bottom-up approach.

• In statistical analysis of the probability of default of the pool, retail pools tend to exhibit the behavior as suggested by a normal distribution, given the large number of loans in the pool. The probability distribution of wholesale loan pools is more left-heavy, and has a longer and thicker tail—the probability distribution is similar to a binomial distribution.

• In the case of retail pools, it is valid to assume, given the nature of the loans, that the loans do not have an intra-obligor correlation. Even if the loans are correlated, they are all correlated with an external factor, such as property prices in the case of home equity loans or unemployment levels in the case of credit card transactions. The assumption that there is internal correlation in the pool is warranted. On the other hand, in the case of CDOs, there might be obligors belonging to industries or industry clusters which are correlated. Correlation is a very significant risk in the analysis of CDOs, and there are several CDOs that are structured to allow investors to trade in correlation.⁵⁰

• The objective of the transaction might be to generate profits being the difference between the rate of return on assets and the funding cost of the transaction. For obvious reasons, it would be in everyone’s interest to prolong this source of profits for sometime—hence, most arbitrage CDOs are reinvesting type transactions. That is, as part of the assets in the pool repay or prepay, the proceeds are reinvested in acquiring more assets.

• Such reinvesting type transactions typically run for 7 to 8 years, and then they are repaid, normally by way of a bullet repayment. ⁵¹

• If there is a reinvesting type CDO, there must be a CDO manager, who would decide what assets to add into the pool. CDOs may be actively managed or static CDOs. If it is static, it would not need any management of the pool as such, as the selection is done at the inception. However, if the CDO manager is free to add and sell assets at his or her discretion, the composition of the pool might change not merely because of amortization or prepayment, but because of a discretionary sale of assets by the manager.

• The selection of the assets is done so as to lead to a desired level of diversification.

• The credit enhancements typically used in CDOs would be subordination. There may be a level of excess spread that may be trapped in extraordinary situations. Structural protection is mostly in the form of control on the leverage of the transaction. This is discussed in Chapter 13.

• While the CDO manager has the right to reinvest the principal proceeds of the assets, the right to reinvest is controlled by two important tests: the overcollateralization (OC) and interest coverage (IC) triggers. These triggers are discussed later in Chapter 13, but broadly, if these triggers are in place, they require the manager to reduce the level of leverage in the transaction by using the principal proceeds to pay off senior liabilities.

• In view of the reinvesting-type nature of the transaction, the paydown structure of the liabilities is mostly sequential.