WestLB credit structuring head Darren Smith and Cross Point Capital Managing Director Pamela Winchie have written a book that introduces readers to the modeling of cash flow CDOs. The book is titled Cash CDO Modeling With Excel: A Step by Step Approach.

The book, which will be launched in the U.K. on May 21 and in the U.S. on July 6, makes it easier for those new to the sector to analyze the cash CDO product. It offers step-by-step instructions on how to build a model for these complex instruments.

Utilizing Microsoft Office Excel, the book features easily understandable mathematical explanations and examples of methods commonly used in cash CDO analysis. Thus far, a couple of CDO asset managers have given their endorsement to the book, according to the authors.

"We wanted to make it easier for new entrants to the market to understand how to model cash
CDOs, enabling them to construct their own models," Smith said. "People from the sell side, investors and rating agencies could even use this to tie this up to their own models. We think there's a wide space for this type of book because previously CDOs have mainly been written about from a legal and accounting vantage point, but not from a modeling perspective."

Smith added that he would have benefited from a book like this when he first started working on the product.

Through this book, the authors are aiming to introduce an Excel-based modeling of cash flow CDOs. They explain how to construct cash flows for both the underlying collateral and the issued notes, how to evaluate default probabilities and expected losses for rating agencies, and how
to apply techniques and approaches that investors can use to value these deals.

The authors started writing the book in 2005, at the height of the CDO boom. At that time, literature on modeling structured finance products, if available at all, were fairly generic. In some cases, CDO modeling techniques used were merely extensions of those used in mortgages.

"It's very specific what we are offering — what we know about CDOs and CLOs," Winchie said. "When we first started writing the book, there didn’t exist a comprehensive book on modeling of CDOs and CLOs.  There was not even an overarching guide from the rating agencies that explained their criteria comprehensively: their criteria were housed in a collection of loosely linked papers."

Winchie explained that their book features a comprehensive look at modeling cash CDOs, including  warehousing for the underlying assets, balance sheet management, as well as regulatory issues, specifically for taking to account Basel II requirements.

She added that with modifications, the modeling techniques featured in the book are  transferable. "It showcases that CDO products are merely vehicles. It's not their technology that is inherently good or bad, it's what you put in them," Winchie said.

What the book offers is a generic model, while acknowledging that all the various types of CDOs and CLOs are modeled differently. "We would like to offer a thought process that could serve as a starting point," she said.

A problem that could be solved by knowing how to model cash flow CDOs properly is understanding the assumptions behind the rating agencies' triple-A ratings.

"When you understand something, you are in a stronger position," Smith said. "One of the big problems during the recent crisis is that commonly available blackboxes did not capture rating downgrades risk. The problem that the deal would terminate early resulting in the collateral being sold at a market value if certain triggers were hit, which in turn, incorporated haircuts linked to rating — this was typically not modeled."

This lack of modeling of the risk in the changes in market value, added Smith, caused a lot of problems for investors because of the higher losses resulting than were expected. "These downgrade triggers were typically not modeled by anyone," Smith said. The book discusses the use of rating migrations to help readers model the impact of changes in rating activity.

Even though there has been a move to standardized blackbox automated systems to model structured finance products, both Winchie and Smith agree that there's room for using Microsoft Excel to model these complex instruments.

"Atlhough the move toward the standardization of structured finance is a good idea, one of the advantages of Excel is it's much more flexible," Smith said. "The problem with blackboxes is that they are more reactive. With excel, you could tinker with it a little, you can run your own
analysis and poke around with the results."

He added that their cash flow CDO model allows users to run basic analysis for pricing and risk evaluations, and allows readers to do their own analysis and eventually if required build their own blackboxes.

According to the authors, a wider aim of this book is to promote discussion and debate regarding the modeling, evaluation and valuation of cash flow CDOs.

The authors acknowledge that there is not necessarily one right way to model, each model is a compromise between several objectives such as speed, flexibility, visibility, degree of automation, ease of change and verification. The book explains the authors' views on best practice and utilizes their experiences in discussing the advantages and disadvantages of different approaches.

The Web site on the book, http://www.cashcdo.com/, stated that it adopts a step by step approach to building a rudimentary model so that any reader who "sticks the course" will have a useful tool in evaluating cash flow CDOs as well as a template that can be built upon to suit personal taste and requirements.

To view the book's cover image, please click on the link below.

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