Cdos

5. Illustrate the proposed SEQUILIS/MINCS structure and compare it with a plain vanilla CDOs issuance. Which structure could add more value?

SEQUILS/MINCS is a specific structure proposed by JP Morgan to RBS. It combines both traditional and synthetic CDO structures and uses two disconnected SPVs. It is considered an arbitrage synthetic CDO structure where a synthetic exposure is provided to a reference portfolio of leveraged bank loans. The main objective of this structure is to transform low rating loans into higher rating loans in order to attract more investors. It also eliminates or minimizes the equity tranche, therefore, transferring the risk from the bank to a third party.

The process starts with RBS –the originating bank- owning a portfolio of loans worth 852.5 million. They are low rated loans from BB- to B+, yet the bank wants to remove them from its balance sheet. The bank creates the first SPV, SEQUILS that is consisted of a traditional CDO structure. SEQUILS would issue low rated BB- to B+ notes to sell to investors. To achieve an investment-grade rating, SEQUILS insures its notes by a credit default swap provided by Morgan Guarantee Trust. SEQUILS would pay Morgan Guarantee a percentage of the 852.5 million as a periodic fee using the spread. Being backed up by a highly rated entity boosts the ratings of the tranches issued by SEQUILS to AAA, AA and BBB loans. This repackaging of loans attracts more investors and minimizes the risk on RBS. The second step is to create a separate SPV, MINCS that uses a synthetic CDO structure. Morgan Guarantee Trust buys credit swaps from MINCS –the second SPV-. MINCS would issue notes worth 144 million based on the original 852.5 million-loan amounts. MINCS would provide Morgan Guarantee Trust insurance through a credit default swap 6 times its capital of 144 million (6 x 144m = 864). Therefore, investors in MINCS would be receiving higher yields, 6 times the credit swap, on the 144 million, yet they are...