Western Asset Arbitrage Harvard Case Solution & Analysis

Western Asset Arbitrage Case Solution

Introduction

Western Asset Management Company has been founded on October 1997, by United California bank. The company becomes investment advisors on December 1971. The company does it business competently and become one of the world’s leading fixed income managers in early 2007. The company has great interest in managing CDOs in its business structure.

In April 2007 few commercial banks offered the company to buy assets comprising of senior secured bank loans and High yielding corporate bonds. Based on the market analysis, as done by Michael Stone who is a senior collateral manager of the company, the proposal looks attractive therefore further analysis was made. He approaches his old friend Jason Keyes who is the managing director at Lehman Brothers to consolidate such a feasible deal.

Problem Statement

The problem is that the credit ratings are driver for these investment opportunities. These ratings might affect the attractiveness of the transaction to investors. Kim, who is the associate at Lehman brothers, has analyzed the transaction and identifies significant cushion for different tranches of rated securities. The estimations she has made gives default rate for these tranches more than the maximum default rates required for achieving specific rating.

There will be conflict of interest between the investors in rated securities, who requires bigger cushions and equity investors who requires smaller cushions.

Collateralized Debt Obligation

Collateralized Debt Obligation CDO is a separate entity that is formed by the investment bank, which holds assets as collateral and bear cash flows for the investors. The investment banker issues CDO and establishes a special purpose vehicle SPV. The SPV holds pool of debt securities and the subsequent cash flow is divided to the investors through participatory arrangements.  In simple words CDO is a pooling of debt so that the risk is minimized to a certain level as well as return can be generated (Collateralized Debt Obligation (CDO), n.d). The asset that is being hold under the CDO includes commercial loans, house mortgages, credit card debt etc. The pool of debt is created and the associated risk is then spread over different tranches, each of which has unique risk profile. The cash flow generated through CDO is distributed to these investors, tranches holders.

Parties involved

The parties involved in this transaction are:

  • Asset management company, in this case Western Asset Management Company
  • Investment Bank
  • CDO, Special Purpose Vehicle
  • Investors

The investment bank is the middle man or servicing agent between the investors and SPV. It receives cash flows from the SPV and distributes it to the investors. SPV purchase and holds assets to work as collateral against the debt tranches issued by it. The asset management company mange assets and receives fee to manage such assets.

Role of Rating Agencies

Credit Rating Agencies play an important role in the CDO transactions. It gives credit ratings to the different tranches of the CDO which influence the investor’s decision. These agencies have stated guidelines to rate a certain debt. The ratings provided by these rating agencies greatly affect the profitability of the CDOs (Dwyer, 2010)..................

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