News / Project Finance CDOs after the credit crisis. Report by IJ & Mayer Brown

Project Finance CDOs after the credit crisis. Report by IJ & Mayer Brown

🕔 September 5, 2010

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I've never writen very much about Project Finance. I consider it's a pretty interesting topic and goes together with Public private partnerships (PPP) in infrastructure.

Today, I'm writing about a new report writen by Paul Forrester (Mayer Brown), one of the world's leading lawyers in Project Finance, and published by Infrastructure Journal.

To be sincere, I didn't know much about collateralised debt obligations (CDOs) before reading this article but we all remember that the last financial crisis was very related to this kind of products. As Paul comments in his article:

Of course, CDOs or Residential Mortgage Backed Securities (RMBS), especially subprime RMBS have been widely criticised regarding their role and function that is seen by many as the centre-ground of the recent credit crisis. As a result, and despite the fact that the market has not seen a RMBS CDO since the beginning of the credit crisis, there are several efforts to subject CDOs to substantially expanded regulation raising the real risk that this financing tool may not be available in the future.

When talking of project finance, we can find similar products, Project Finance CDOs. As Paul states:

Project finance CDOs are simply CDOs backed by project loans, bonds, or lease collateral and are particularly appealing as vehicles via which project lenders can synthetically refinance their project finance portfolios. Because project finance CDOs provide investors with access to a diversified portfolio of project finance debt obligations, project lenders can find it easier to refinance by selling to such a CDO than if each specific credit exposure had to be individually sold or refinanced.
As such, the sale of a project finance portfolio enhances the seller's opportunity to undertake additional project finance business with favoured existing clients or new borrowers. Additionally, project finance CDOs enable financial institutions to manage their exposures (to particular countries, industries, and creditors), potentially enabling them to achieve better economic results than they could if they sold the loans in secondary transactions.
There are two types of Project Finance CDOs: Collateralised loan obligations (CLOs) and Collateralised bond obligations (CBOs). Likewise there are two kind of CLOs: Cash CLOs and synthetic CLOs. Paul explains it very well in his article:
CLOs collateralised by project finance loans can be either cash or synthetic CLOs. In a typical cash CLO, the SPE purchases whole loans or loan participations, with the cash to finance the purchase of those loans raised by issuing liabilities collateralised by the loan assets. In a synthetic CLO, by contrast, the SPE acquires exposure to the underlying loan portfolio synthetically through the sale of credit protection on that reference portfolio.
As you see the difference between cash or synthetic CLOs is easy, it depends on where the SPE gets the money from. Below find the reference to CBOs:
The closing of the WISE 2006-1 transaction in 2006 marked the first project finance CDO based on project finance bonds rather than loans, making it the first project finance CBO. Specifically, WISE 2006-1 was based on exposure to 31 bonds, all of which were wrapped by monoline insurance companies rated AAA at the time. In the WISE 2006-1 structure, the WISE 2006-1 PLC SPE issued £63.75 million in three classes of floating-rate notes.

I particularly like the following paragraph extracted from the article too:

The notion that the risk of an asset portfolio can be allocated across different securities based on their depth of subordination is, after all, a basic tenet of corporate finance. Every time a corporation decides to issue subordinated debt (in lieu of senior debt), that security issuer makes a risk allocation decision that is fundamentally the same as the design principle underlying CDOs.

I am not very convinced that this kind of products is not misleading.I know they are good for banks, no doubt about that. But for instituional investors buyers? In the end when you buy loans from 20 different project finance loans, who tells you that there are not two of them that heading to default and that may cause the default of the whole product too. I know there are due dilligence processes for that. but we are talking of twenty very different proudcts (from wind farms to airport and from gas pipalines to roads). What do you think?

Just let me attach Paul Forrester's conclusion. It follows:

Project finance CDOs are an efficient means of facilitating risk transfer for banks. By bundling multiple project risks in a single portfolio whose risks are borne primarily by non-bank investors, project finance CDOs can facilitate extensions of project credit that might otherwise be impossible in the current market environment, release "precious" bank regulatory capital for redeployment and permit banks to "fine-tune" their project finance exposures. In turn, investors benefit from a tranched structure with attendant risk/reward choices and, in some cases, from capable and properly incentivized CDO management.
You can find the report below here:Project Finance CDOs After the Credit Crisis. IJ & Mayer Brown And follow us on twitter!

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