Collateralized Debt Obligation (CDO)
Investments that take an asset and split it into several levels of risk and yield.
Updated:
August 26, 2022Collateralized debt obligations are investments that take an asset and split it into several levels of risk and yield. Bank loans, as well as fixed-income assets such as bonds and other debt instruments, are included in these asset-backed securities.
The advantages of CDO are:
• Helps improve the overall rating of the debt by tranching the interest payments and combining junk & investment grade debt.
• The returns are typically 2 to 3% greater than corporate bonds with the same rating.
• The investor has the option of selecting from a variety of risk and reward combinations.
The disadvantages of CDO are:
• Lower tranches are only paid if there is enough money to pay investors in higher-tiered tranches.
• If the collateral portfolio defaults, there is a risk of non-payment of owing interest as well as the remaining principal.
• Fears in the market can bring trading to a halt, resulting in liquidity difficulty for the investor.
Understanding Collateralized debt obligations
One of the most notable innovations of the securitization market in the 1990s was collateralized debt obligations.
They produce new, customizable asset classes by enabling different investors to share the risk and return of an underlying pool of debt obligations.
The underlying debt and the guidelines for allocating risk and reward are exactly what define an investment's attractiveness to investors.
In a collateralized debt obligation, a portfolio of securities is transferred to a special purpose vehicle (SPV) as part of the securitization process.
To pay for the acquisition of the portfolio, the SPV in turn issues tranches of debt instruments (notes) with varying levels of seniority and equity.
Securitization is seen as a risk reallocation where assets are transformed into securities backed by those assets, in order to reduce funding costs, access the capital markets, produce management fees, and fulfill some accounting requirements.
The fundamental framework of CDOs is derived from collateralized mortgage obligations. A CDO may hold real estate investment trusts, mortgage-backed securities, asset-backed securities, and even other CDOs.
structure
The assets are transferred to the SPV that funds these assets, from cash proceeds of the notes it has issued.
The collateralized debt obligation structure distributes interest revenue and principal repayment from a pool of various debt instruments to a series of securities notes known as tranches in order of priority.
Generally, they are rated based on portfolio quality, diversification, and structural subordination. There are always at least two tranches.
The losses in interest or principal to the collateral are absorbed first by the lowest level tranche and then in order to the next tranche and so on.
The mechanism for distributing the losses to the various tranches is called a waterfall. Senior notes are paid before the mezzanine and lower-rated notes.
Any residual cash flow is paid to the equity piece. This makes the senior CDO liabilities significantly less risky than the collateral.
After the planned debt payments and other costs have been paid on each payment date, equity gets cash distributions. Equity is also called the first-loss position in the collateral portfolio because it is exposed to the risk of the first dollar loss in the portfolio.
Losses occur when there is some kind of credit event. A credit event is usually either a default of the collateral or a credit downgrade of the collateral.
In either case, the market value of the collateral drops. The lowest tranche is the riskiest and is called the equity tranche. All the tranches except the equity tranche have credit ratings. The highest tranche is usually rated AAA.
The CDOs rating is based on its ability to service debt with the cash flows generated by the underlying assets. The debt service depends on collateral diversification, subordination, and structural protection.
A CDO is referred to as an asset-backed security collateralized debt obligation (ABS CDO).
If it invests in a first-order securitization product like a student loan or credit card receivable-backed security, Alt-A mortgage-backed security, commercial mortgage-backed security, or another asset-backed security (ABS CDO).
The market is dominated by ABS CDOs in terms of collateral type.
Example of an ABS CDO
Because the senior AAA-rated ABS tranches offered yields that were extremely attractive when compared to the return on AAA-rated bonds, finding investors to acquire them was typically not a problem. Generally, the asset's originator kept or sold the equity tranches to a hedge fund.
It was more challenging to find investors for mezzanine tranches. This resulted in the development of ABSs. The figure below demonstrates how this was accomplished.
The risk associated with the cash flows from a portfolio of several different mezzanine tranches is tranched out similarly to how the risk associated with the cash flows from the assets are tranched out in the previous image.
An ABS CDO, often known as a Mezz ABS CDO, is the resulting structure.
In this example, the equity tranche represents the remaining 10% of the principal, the mezzanine tranche represents 25% of the principal, and the senior tranche of the ABS CDO represents 65% of the principal of the ABS mezzanine tranches.
The agreement is designed to grant the senior tranche of the ABS CDO the highest credit rating of AAA. This shows that roughly 90% of the total principal of the AAA-rated instruments is generated in the instance under consideration.
This might sound high, but if the securitization went on and an ABS was created from ABS CDO tranches, the proportion would be further increased.
Cash VS Synthetic Collateralized debt obligations
A conventional cash CDO is built from a bond portfolio, as was already described. In a significant market breakthrough, a new equivalent financial product was established based on two cash flow-generating products namely, corporate bonds and CDSs.
When the reference company in the Credit Default Swap is the bond issuer, it has been found that a long position in a corporate bond has a variability similar to a short position in a CDS. As such, a new structure known as Synthetic CDOs came into existence.
A synthetic CDO's creator selects the portfolio of companies and the structure's maturity (for example, five years). It sells CDS protection on Each firm in the portfolio, with CDS maturities matching the maturity of the structure.
The sum of the notional principals supporting the CDSs constitutes the synthetic CDO principal. When companies in the portfolio default, the originator faces cash outflows, if not, inflows are generated based on the CDS spreads.
Inflows and outflows are divided among the tranches after their creation.
Cash CDOs demand a down payment from the holders of the tranches (to finance the underlying bonds). The holders of synthetic CDOs, on the other hand, are not required to make a prior investment.
They only need to accept the method for calculating cash inflows and outflows. In reality, they are nearly always asked to post the principle of the initial tranche as collateral.
The money is taken out of the collateral when the tranche is in charge of a CDS payout. The collateral account's balance typically receives interest at LIBOR.
Example of a Synthetic Collateralized debt obligation
In comparison to a cash CDO, the rules for calculating the cash inflows and outflows of tranches are simpler for a synthetic CDO. Assume there are only the three tranches of senior, mezzanine, and equity.
The rules might consist of the following :
1. Before exceeding 5% of the synthetic CDO principal, cash outflows are covered by the equity tranche., which receives a spread of 1000 bp annually On the outstanding principal of the tranche
2. The mezzanine tranche covers cash outflows of more than 5 % before reaching a maximum of 20 % of the principal. It earns a spread of 100 bp per year on the tranche principal.
3. All payouts in excess of 20% are covered by the senior tranche with earnings as low as 10 pb per year on the outstanding tranche principal.
Assume that the synthetic CDO's principal is $100 million to get a sense of how it might operate. Principal amounts for the equity, mezzanine, and senior tranches are $5,000,000, $15,000,000, and $80,000,000, respectively.
The tranches first earn the required spreads on these notional principals. Assume that after a year, portfolio company failures result in CDS payouts of $7 million.
These distributions are the responsibility of the equity tranche holders. The equity tranche's principle is reduced to $3 million, and instead of earning its spread on $5 million, it now earns it on $3 million.
If there are further CDS payouts of $4 million over the CDO's lifetime, the total amount of payments due by the equity tranche will total $5 million, resulting in a principal balance of zero.
Owners of the Mezzanine Tranche are required to pay $1,000,000. Their remaining principal now stands around $14 million.
the 2007 Credit crisis
The housing slump and financial crisis exposed a unique and harmful feature of synthetic CDOs:
They magnify and disseminate risk in an unusual and catastrophic way. To grasp the specific danger, consider the difference between a non-synthetic ("cash") and a synthetic collateralized debt obligation.
The Special Purpose Entity must purchase Residential Mortgage-Backed Securities to securitize in order to construct a cash CDO. These RMBSs cannot be used in any other cash CDO once they have been purchased for use in the cash CDO.
As a result, if the RMBSs default, the investors in that one cash CDO will bear the brunt of the loss.
At that point, the contagion is effectively halted. RMB, on the other hand, are not purchased by an SPV in synthetic collateralized debt obligations; they are simply named as part of the reference portfolio.
This means that a single RMBS can be referenced by many synthetic CDOs, spreading risk across the financial system.
When the housing bubble burst, losses spread across the economy quickly. Homeowners defaulted on their mortgages, resulting in RMBS defaults, which resulted in losses on synthetic CDOs referencing those RMBSs.
While short speculators made huge profits, long investors in synthetic collateralized debt obligations, such as insurance firms, commercial banks, and pension funds, lost everything.
The US government, for example, had to bail out AIG. The governments of several huge non-US banks bailed them out, and all but one of the monoline insurance businesses went out of business.
The consequences of these failures were felt all across the world, and by 2009, the $520 billion CDO market had shrunk to $4.3 billion.
- The value of a collateralized debt obligation is determined from its claim on a particular pool of assets because CDOs are a type of asset-backed security.
- Boat loans, mortgages, credit card receivables, mortgages, and others can all be included in the underlying pool of assets.
- Typically, an investment bank or other party will gather the assets that make up the CDO and sell them to the special purpose entity. The bank has established a special purpose entity to buy the assets, so removing them from the balance sheet of the bank.
- The special purpose vehicle offers securities to investors to pay for the acquisition of assets from the bank.
- CDOs offer investors a mutual fund-like investment vehicle that enables them to buy a portion of a diversified underlying portfolio.
- Contrary to a mutual fund, the securities sold to the investors are often tranched, which means that they are split into various classes with distinct claims on the cash flows generated by the underlying assets.
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