Collateralized debt obligation (CDO)

RECENT NEWS
TechCrunch  Nov 22  Comment 
 In an increasingly digital world, where everything from marketing to R&D and customer service is becoming digital, the Chief Digital Officer (CDO) is more important than ever in helping drive company growth and a better connection with...
Forbes  Nov 19  Comment 
As digital disruption impacts every industry, the emerging role of chief digital officer (CDO) is becoming increasingly important. According to ​​a recent survey by Harvey Nash, some 7 percent of companies polled--and 16 percent of companies...
Clusterstock  Nov 14  Comment 
A federal appeals court ruled Friday that Michael Lewis still didn't defame money manager Wing Chau in his best-seller " The Big Short." In April, a lower court sided with Lewis in a 2011 lawsuit accusing him of libel. Chau appealed, and today...
Forbes  Nov 11  Comment 
Data flows through every part of business – it is the modern enterprise. At the top of modern global enterprises today there is a pattern emerging: hard-to-solve, multi-departmental, multifaceted problems are being tackled by targeting a...
Forbes  Oct 23  Comment 
At the CIO Solutions Gallery hosted by the Ohio State University the Chief Data Officer [CDO] at a major financial institution began her talk regarding the evolving role of the CDO asking the assembled executives [mostly CIOs] what they wanted to...
TechCrunch  Sep 17  Comment 
 After four long months of speculations and political maneuvering, the French Government finally announced that France is getting its first Chief Data Officer. While the name of the CDO is still unknown, a source told me that current Etalab...
Forbes  Aug 31  Comment 
The rise of the CDO is being driven by many different forces, but one that is rarely acknowledged is class struggle. The classes are not the proletariat or the bourgeoisie, but rather the tech incumbents, the CIOs and CTOs of the world, versus...
Forbes  Aug 29  Comment 
When I attended the CDO Summit earlier this year I finally understood the true meaning of digital: The application of marketing techniques to all phases of technology adoption.
newratings.com  Aug 21  Comment 
CHARLOTTE (dpa-AFX) - Bank of America Corp. (BAC) has reached a comprehensive settlement with the U.S. Department of Justice or DoJ, certain federal agencies and six states. The settlement includes releases on the securitization, origination, sale...
Mondo Visione  Jul 14  Comment 
Citigroup today announced that it has reached an agreement to settle the ongoing investigation of the Residential Mortgage-Backed Securities (RMBS) Working Group, part of the Financial Fraud Enforcement Task Force. Today’s agreement resolves...




 

A Collateralized Debt Obligation, or CDO, is a synthetic investment created by bundling a pool of similar loans into a single investment that can be bought or sold. An investor that buys a CDO owns a right to a part of this pool's interest income and principal.

For example, a bank might pool together 5,000 different mortgages into a CDO. An investor who purchases the CDO would be paid the interest owed by the 5,000 borrowers whose mortgages made up the CDO, but runs the risk that some borrowers don't pay back their loans. The interest rate is a function of the expected likelihood that the borrowers whose loans make up the CDO will default on their payments - determined by the credit rating of the borrowers and the seniority of their loans.

CDOs are created and sold by most major banks (e.g. Goldman Sachs, Bank of America) over the counter, i.e. they are not traded on an exchange but have to be bought directly from the bank. Securities Industry and Financial Markets Association estimates that US$ 503 billion worth of CDOs were issued in 2007.[1]

CDOs played a prominent role in the U.S. subprime crisis, where critics say CDOs hid the underlying risk in mortgage investments because the ratings on CDO debt were based on misleading or incorrect information about the creditworthiness of the borrowers.

Market history and growth

The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association. A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles. It may also reflect the greater profit margins that CDOs provide their manufacturers.

A major factor in the growth of CDOs was the 2001 introduction by David X. Li of Gaussian copula models, which allowed for the rapid pricing of CDOs.

According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled US$ 157 billion in 2004, US$ 272 billion in 2005, US$ 552 billion in 2006 and US$ 486 billion in 2007. Research firm Celent estimates the size of the CDO global market to close to $2 trillion by the end of 2006.

How CDOs Work

Bundling debt into a CDO changes the riskiness of investing in debt in two ways:

Reduction of Statistical Outliers

First, CDOs reduce the effect of statistical outliers. Lending someone money to buy a house is risky, because that person either defaults or they don't - even if there's only a one in 5,000 chance of someone defaulting on their mortgage, if you happened to be the lender for the person who defaults, you're out of luck. CDOs turn individual loans into a portfolio in which a default by any single lender is unlikely to have an enormous impact on the portfolio as a whole. By aggregating many different mortgages together into a CDO, investors can own a small percentage of many different mortgages, and therefore the CDO's losses as a result of borrowers defaulting on their obligations usually represent the statistical averages in the market as a whole

Tranches

Second, CDOs are created in tranches - portions of the underlying debt that vary in their riskiness, despite being backed by a generic pool of bonds or loans.

Typically, a pool of debt is divided into three tranches, each of which is a separate CDO. Each tranche will have different maturity, interest rates and default risk. This allows the CDO creator to sell to multiple investors with different degrees of risk preference.

The bottom tranche will pay the highest interest rate, but will be the first to lose money if some of the loans in the pool aren't repaid. The top tranche will have the lowest interest rate, but will always be the first to be repaid - the bottom two tranches have to be wiped out before the top tranche is affected. This allows bankers to create investments with risk / reward profiles that are very different from the underlying debt in the pool. So, one pool of mortgages can be divided into three CDOs, one with an "AAA" debt rating that pays low interest, one with an intermediate debt rating with moderate interest, and one with a low debt rating with high interest. This is important because some asset manager is only allowed to invest in "AAA"-rated debt - dividing a pool of debt that is not AAA rated into three different CDO tranches means at least some portion of that debt is now AAA-rated and can be purchased by institutions that can only invest in AAA debt.

For example, assume a bond pool of $100 million divided into three tranches and expected to earn 15% or $15 million in interest pa. The three tranches are A ($25 million), B ($50 million) and C ($25 million); and, A is senior to B and B is senior to C. A, B and C tranches provide 10%, 15% and 20% interest rates, respectively. If none of the bonds defaults, A receives $2.5 million, B $7.5 million, and C $5 million. But, say there is a default and the interest income shrinks to $11 million. As A and B are senior to C, they will be settled first. So, tranche A and B receive full interest of $2.5 million and $7.5 million, whereas tranche C receives $1 million only.

CDO Market

Global CDO Issuance
Global CDO Issuance[2]

According to data from Securities Industry and Financial Markets Association global CDO issuance increased from $157 billion in 2004, to $503 billion in 2007.[3] The total outstanding CDO is estimated to be over $2 trillion.[4]

CDOs are structured by investment banks and are bought by all types of asset managers, including hedge funds, insurance companies, banks and pension funds. CDOs can also be purchased through most retail brokerage accounts.

For an example of CDO prospectus look at Triaxx Prime CDO 2006-1.

Other Types of CDOs

Collateralized mortgage obligations (CMOs) and collateralized bond obligations (CBOs) are examples of CDOs in which the loans that make up the pool of debt in the CDO are mortgages and bonds, respectively. A PreTSL (acronym for Preferred Term Securitites Ltd) is a CDO in which the debt that makes up the pool is issued by smaller banks, real estate investment trusts, and insurance companies.

Synthetic CDOs

The term synthetic applies to a CDO in which the underlying assets are credit default swaps (CDS) rather than debt instruments like bonds or loan.

Credit default swaps are insurance on debt. The buyer of the insurance pays a certain amount to the seller in exchange for protection from default. In effect, these securities behave very similarly to the underlying debt, but are easier to buy and sell. ...

CDO^2

CDO Squared, Cubed, etc refers to a security that is constructed from pools of CDOs rather than a pool of debt instruments such as loan or bond. Essentially, this is a CDO of CDOs.


References

  1. SIFMA, Global CDO Market Issuance Data, Retrieved September 23, 2008
  2. SIFMA.org, Retrieved September 23, 2008
  3. SIFMA.org, Retrieved September 23, 2008
  4. Celent.com, Retrieved Sept. 23, 2008
Wikinvest © 2006, 2007, 2008, 2009, 2010, 2011, 2012. Use of this site is subject to express Terms of Service, Privacy Policy, and Disclaimer. By continuing past this page, you agree to abide by these terms. Any information provided by Wikinvest, including but not limited to company data, competitors, business analysis, market share, sales revenues and other operating metrics, earnings call analysis, conference call transcripts, industry information, or price targets should not be construed as research, trading tips or recommendations, or investment advice and is provided with no warrants as to its accuracy. Stock market data, including US and International equity symbols, stock quotes, share prices, earnings ratios, and other fundamental data is provided by data partners. Stock market quotes delayed at least 15 minutes for NASDAQ, 20 mins for NYSE and AMEX. Market data by Xignite. See data providers for more details. Company names, products, services and branding cited herein may be trademarks or registered trademarks of their respective owners. The use of trademarks or service marks of another is not a representation that the other is affiliated with, sponsors, is sponsored by, endorses, or is endorsed by Wikinvest.
Powered by MediaWiki