Collateralized debt obligation (CDO)

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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
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