What are Collateralized Debt Obligations (CDOs)?

Collateralized Debt Obligations (CDOs) were an advancement of securitization. While in securitization, the securities issued by Special Purpose Vehicle (SPV) are backed by the loans and receivables, the CDOs are backed by pool of bonds, asset backed securities, REITs, and other CDOs. Accordingly, it covers both Collateralized Bond Obligations (CBOs) and Collateralized Loan Obligations (CLOs).

 

Types of CDOs

The various types of CDOs can be explained below:

Cash Flow Collateralized Debt Obligations (Cash CDOs): Cash CDO is a type of CDO which is backed by cash market debt. That is securities which normally have low risk weight. This structure mainly relies on the collateral’s risk weight and collateral’s ability to generate sufficient cash to pay off the securities issued by SPV.

Synthetic Collateralized Debt Obligations: It is similar to a Cash Flow CDOs but with the difference that instead of transferring of ownerships of collateral to SPV (a separate legal entity), synthetic CDOs are structured in such a manner that credit risk is transferred by the originator without actual transfer of assets. Normally the structure resembles the hedge funds. The value of portfolio of CDO is dependent upon the value of collateralized instruments and market value of CDOs depends on the portfolio manager’s ability to generate adequate cash and meeting the cash flow obligations (principal and interest) in timely manner. While in cash CDO, the collateral assets are moved away from Balance Sheet, in synthetic CDO there is no actual transfer of assets instead economic effect is transferred. This effect of transferring economic risk is achieved by creating provision for Credit Default Swap (CDS) or by issue of Credit Linked Notes (CLN), a form of liability. Accordingly, this structure is mainly used to hedge the risk rather than balance sheet funding.

Further, for banks, this structure also allows the customer’s relations to be unaffected. This was started mainly by banks who want to hedge the credit risk but not interested in taking administrative burden of sale of assets through securitization.

Technically, speaking synthetic CDO obtain regulatory capital relief benefits vis-à-vis cash CDOs. Further, they are more popular in European market due to the reason of less legal documentation requirements. Synthetic CDOs can also be categorized as follows:

 

• Unfunded: It will be comprised of CDs only.
• Fully Funded: It will be through issue of Credit Linked Notes (CLN).
• Partially Funded: It will be partially through issue of CLN and partially through CDs.
• Arbitrage CDOs: Basically, in Arbitrage CDOs, the issuer captures the spread between the return realized collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addition to this, the issuer also collects the fee for the management of CDOs. This arbitrage arises due to acquisition of relatively high yielding securities with large spread from open market.

 

Risk involved in CDOs

CDOs are structured products and just like other financial products are also subject to various types of Risk.

The main types of risk associated with investment in CDOs are as follows:

Default Risk: Also called ‘credit risk’, it emanates from the default of underlying party to the instruments. The prime sufferers of these types of risks are equity or junior tranche in the waterfall.

Interest Rate Risk: Also called Basis risk and mainly arises due to different basis of interest rates. For example, asset may be based on floating interest rate but the liability may be based on fixed interest rates. Though this type of risk is quite difficult to manage fully but commonly used techniques such as swaps, caps, floors, collars etc. can be used to mitigate the interest rate risk.

Liquidity Risk: Another major type of risk by which CDOs are affected is liquidity risks as there may be mismatch in coupon receipts and payments.

Prepayment Risk: This risk results from unscheduled or unexpected repayment of principal amount underlying the security. Generally, this risk arises in case assets are subject to fixed rate of interest and the debtors have a call option. Since, in case of falling interest rates they may pay back the money.

Reinvestment Risk: This risk is generic in nature as the CDO manager may not find adequate opportunity to reinvest the proceeds when allowed for substitutions.

Foreign Exchange Risk: Sometimes CDOs are comprised of debts and loans from countries other than the country of issue. In such a case, in addition to above mentioned risks, CDOs are also subject to the foreign exchange rate risk.

 

CDOs and US Credit Crisis

 Looking at the above discussion it seems simple enough to understand what a CDO really is. But here’s the catch: CDOs were marketed as investments with defined risk and reward. If you bought one, you would know how much of a return you could expect in exchange for risking your capital. The investment banks that were creating the CDOs presented them as investments in which the key factors were not the underlying assets. Rather, the key to CDOs was the use of mathematical calculations to create and distribute cash flows. In other words, the basis of a CDO wasn’t a mortgage, a bond, or even a derivative—it was the metrics and algorithms of quants and traders.

In early 2007, Wall Street began to feel the first tremors in the CDO world. Defaults were rising in the mortgage market, and many CDOs included derivatives that were built on mortgages—including risky, subprime mortgages.

By early 2008, the CDO crisis had morphed into what we now call the credit crisis. As the CDO market collapsed, much of the derivatives market tumbled along with it, and hedge funds folded.

Although, CDOs were one of the major reasons for the fall of one of the biggest economies of the world, it is again gaining attention; “Today, hedge funds are securitizing and selling the CDOs,” Sbeih said. “They need higher returns, so in order to juice their yields, they are holding the first tranche on the CDOs they sell. In turn, to cover these loss reserves, the hedge funds are borrowing from banks. So, in essence, the banks are ultimately once again holding the bag.”

In 2016 not long after the crisis we saw the market welcoming the bespoke CDO. In its reincarnation, it’s often called a bespoke tranche opportunity (BTO).