Collateralized debt obligation
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Collateralized debt obligations (CDOs) are a type of asset-backed security or structured finance product. At a high level, a CDO can be thought of as a mutual fund where the owners (i.e. the equity class(es)) leverage their investment by borrowing (by issuing debt) against the portfolio.
The term CDO is often used as a generic term that includes:
- Collateralized bond obligations (CBOs) -- CDOs backed primarily by bonds
- Collateralized loan obligations (CLOs) -- CDOs backed primarily by leveraged loans
- Structured finance CDOs (SFCDOs) -- CDOs backed primarily by asset-backed securities
- Commercial Real Estate CDOs (CRE CDOs) -- backed primarily by real estate assets
- CDO-Squared -- CDOs backed primarily by securities issued by other CDO vehicles.
- CDO^n -- Generic term for CDO^3 (CDO cubed) and higher, where the CDO is backed by other CDOs/CDO^2/CDO^3. These are particularly difficult vehicles to model due to the possible repetition of exposures in the underlying.
- CPDO --Constant Proportion Debt Obligation -- backed by an index of debt securities (such as CDX or Itraxx but could be deal specific) which is periodically rolled, thus introducing market risk through the rollover. The leverage of the CPDO is periodically re-adjusted to match asset and liability spread.
ŖĶ=Types of CDOs=
CDOs can be categorized in several ways. The primary classifications are as follows:
- Source of funds -- cash flow vs. market value
Cash flow CDOs should be distinguished from the long-established, but less common market value CDO format. Whereas cash flow CDOs are primarily managed to pay off liabilities from the interest and principal payments of collateral, market value CDOs attempt to enhance the return of equity investors through the more frequent trading and profitable sale of collateral. This means that cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio, while market value CDOs, which are the minority, focus on maximizing the portfolio's value based on perceived trends in the market.
- Motivation -- arbitrage vs. balance sheet
Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital.
- Funding -- cash vs. synthetic
"Cash CDOs" involve a pool of physical assets, such as loan contracts, corporate bonds, asset-backed securities or mortgage-backed securities, whose ownership is transferred to the legal entity issuing the CDO (known as a special purpose vehicle or SPV).
Some balance sheet transactions use credit derivatives to transfer the credit risk of assets from balance sheets to CDOs without the sale or transfer of the assets themselves. These structures, which may be non-funded or partially funded, are called "synthetic CDOs." Synthetic CDOs are formed from a large pool (usually 100 names) of credit default swaps (CDSs). They have become very popular in recent years, especially in Europe where over 90% of deals are synthetic.
In the U.S., synthetic deals account for one half of all arbitrage CDOs. Synthetic CDOs allow more flexible structure than cash CDOs, thanks to the unique characteristics of CDS. This flexibility is most used to construct Single Tranche CDOs (bespoke CDOs) where the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches are never sold but held by the dealer based on valuations from his internal models.
CDOs also frequently use swaps and caps. CDO transactions use swaps whenever there is a mismatch between interest payments of collateral and bonds. Collateral payments are frequently fixed whereas bonds are usually floating, so CDOs can be said to be paying floating but receiving fixed. In this way a swap would correct the mismatch. A cap, on the other hand, protects a floating CDO from unexpected and unwanted changes in interest rates (mostly LIBOR). If LIBOR rises above the cap strike, CDOs receive payments from a counterparty that entered in the Cap with the CDO.
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[edit] Collateral Asset Classes
Subject to investment guidelines set by each individual CDO the underlying assets may be static or revolving (i.e. the portfolio may allow for trading) and may consist of any variety and configuration of:
- corporate bonds;
- bank loans (alternatively referred to as leveraged loans);
- emerging-market sovereign debt;
- project finance debt;
- asset-backed securities (ABS) and other structured finance securities (such as CMBS, RMBS and HEL);
- trust preferred securities;
or
The underlying collateral may be static or may be managed by an asset manager (alternatively referred to as the "collateral manager" or "portfolio manager") who generally has demonstrated experience in managing the asset classes mandated by the transaction but may not possess the necessary skills and infrastructure to manage an alpha reducing portfolio strategy.
[edit] Transaction Participants
[edit] Investors
Depending on the level of the capital structure in question, investors have different motivations for purchasing CDO securities. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities (e.g. corporate bonds) of a similar rating or credit profile. At the most subordinated levels, the investor achieves a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Where the CDO's portfolio is permitted to be actively managed, the investors are also able to take advantage of the expertise of a third-party asset manager, and should actively seek to negotiate by way of supplemental indenture trading restrictions on the portfolio.
[edit] Underwriter
The underwriter acts as the structurer of the CDO. The underwriter takes a pool of capital from the issuer (ie. Hedge Fund) and structures the deal into Tranches. The pricing and structuring is completed by the Underwriter and is subject to review from the Rating Agencies (Moody's, S&P, Fitch). Once the deal is placed with investors the underwriter is no longer party to the transaction, however is generally expected to provide some type of secondary liquidity in the senior classes of the deal. According to Thomson Financial, the top players are Merrill Lynch, Citigroup, Deutsche Bank, and Banc of America Securities.
[edit] The Asset Manager
The asset manager often has broad discretion to purchase and/or trade collateral and plays a key role in each CDO transaction. There are approximately 300 asset managers in the marketplace. Some collateral managers are active whilst some are nothing more than placebos where the investor will be at risk to the underlying portfolio. Asset Managers make money by virtue of the fees, senior fee, subordinated fee and equity incentive fee which they are paid, making this a very lucrative business for any asset manager, given the limited alpha generating function, the deal guidelines allow. These fees, together with underwriting fees, administration{approx 1.5 - 2%} by virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.
Most Active Managers of all CDO types, according to Asset-Backed Alert
Most Active Managers of Real Estate CDOs, according to Commercial Mortgage Alert
[edit] The Trustee
The trustee holds title to the assets of the CDO for the benefit of the noteholders. In the CDO market, the trustee also typically serves as collateral administrator (two notable exceptions to this are Virtus Partners and Wilmington Trust Conduit Services, a subsidiary of Wilmington Trust, which offer collateral administration services, but are not a trustee bank), and produces the required reporting for the investors. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:
- The Bank of New York (note: the Bank of New York recently also acquired the corporate trust unit of JP Morgan which is the market share leader)
- HSBC
- LaSalle Bank (note: operates in Europe under the name of its parent, ABN AMRO)
- Wells Fargo
- Deutsche Bank
- US Bank (note: US Bank recently also acquired the corporate trust unit of Wachovia)
- Fortis Intertrust (note: currently serves the European market only; was formerly known as MeesPierson Intertrust)
- BNP Paribas Securities Services (note: currently serves the European market only)
- Investors Bank & Trust Company
- Wilmington Trust Company
[edit] Accountants
Perform due diligence on the assets, providing comfort to investors over future cashflows of the collateral.
[edit] Attorneys
Ensure compliance with applicable securities law and negotiate and draft the transaction documents. Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory requirements to disclose certain information to investors. This will be cirulated to investors.
[edit] Capital Structure and Waterfall (Priority of Payments)
The securities issued by the CDO are split into rated and unrated classes of bonds and equity, where the rating of each bond class is determined by its position in the priority of payments and other rating criteria. Payments of interest and principal to the various bond classes (or liabilities) issued by a CDO are generally made sequentially, such that payment is first made to the most senior class and then to other classes, in the order of their subordination. These payments are made solely from the cash flows received from the underlying assets (including hedges).
The senior bonds are usually rated AAA to A and have first claim on cash flows. The mezzanine and subordinated bonds are usually rated BBB to B and have a subordinate claim on cash flows. The equity tranche, which occupies a first-loss position, is generally unrated and receives all or most of the residual interest proceeds of the collateral, depending on the structure of the waterfall e.g. sequential, pro rata or hybrid. The CDO equity represents a leveraged investment in the collateral; it has both a higher expected return (assuming of course that the expected return of the underlying return is positive, ie that expected losses are lower than coupon payments) and a higher volatility of return than the underlying assets.
The high risk of the equity tranche has led to allegations of mis-selling[1], with market commentators referring to this asset class as 'Toxic Waste' [2].A large portion of equity buyers are based in Germany, where certain funds are not required to value their holdings on a mark to market basis. In general, whilst equity is the riskiest investment, the mezzanine tranches are generally the least attractive risk adjusted investment.
[edit] Market History and Growth
First issued in the late 1980s, CDOs emerged a decade later as the fastest growing sector of the asset-backed securities market. This growth reflects 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.
According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totalled USD 157 billion in 2004, USD 249 billion in 2005, and USD 489 billion in 2006.
