Collateralized debt obligations are privately placed securitizations that were first created in the 80s. A securitization, in abstract terms, is a reallocation of risk. Securitization is the process of converting assets into securities backed by those assets and is used for:- Lower funding costs
- Accounting purposes
- Accessing the capital markets
- Generating fees-servicing and underwriting
CDOs; collateralized bond obligations (CBOs); and collateralized loan obligations (CLOs), are a successful application of sophisticated securitizations originally developed for collateratized mortgage-backed securities (CMBS)
These structuring techniques create special-purpose entities/vehicles (SPE/SPVs) to hold the underlying collateral. The SPE then issues securities backed by the underlying collateral pool. The underlying collateral's cash flows are then used to pay interest and principal on the issued securities.
The subsequent securities' higher credit quality is due in part to a fundamental concept in portfolio management theory - diversification. However, diversification is only part of the story.
TRANCHING
Diversification redistributes risk by "pooling" numerous underlying collateral risk-return profiles, thereby creating a single risk-return profile on the underlying collateral pool (the assets). Securitizations go one step further and seek to redistribute liability risk through a process known as tranching - taking the underlying collateral cash flow and dividing it among numerous tranche interest and principal components.
This means creating different classes of securities (the liabilities), each of which carry a different risk component defined by its payment priority and timing. Tranching creates multiple securities that appeal to different investors given the investor's risk-return threshold.
For example, highly-rated securities will have a lower return and can appeal to institutional investors like pension funds. Lower-rated securities will have a higher return and can appeal to hedge fund managers who are willing to sacrifice safety for the juicer yields (up to 30 percent annually). Thus, the underlying collateral pool's single risk-return profile (created through diversification) is transformed into multiple risk-return profiles on the newly created securities (liabilities).
In the end, a less attractive investment on the collateral side - even though risk is mitigated through diversification - is transformed into a more attractive investment opportunity by tranching.
Generally, CDOs are either "balance sheet" or "arbitrage". Balance sheet CDOs are structured as "sales" for accounting and regulatory capital purposes but are "debt" for tax purposes.Banks use balance sheet CDOs primarily for portfolio management and regulatory capital efficiency.By contrast "arbitrage" CDOs are structured as sales for all purposes, including tax.
CDO Collateral Types
As Debt Securities:
- Forfaiting Paper
- Bonds (Senior, Unsecured, or Subordinated)
- Distressed/Non-Performing
- Junk Bonds
- Emerging Market
- Structured Finance (ABS,CBO/CLO,CMBS,REITS(real estate investment trusts) and RMBS)
- Project Finance
- Synthetic Securities
As Corporate Loans:
- Term Loans
- Revolving Loans
- Secured & Unsecured
- Syndicated Loans
- Bilateral Loans
- Distressed/Non-Performing Loans
- Unfunded Commitments to Lend
CDOs employ many credit enhancement features including:
- Overcollateralization;
- Cash collateral/reserves;
- Excess spread/interest;
- Amortizing and insured tranches; and
- Hedges (interest rate swaps).
CDO Motivations under the Issuer's perspectives;
As Arbitrage:
- Realize positive spread
- Increase assets under management
- Generate stable management fees, and
- Participate in equity upside.
As Balance Sheet:
- Capital relief
- Enhance lending capacity
- Lower funding cost
- Diversification of Funding sources, and
- Increase ROE.
Summary
CDOs are pools of debt instruments repackaged into slides, or tranches, carrying different levels of risk designed to spread risk by giving investors exposure to a range of underlying instruments.
Issuance is expected to grow from $175bn (€148bn)last year to $211bn, according to Citigroup's CDO Outlook 2006 report. "A generally strong global economic environment, the need for high rating-adjusted spread product, an expanding investor base, an expanding issuer base and availability of collateral will all contribute to market growth in 2006", the report concludes.
(q.v) http://www.fonseca-robbins.org/
