Collateralized Debt Obligations
Collateralized Debt Obligations (CDOs) are financial instruments that pool together various types of debt, such as mortgages, and then repackage them into different tranches with varying levels of risk and return. These tranches are then sold to investors. CDOs played a significant role in the 2008 financial crisis, as the underlying mortgage assets often turned out to be riskier than anticipated.
8 Key excerpts on "Collateralized Debt Obligations"
eBook - ePub- Filippo Stefanini(Author)
- 2010(Publication Date)
- Wiley(Publisher)
...8 Strategies on CDOs A Collateralized Debt Obligation (CDO) is a diversified set of similar financial instruments where credit risk is allocated differently among the various tranches making up the CDO. It gives investors exposure to a customized slice (tranche) of the credit risk of a selected portfolio of reference credits. Many different financial assets can be used to collateralize a CDO: asset-backed securities (ABS), corporate bonds, bank loans, emerging markets bonds, credit default swaps, etc. The CDO market has reached a size of $583 billion (Figure 8.1), representing 15 % of the ABS market. According to some observers, the CDO market is still at its infancy and gives rise to many investment opportunities for the more experienced fund managers. In more detail, a Collateralized Debt Obligation is a basket of bonds or Credit Default Swaps that is cut in different tranches and then sold to investors. Every tranche has a different credit rating and pays a different interest rate. The senior tranche, which has claims to cash flow generated by the underlying securities, has a credit rating of AAA. This is followed by the mezzanine tranche and the equity tranche (completely different from an equity!), which absorbs the eventual losses caused by a default of the underlying securities and receives payments only after all the other tranches have been paid. In Figure 8.2, the cash flows generated by the pool of securities backing the CDO are portrayed using “Le Jet d’eau de Genève”, symbol of the town of Geneva in Switzerland. The senior bond tranche receives the cash flows first and therefore has a higher rating and pays a lower interest rate compared to the other tranches. The equity tranche gets only the residual cash-flows: The lower the rating of the tranche, the greater the return. Each CDO tranche has a default rate, the lowest for senior tranches and the highest for equity tranches...
eBook - ePub- Frank J. Fabozzi, Frank J. Fabozzi(Authors)
- 2018(Publication Date)
- Wiley(Publisher)
...Chapter 20 Collateralized Debt Obligations Laurie S. Goodman, Ph.D. Managing Director UBS Warburg Frank J. Fabozzi, Ph.D., CFA Adjunct Professor of Finance School of Management Yale University Acollateralized debt obligation (CDO) is an asset-backed security backed by a diversified pool of one or more of the following types of debt obligations: U.S. domestic investment-grade and high-yield corporate bonds U.S. domestic bank loans emerging market bonds special situation loans and distressed debt foreign bank loans asset-backed securities residential and commercial mortgage-backed securities When the underlying pool of debt obligations consists of bond-type instruments (corporate and emerging market bonds), a CDO is referred to as a collateralized bond obligation (CBO). When the underlying pool of debt obligations are bank loans, a CDO is referred to as a collateralized loan obligation (CLO). In this chapter we explain the basic CDO structure, the types of CDOs, the risks associated with investing in CDOs, and the general principles for creating a portfolio of CDOs. STRUCTURE OF A CDO In a CDO structure, there is an asset manager responsible for managing the portfolio. There are restrictions imposed (i.e., restrictive covenants) as to what the asset manager may do and certain tests that must be satisfied for the CDO securities to maintain the credit rating assigned at the time of issuance. We’ll discuss some of these requirements later. The funds to purchase the underlying assets (i.e., the bonds and loans) are obtained from the issuance of debt obligations. These debt obligations are referred to as tranches. The tranches are: senior tranches mezzanine tranches subordinate/equity tranche There will be a rating sought for all but the subordinate/equity tranche. For the senior tranches, at least an A rating is typically sought. For the mezzanine tranches, a rating of BBB but no less than B is sought...
eBook - ePub- Frank J. Fabozzi, Vinod Kothari(Authors)
- 2008(Publication Date)
- Wiley(Publisher)
...We discuss index trades later in this chapter. TERMINOLOGY: CDO, CBO, CLO The term CDO owes its origin to the collateralized mortgage obligation 48 (CMO) market where RMBS transactions migrated from a pure pass-through form to use the bond or obligations form, backed or collateralized by a pool of mortgages. When banks used the same device to securitize pools of corporate loans, the natural term to use was collateralized loan obligations or CLOs. The term CLO is restricted to a pool of straight loans. However, quite often, corporate exposures are held in the form of bonds. Hence, collateralized bond obligations (CBOs) would refer to securitization of a pool of corporate bonds. More likely than not, a securitization of corporate exposures would include both loans and bonds—hence, the term CDO was more appropriate. A CDO is a generic name for collateralized loan obligations and collateralized bond obligations. Over a period of time, the CDO technology has continued to proliferate, and lots of collateral types have come up using the same essential structuring principles: Hence, in the marketplace, one may hear many similar sounding terms referring to the collateral type that has gone into making a CDO or CDO-like structure: • Collateralized synthetic obligations (CSOs). A CDO that consists of a synthetic asset pool. • Collateralized fund obligations (CFOs). A CDO-like structure that acquires investments in hedge funds or private equity funds • Collateralized commodity obligations (CCOs). A structure that acquires exposures in commodity derivatives • Collateralized exchange obligations (CXOs). A structure that acquires exposures in exchange rate derivatives, and so on. TYPES OF CDOs CDOs may be classified into various types from different perspectives as shown in Table 11.1. In this section, we describe each type briefly...
eBook - ePubCash CDO Modelling in Excel
A Step by Step Approach
- Darren Smith, Pamela Winchie(Authors)
- 2011(Publication Date)
- Wiley(Publisher)
...Chapter 2 What are Cash CDOs? 2.1 TYPES OF CDOs This book is intended as a guide to modelling CDOs. It is not an introductory book to all aspects of CDOs. There are many existing books that discuss the legal, accounting, regulatory and other aspects of CDOs. Nevertheless, it is worthwhile from a completeness perspective to briefly discuss what a CDO is. The first incarnations of CDOs were CBOs (collateralized bond obligations) of high yield bonds and CLOs (collateralized loan obligations) of leveraged loans. The concept of these structures was then extended to many more asset classes, including investment grade bonds, asset backed securities, real estate investment trusts (REITs), hedge fund units, private equity shares, trust preferred bonds, derivatives (such as credit default swaps) and equity (through either shares, equity default swaps, and/or options and commodities). CDOs can be categorized by their various different attributes in many different ways, some of which are listed below: cash, synthetic, or hybrid assets; managed or static; full capital structures or single tranche technology; cash flow (asset-liability matched) or market value; asset classes. Another way to categorize CDOs is by their primary function. CDO technology may be used to achieve one or more of the following goals: credit risk transfer; funding illiquid assets; leveraged return on credit assets; regulatory and/or economic capital relief. It should be remembered that a CDO, particularly a cash CDO, is not an asset class in its own right but a financing technique particularly suited to illiquid assets. It is therefore only as robust as the assets that are put into it. It is like a “mini-bank”: it raises capital by selling debt and “equity”, and invests the money raised into assets to generate an “excess” return...
eBook - ePubQuantitative Finance
A Simulation-Based Introduction Using Excel
- Matt Davison(Author)
- 2014(Publication Date)
- Chapman and Hall/CRC(Publisher)
...Chapter 9 Tranching and Collateralized Debt Obligations 9.1 CHAPTER SUMMARY This chapter presents a brief description of the first “engineered” financial product we shall meet: the so-called “Collateralized Debt Obligation,” or CDO. These products present a way for converting debt with one risk profile into other debt products with other, different, risk profiles. The resulting idea can be used to make money from inconsistencies in the risk-reward profile observed in the corporate debt market. After introducing CDOs in Section 9.2, we perform a quantitative analysis of the structure in Section 9.3, using some results about bonds which can default in two distinct ways with two distinct recovery rates in Section 9.4. In particular, we use this analysis to show that if investors only pay the actuarial, present value of the expected-value price for bonds derived in the previous chapter, no riskless profits, or arbitrage, can be created by tranching. For tranching to make sense, a “market-value of risk” premium must be built into the yield curve for corporate debt, and then the question of how best to arbitrage this by tranching is of interest. We address this topic to some extent in the exercises, but also in Chapter 10, with the aid of simulation spreadsheets. This chapter, however, deviates in another direction. It considers correlated defaults between bonds and shows that positive correlations are the enemy of the senior tranche of a CDO structure. A toy model to analyze this behavior is provided in Section 9.6. 9.2 Collateralized Debt Obligations Investors can be divided into two broad classes. Some seek high degrees of safety. They might be life insurers who have sold life annuities and who need to make sure they have the cash on hand to pay their annuitants each month. Such investors are interested in bonds with low probability of default, and are willing to accept rather low coupons in exchange...
eBook - ePub- Steven Peterson(Author)
- 2012(Publication Date)
- Wiley(Publisher)
...Why would the standard credit rating model not be applicable in the case of CDOs? First, corporate credit risk is probably more heavily influenced by fundamentals within the firm and not management decisions made at other firms. Second, loans that were pooled to form CDOs (and other forms of collateralized obligations) began to gain exposure to the same sources of risk. This was especially true for regional pools of loans that originated from California, Florida, Arizona, and Nevada mortgage originations, or home equity, car, and credit card debt that were all exposed to the same macro risk factors like unemployment. As the credit crisis unfolded in 2007, SPVs were holding pools of highly correlated risks that were not being priced into the underlying tranches of the CDOs. Historically, mortgage loans were of much shorter duration. Thus, during the depression of the 1930s, banks that found themselves with much lower reserves (due in part to their huge capital losses when equity markets imploded) could not roll over mortgage debt. As a result, homeowners who did not have the cash on hand to pay off their mortgages, found their homes foreclosed upon. The government's response was Fannie Mae and the long-term mortgage. This model worked reasonably well until the 1970s, when the explosion of money market funds sparked disintermediation of deposits from savings and loan institutions and the subsequent banking crisis, whose solution was to impose stricter capital requirements on banks. Ironically, these capital requirements are to some degree responsible for the credit crisis begun after housing prices peaked in July of 2006. Banks were required to hold more capital against their holdings of mortgage loans and CDOs than bonds issued by the GSEs. Therefore, banks accelerated the securitization of their loan originations and bought GSEs instead...
eBook - ePubCredit Default Swaps
Mechanics and Empirical Evidence on Benefits, Costs, and Inter-Market Relations
- Christopher L. Culp, Andria van der Merwe, Bettina J. Stärkle(Authors)
- 2018(Publication Date)
- Palgrave Macmillan(Publisher)
...For example, bank lenders primarily managed and laid off their credit exposures to corporate borrowers through the loan syndication market and through the sale of loan participations on loan trading desks, as discussed in Chapter 3. Until the mid-1990s, however, the syndicated loan market was largely non-standardized and not easy for non-financial institutions to access except through loan or prime funds and early CLOs. Asset managers and other investors in corporate and sovereign debt were limited to hedging in the cash bond markets, where a bond investor concerned about the credit risk of the bond issuer could either sell the bond or utilize repurchase agreements (repos) and reverse repos to construct synthetic bond forward contracts. The former option deprived the bond investor of any ongoing exposure to the issuer, and the latter alternatives were often prohibitively expensive and gave rise to significant basis risks. The introduction of single-name CDSs fundamentally altered the availability of risk-sharing mechanisms by creating a new, more efficient product that enables market participants to customize their credit risk profile. Instead of being forced to sell a bond or loan investment or rebalance a whole portfolio, single-name CDSs present a more surgical and precise risk management tool (Duffee and Zhou 2001)...
eBook - ePubA Pragmatist's Guide to Leveraged Finance
Credit Analysis for Below-Investment-Grade Bonds and Loans
- Robert S. Kricheff(Author)
- 2021(Publication Date)
- Harriman House(Publisher)
...For example, if the assets and the liabilities of the CLO are worth $100 million and the AAA bond tranche of the CLO is 60% of the CLO’s liabilities, it is over-collateralized by $40 million, so there are excess assets to support the debt by 40%. The AA rated debt issued by the CLO will still have excess collateral, but it will be somewhat less, thus the lower rating. The junior-most tranche is effectively the equity and receives any residual value after all of the other tranches are properly paid. This is not that different from many other asset-backed/securitized financing vehicles, such as mortgage-backed securi ties (MBSs). CLOs fall into a category of investments called structured credit and also asset-backed securities (ABSs). CLOs are widely used, but there are other structures that may have different rules and structures but still invest in assets of the leveraged finance market. These could include Collateralized Debt Obligations (CDOs) and collateralized bond obligations (CBOs). The basics of these products are similar to CLOs. The structured credit market is constantly evolving, adding nuance to existing structures and creating creating new structures. As CLOs are both buyers and sellers of debt, credit analysis can be used to analyze whether a loan is a good fit for the CLO to buy. Analysts can also be used to analyze the debt that is issued by a CLO by analyzing the quality of the underlying investments (the assets) within that CLO relative to those of other C LO tranches. Analysts examining investments in CLO tranches will use programs to stress-test the underlying collateral and the recoveries on the collateral in various default scenarios. The level of default loss rates can be critical to the success of a CLO and how CLO tranches trade. It will not just be the default rate but also the type of recovery expected on any defaulted loans...
