Collateralized Debt Obligations

11 Key excerpts on "Collateralized Debt Obligations"

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  Risk Of Investment Products, The: From Product Innovation To Risk Compliance

  From Product Innovation to Risk Compliance

  • Michael Chak Sham Wong(Author)
  • 2011(Publication Date)
  • World Scientific

    (Publisher)

  Chapter 7 RISK MANAGEMENT OF Collateralized Debt Obligations Shwn Meei Lee 1. INTRODUCTION The term collateralized debt obligation (CDO) refers to a wide variety of structured investment products. The products are normally maintained by a broad range of essential securities such as bonds, credit default swaps, loans and asset-backed securities as well as more unusual collateral such as equity default swaps and CDO tranches from external sources. A CDO raises money by offering debt and equity to investors. The money raised is then used to invest in a pool of financial assets, either corporate or structured. In theory, an investment decision is made through a highly rational process (Shleifer and Vishny, 1997; Thaler, 1999). With no exception, if there are other opinions or suggestions during the process of decision making, investors will feel a need to conform to the others’ expectations because of such irrational factors as conflict avoidance and the pressure of social norms (Camerer, 1998; Daniel and Titman, 1999). The proceeds from the assets are then distributed to the investors according to the level of liabilities and the associated risks (Lucas, Goodman and Fabozzi, 2007) as shown in Fig. 1. The makeup of any CDO depicts the volume and amount of tranches and the policies that govern the distribution of the security profits to the tranches. These policies and the makeup differ widely from one collateral deal to another. For instance, interest payments to the tranches are made in accordance with the position of the tranche on the tranche ladder. As Morokoff (2003) states, “the structures may be simple pass-throughs, 161 162 S.M. Lee Fig. 1 Assets Pool of CDO. Source : Lucas, Goodman and Fabozzi (2007). whereby interest payments are made in order of tranche seniority”. In other cases, there are rules which require that interest payments be made based on the value and performance of the principal securities.

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  Booms and Busts: An Encyclopedia of Economic History from the First Stock Market Crash of 1792 to the Current Global Economic Crisis

  An Encyclopedia of Economic History from the First Stock Market Crash of 1792 to the Current Global Economic Crisis

  • Mehmet Odekon(Author)
  • 2015(Publication Date)
  • Taylor & Francis

    (Publisher)

  Before long, specialists developed pooling techniques to shorter-term structured notes that were similar to CMO bonds. Then the technique was extended to other debt pools, including credit card debt, insurance contracts, small business loans, and so on. CDOs were even created that were backed by other CDOs, and those CDOs backed still other CDOs, to create several layers of investment. The complexity of the instruments resulted in a significant abstraction of the structured notes from the underlying assets used as collateral. In many cases, investors did not actually know what they owned—especially given the prevalence of CDOs in hedge funds, pension funds, and mutual funds. When the subprime mortgage crisis struck, many of the CMO bonds backed by subprime mortgages became part of the plague of toxic assets that contributed to the global financial crisis in 2008, when exposure to these assets ruined so many banks and other businesses.

  Bill Kte’pi

  See also: Collateralized Debt Obligations; Collateralized Mortgage Obligations; Debt; Debt Instruments.

  Further Reading

  Ahamed, Liaquat. Lords of Finance: The Bankers Who Broke the World . New York: Penguin, 2009.

  Davenport, Penny, ed. A Practical Guide to Collateral Management in the OTC Derivatives Market . New York: Palgrave Macmillan, 2003.

  Garrett, Joan. Banks and Their Customers . New York: Oceana Publications, 1995.

  Sena, Vania. Credit and Collateral . New York: Routledge, 2007.

  Collateralized Debt Obligations

  Collateralized Debt Obligations (CDOs) are complex financial instruments created from pools of debt securities (obligations). CDOs are backed by the principal and interest payments made on the underlying securities, which are passed through to the owners of the CDO. The payments made on the CDOs are divided into different tranches (classes), or slices, with different risks. Since principal and interest payments are not passed through in a straightforward, proportional way, various risks can be transferred among investors in different tranches within the CDO. The CDO specifies the number of tranches, which have ranged from a few to around 100.

  The three categories of tranches are the senior tranche, the mezzanine tranche, and the subordinate/equity tranche. Usually at least one of the tranches pays a floating rate where the interest rate is periodically reset based on an index. Those in the highest (most secure) tranche would be repaid principal and interest payments first, while those in the lowest (least secure) tranche would be repaid last and not until the securities in all the other tranches had been fully repaid. The investor in the most secure tranche would earn a lower return than the investor in a more risky tranche because of the lower risk. Given the different risks involved in the various CDO tranches, rating agencies such as Moody’s, Standard & Poor’s, and Fitch Ratings rate each tranche of the security separately. Investors in high-rated tranches can use the rating system to feel more secure about their investment, and all investors can more accurately evaluate the risk/ return relationship.

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  The Handbook of Financial Instruments

  • Frank J. Fabozzi(Author)
  • 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. Since the subordinate/equity tranche receives the residual cash flow, no rating is sought for this tranche.

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  Credit Risk

  Pricing, Measurement, and Management

  • Darrell Duffie, Kenneth J. Singleton(Authors)
  • 2012(Publication Date)
  • Princeton University Press

    (Publisher)

  11

  Collateralized Debt Obligations

  THIS CHAPTER ADDRESSES the risk analysis and market valuation of Collateralized Debt Obligations (CDOs).1 After describing some of the economic motivations for, and institutional features of, CDOs, we turn to an extensive illustration of the effects of correlation and prioritization for the market valuation, diversity score, and risk of CDOs, in a setting of correlated default intensities.

  11.1. Introduction

  A CDO is an asset-backed security whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loans. A CDO cash flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection of CDO securities, which we shall call tranches . While there are many variations, a standard prioritization scheme is simple subordination: Senior CDO notes are paid before mezzanine and lower-subordinated notes are paid, with any residual cash flow paid to an equity piece. Some illustrative examples of prioritization are provided in Section 11.4.

  A cash flow CDO is one for which the collateral portfolio is not subjected to active trading by the CDO manager, implying that the uncertainty regarding interest and principal payments to the CDO tranches is determined mainly by the number and timing of defaults of the collateral securities. A market value CDO is one for which the CDO tranches receive payments based essentially on the mark-to-market returns of the collateral pool, which depends on the trading performance of the CDO asset manager. In this chapter, we concentrate on cash flow CDOs, avoiding an analysis of the trading behavior of CDO managers.

  A generic example of the contractual relationships involved in a CDO is shown in Figure 11.1 , taken from Schorin and Weinreich (1998). The collateral manager is charged with the selection and purchase of collateral assets for the special purpose vehicle (SPV). The trustee of the CDO is responsible for monitoring the contractual provisions of the CDO. Our analysis assumes perfect adherence to these contractual provisions. The main issue that we address is the impact of the joint distribution of default risk of the underlying collateral securities on the risk and valuation of the CDO tranches. We are also interested in the efficacy of alternative computational methods and the role of diversity scores

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  Asset Securitization

  Theory and Practice

  • Joseph C. Hu(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  Collateralized Debt Obligations (CDOs) are also a product of asset securitization. However, CDOs are different from all the previously discussed asset-backed securities in many aspects. Most significant, the underlying assets of CDOs are speculative-grade corporate bonds and credit classes of asset-backed securities. These assets, which are securities themselves, are heterogeneous and contrast sharply with the homogeneous underlying assets (which are consumer and business loans) for the asset-backed securities. Further, the underlying assets for CDOs are managed as an investment portfolio by the sponsor (or sponsor-designated portfolio manager), who creates the SPE that issues the CDO securities to investors.

  This chapter will first introduce the market development of CDOs. It will then discuss the following topics: (1) the basic concept of a CDO; (2) the various types and structures of CDOs; (3) the motivation for issuing and the incentives for investing in CDOs; (4) the structuring and credit rating of CDOs; and (5) the trading and relative value of CDOs.

  Basic Concept and Market Development of CDOs

  The term CDO is a generic one which combines two different types of asset securitization transaction: a collateralized loan obligation (CLO) and a collateralized bond obligation (CBO). A CLO is generally a funding instrument for a commercial bank, which raises funds in the capital market by selling its holding (or origination) of commercial and industrial loans (C&I loans) to investors in the form of notes of beneficial interest issued by an SPE. The interest and principal of the notes are supported by the cash flow of the underlying C&I loans. (In that sense, a CLO is no different from an ABS which is backed by the receivable cash flow of the underlying assets.)

  A CBO, on the other hand, is a funding vehicle for professional money managers. A money manager purchases a pool of corporate bonds or asset-backed securities (mostly with BB or B ratings) or equity securities and finances the purchase ofthese securities through the creation of an SPE that issues notes to investors. From the funding point of view, both CLOs and CBOs are no different from asset-backed securities in that they are a form of direct capital-market financing mechanism that connects those who seek financing and those who provide financing.1

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  Structured Finance and Insurance

  The ART of Managing Capital and Risk

  • Christopher L. Culp(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  2 making CDOs the second largest type of term asset-backed security (ABS), excluding MBSs, after home equity ABSs.

  CDOs are widely admired for the rich and complex character of their market and their enviable success. Originally applied to bonds and loans, CDOs have since been applied to portfolios of emerging-market debt, subordinate and mezzanine ABSs and MBSs, real estate investment trust (REIT) debt, distressed debt, trust preferred securities (a debt/equity hybrid), and, most recently, to alternative investments (private equity and hedge funds), as well as to project finance loans, leases, or similar debt obligations.

  The core concept of CDOs is that a pool of defined financial assets will perform in a predictable manner (that is, with default rates, loss severity/recovery amounts, and recovery periods that can be forecast reliably) and, with appropriate levels of credit enhancement applied thereto, can be financed in a cost-efficient fashion that reveals and captures the arbitrage between the interest and yield return received on the CDO’s assets, and the interest and yield expense of the securities (CDO securities) issued to finance them. Each of the recognized rating agencies (Fitch, Moody’s, and Standard & Poor’s) has developed CDO criteria and statistical methodologies and analyses to so-called stress pools of CDO assets to determine the level of credit enhancement required for their respective credit ratings for the CDO securities to finance such pools.

  Typically, CDOs require the CDO assets to meet certain eligibility criteria (including diversity, weighted average rating, weighted average maturity, and weighted average spread/coupon) in accordance with established rating-agency methodologies to ensure the highest practicable rating for the related CDO securities. A CDO allocates the interest and principal proceeds of such assets on periodic distribution dates according to certain collateral quality tests (typically an overcollateralization ratio and an interest-coverage ratio). CDO securities usually are issued in several tranches. Each tranche (other than the most junior tranche) has a seniority or priority over one or more other tranches, with tighter collateral quality tests set to trigger a diversion of interest and principal proceeds that otherwise would be allocable to more junior tranches, which then are used to redeem or otherwise retire more senior tranches. The resulting subordination of such junior tranches constitutes the required credit enhancement for the more senior tranches and allows the CDO securities of such senior tranches to receive a credit rating that reflects such seniority or priority. Some CDOs use financial guaranties or insurance for the same effect.

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  The Financialization of Latin American Real Estate Markets

  New Frontiers

  • Alfonso Valenzuela Aguilera(Author)
  • 2022(Publication Date)
  • Routledge

    (Publisher)

  Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States suggests, the subprime crisis could have been prevented if adequate regulation of financial institutions had been put in place: mechanisms for corporate governance, transparency, and the effective management of risk in financial operations, as well as the enforcement of ethical standards.

  Which brings us to a second underregulated financial instrument that led to the crisis, and also reshaped real estate investment, the collateralized debt obligation (CDO). CDOs were first engineered as a credit risk transfer device that would allow investment banks to repackage loans and mortgages into tranches,9 originating value from the amortization of the corresponding debt (Fabozzi et al., 2016 ). One of the innovations of capital market instruments was their use of credit derivatives to transfer risk, especially through credit default swaps (CDSs), which enabled mechanisms of synthetic securitization.10 However, this variant added risk to the banks’ trading books, exposing them – as well as investment banks and conduit investors – to concentrated risks and losses in events of crisis or fraud. The use of credit derivatives technology to transfer asset risks and cash flows permitted the creation of synthetic CDOs, which had three-quarters of the market, having significant advantages over cash

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  Introduction to Credit Risk Modeling

  • Christian Bluhm, Ludger Overbeck, Christoph Wagner(Authors)
  • 2016(Publication Date)
  • Chapman and Hall/CRC

    (Publisher)

  Many of the CBOs we currently find in the market are motivated by arbitrage spread opportunities, see Section 8.2.1. • Collateralized loan obligations (CLO): Here the collateral pool consists of loans. Regulatory capital relief , cheaper funding , and, more general, regulatory arbitrage combined with economic risk transfer are the major reasons for the origination of CLOs by banks all over the world, see Section 8.2.1. Besides these two, CSOs (see the introductory remarks) are market standard today. Their advantage is the reduction of funding costs, because instead of funded instruments like loans or bonds, the cash flows from credit derivatives are structured in order to generate an attractive arbitrage spread. A second advantage of CSOs is the fact 1 The only exception to that rule is the use of the binomial expansion method (see Section 8.5) by Moody’s. This method is outdated and today rating agencies use more sophisticated models. Collateralized Debt Obligations 285 CDOs arbitrage-motivated balance sheet-motivated cash flow structure synthetic structure cash flow structure synthetic structure market value structure Assets high-yield bonds/loans derivatives multisector Assets credit risky instruments FIGURE 8.1 : Classification of CDOs. that credit derivatives are actively traded instruments, such that, based on the fair market spread of the collateral instruments, a fair price of the issued securities can be determined, for example, by means of a risk-neutral valuation approach. In Section 8.6 we will see that CDO tranches based on derivatives constitute a very much standardized market instrument today. Another class of CDOs gaining much attention are multisector CDOs . In this case, the collateral pool is a mixture of different ABS bonds, high-yield bonds or loans, CDO pieces, mortgage-backed securities, and other assets.

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  Austrian Economics, Money and Finance

  • Thomas Mayer(Author)
  • 2017(Publication Date)
  • Taylor & Francis

    (Publisher)

  To this end, various credits, whose probabilities of default were correlated as little as possible, were packed into a portfolio. Diversification was supposed to reduce the aggregate risk of the portfolio. In the next step, the bonds issued for the funding of the portfolio were split into different tranches. The intention was to distribute any losses emanating from the portfolio unevenly. Thus, all initial losses were allocated to the first tranche. If they exceeded the value of the tranche, they were allocated to the next tranche, and then again to the next tranche, and so on. The entire credit portfolio was called “Collateralized Debt Obligation” (CDO). The first tranche was dubbed “equity tranche”, because it would be hit first in case of losses like the equity capital of a firm. Then came the further tranches of different quality, which depended on the hierarchy of the loss assignments.

  Following the segmentation, the tranches were graded by the rating agencies. The ratings were supposed to reflect the probability of being affected by possible losses. To this end, the loss potential of the entire portfolio had to be estimated on the basis of the default probabilities of single credits and the correlation of loss probabilities among credits. Then potential losses were allocated to the individual tranches according to their ranking in the loss absorption hierarchy. The rating and securitization agencies worked hand in hand to shape the CDOs such that the ratings of the tranches ranged from top quality (AAA) to equity (not rated). The different tranches of the CDOs could then be sold to investors or left in total or in parts in the SIVs.

  To fund their stock of CDO tranches, the SIVs issued different types of securities. For money market funds they had a special bonbon. These funds issued shares against book money, which they made palatable to investors by claiming that these shares were as safe as money but came with a higher yield. To generate the higher yield, the money market funds looked for highly rated, short-dated securities with an attractive rate of return. The SIVs satisfied this demand by issuing part of their top (AAA) rated tranches of CDOs in the form of short-maturity securities called commercial paper.

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  Introduction to Financial Mathematics

  With Computer Applications

  • Donald R. Chambers, Qin Lu(Authors)
  • 2021(Publication Date)
  • Chapman and Hall/CRC

    (Publisher)

  Two observations should be noted about the net benefits to financial derivatives even after the fiascos of the recent financial crisis. First, the ability of financial derivatives to devastate an economy demonstrates the power of these products. Financial derivatives are used for important economic activities such as risk management and hedging – they are not just devices for whimsical speculations. If they were purposeless gambling devices their demise would not have so badly devastated the entire economy. Financial derivatives themselves are zero-sum games in the short run; they are merely vehicles for transferring risk. Each loss they convey to one side of the contract tends to be a profit to the other side of the contract. In other words, the CDO losses were primarily driven by declining mortgage values, not by the CDO structures themselves. Second, in the decades leading up to the financial crisis, financial derivatives were important drivers of the economy’s success. In particular they generated tremendous cost savings within the real estate financing industry that was passed on to borrowers in the form of relatively low loan rates. Modern economies benefited greatly from the highly efficient capital markets that evolved in the previous decades as a result of financial engineering innovations such as financial derivatives.

   

  Chapter Summary

  This chapter discusses default probabilities and investigates how to derive default probabilities from bond and asset swaps. Then, the chapter overviews the management of credit risk in general and default risk in particular. Credit derivatives are introduced for hedging credit risk and default risk. The potential role of credit derivatives in the global financial crisis is discussed.

  Credit derivative contracts have two parties. The two parties swap cash flows based on credit events. Analysts need to clearly understand the cash flows being exchanged between the two parties so that they value the derivatives and model their risks.

  CDOs are often modeled with the copula method, which has been used effectively to capture the tendency of actual default rates to differ randomly from expected default rates. The cash flows to CDOs or CDO squareds also depend on default correlation. In fact, CDO prices (spreads) are very sensitive to copula correlations. Recovery rates serve as another important parameter in CDO pricing. So correctly modeling the copula correlation and the recovery rate is vital for valuing CDO tranches. CDO models were not used effectively to capture extremes in these important parameters (i.e., recovery rates and correlations) in the years leading up to the 2007–2008 global financial crisis.

   

  Demonstration Exercises

  1.   Consider a CDO with 100 bonds (i.e., credit names or corporations) with $1 principal for each bond. Assume the recovery rate is 20%. There is an equity tranche, a mezzanine tranche and a senior tranche within the CDO structure. The attachment for the equity tranche is 0% and the detachment is 5%. The attachment for the mezzanine tranche is 5% and the detachment is 25%. The attachment for the senior tranche is 25% and the detachment is 100%. Assume that the CDO has five years to termination, that default occurs at the middle of the year, that the default and the accrual legs are paid at the time of default, that the premium is paid at the end of the year, that the equity tranche spread is 30%, that the mezzanine tranche spread is 3%, that the senior tranche spread is 1% and that there are three defaults each year. Calculate the mezzanine tranche premium leg, the default leg, and the accrual leg in the third year.

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  Introduction to Securitization

  • Frank J. Fabozzi, Vinod Kothari(Authors)
  • 2008(Publication Date)
  • Wiley

    (Publisher)

  The typical assets of structured finance CDOs are mezzanine (BBB or BB rated) ABS. Many CDOs have acquired investments in subprime mortgage securitizations.

  A CDO2 , or CDO-squared, is a CDO (issuing CDO) that invests in other CDOs (sub-CDOs). Each sub-CDO is itself a pool of assets or entities. Quite often, there is an overlap in entities (i.e., common entities in the sub-CDOs).

  In CDO2 as well as other structured finance CDOs, there is obviously a high degree of correlation. In the case of CDO2 s, there is perfect correlation to the extent of common names. In the case of other structured finance CDOs, assuming a CDO invests in BBB tranches of 20 home equity securitizations, if the home equity sector starts exhibiting problems, each of those BBB investments might realize losses. Since the losses arise from a common source, that is, home equity sector, the issuing CDO realizes a leveraged impact of the losses.

  INDEX TRADES AND INDEX TRACKING CDOs

  If we think of an arbitrage synthetic CDO, it is a pool of synthetic exposure in a broad-based list of corporates or structured finance products. An investor investing in, say, a BBB tranche of this CDO is making a synthetic investment in the pool of assets of the CDO. Because the investor is taking a position in a subordinated tranche in the pool, the investor is effectively making a leveraged synthetic investment in the pool of entities comprised in the pool. The investor is therefore taking a view on the credit quality of the underlying names.

  As synthetic CDOs grew, there emerged in the marketplace a need to offer an instrument whereby investors may express a view on a generalized pool of corporate names. For example, if someone wanted to express a view on the quality of Corporate America, this would not be possible in a single-tranche CDO (referred to as a bespoke CDO). Hence, structurers developed indexes

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