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Collateralized Debt Obligation
(CDO)
Fixed Income Securities & Debt Markets
Faculty: Dr. Meera Sharma
Course:PTMBA20092012|IIIYear|TermVII|FINANCEDiv.B
Assignmentsubmittedby:Group7
RollNo. StudentName107 VatsalDhandhukia
110 MukundGhumara
129 VivekParulekar
142 AashikaShah
162 SunilObhan
September4,2011
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Contents1. Introduction ...................................................................................................................................................
2. How CDO works? .........................................................................................................................................
3. Why CDO? .......................................................................................................................................................
4. CDO Structures .............................................................................................................................................
5. Types of CDO ..................................................................................................................................................
6. Transaction participants ..........................................................................................................................
7. CDO Life Cycle ...............................................................................................................................................
8. Pros & Cons ....................................................................................................................................................
9. CDO Market Growth ....................................................................................................................................
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1. IntroductionThe basic principle behind a CDO involves the re-packaging of fixed income securities and the divis
of their cash flows according to a strict waterfall structure. A Collateralized Debt Obligation (CDO) is a cre
derivative that creates fixed income securities with widely different risk characteristics from a pool of ri
assets.
The coupon and principal payments of these securities are linked to the performance of the underly
pool. These fixed income securities are known as tranches and are divided into senior, mezzanine a
subordinated/equity tranches. Each of these tranches has a different level of seniority relative to the others in
sense that a senior tranche has coupon and principal payment priority over a mezzanine tranche, whil
mezzanine tranche has coupon and principal payment priority over an equity tranche. It is important to note t
a CDO only redistributes the total risk associated with the underlying pool of assets to the priority orde
tranches. It neither reduces nor increases the total risk associated with the pool.
A CDO is similar to a regular mutual fund that buys bonds. However, unlike a mutual fund, most of
securities sold from a CDO are themselves bonds, rather than shares. In simplest terms, a CDO is
arrangement that raises money primarily by issuing its own bonds and then invests the proceeds in a portfolio
bonds, loans, or similar assets. Payments on the portfolio are the main source of funds for repaying the CD
own securities. CDOs had become a notable feature of the financial landscape from 2000 to 2007. Aver
global CDO issuance has exceeded $161.7 billion per year, for each of the past ten years.
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Figure21
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One analogy is to think of the cash flow from the CDOs portfolio of securities (say mortgage payme
from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, th
junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient c
flow to fill all these cups and equity tranche investors face the losses first.
The risk and return for a CDO investor depends directly on how the tranches are defined, and o
indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods u
to define the risk and return of the tranches. CDOs, like all asset-backed securities, enable the originators of
underlying assets to pass credit risk to another institution or to individual investors. Thus investors m
understand how the risk for CDOs is calculated.
The issuer of the CDO, typically an investment bank, earns a commission at time of issue and ea
management fees during the life of the CDO. The ability to earn substantial fees from originating CDO
coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volu
rather than loan quality.
In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by ot
CDOs. This explains why some CDO became entirely worthless, as the equity layer tranches were paid las
the sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of wh
defaulted) to trickle down to the equity layers.
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Capital Structure
A typical CDO might have an underlying portfolio of roughly 100 corporate bonds with an aver
rating of single-B-plus (Moody's B1, S&P B+). If the total size of the portfolio is $300 million, the CDO mi
issue six classes of securities as follows:
Table21ExampleofBasicCDOStructure
ClassAmount
($millions)%ageofDeal
Ratings
(Moody's/S&P)
ClassA 243 81 Aaa/AAA
ClassB 13.5 4.5 Aa2/AA
ClassC 10.5 3.5 A2/A
ClassD 9 3 Baa2/BBB
ClassE 9 3 Ba2/BB
Equity 15 5 notrated
In buying and selling assets for the portfolio, the manager would be required to maintain an aver
portfolio rating of single-B-plus or higher. If the average rating of the portfolio slips lower, the terms of the d
might curtail the manager's discretion in managing the portfolio. In addition, the rating agencies mi
downgrade the securities.
Naturally, investors demand higher yields on classes exposed to greater credit risk. In the exam
above, the Class A securities would command the lowest yield because they carry the highest ratin
Conversely, the equity class would command the highest yield because of its station at the bottom of the de
capital structure.
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3. WhyCDO?The ability to enhance overall market liquidity for an asset class is a key value proposition of CD
This feature alone secures CDOs a critical role in the global financial marketplace.
The barriers that CDOs help investors overcome are not limited to providing diversified asset cl
access alone. More fundamentally, they provide a means to diversify into an asset class with the optional ben
of expert advice. Although static portfolios (and more recently indexation-based portfolios) can be construc
most CDOs formally contract an asset manager with a unique specialization in the targeted asset class
administer the portfolio.
Another service a CDO affords investors is an ability to select the degree of risk an investor takes to
asset class (and, if applicable, the asset manager) depending on where in the CDOs capital structure
investor invests.
Companies have different reasons for creating or sponsoring CDOs. For example, some CDOs
created by investment advisory firms (i.e., money management firms). Such a firm earns fees based on
amount of assets that it manages. By creating a CDO, the firm can increase its income by increasing its ass
under management. This kind of CDO is usually called an arbitrage CDO because of the (hopefully) posit
spread between the yield that the CDO earns on its portfolio and the yield that it must pay out on its own d
securities. In many cases, the profit goes mostly to the holder of the equity class, with some portion going to
manager as a performance-based fee.
Other CDOs are created by banks as a way to remove assets from their balance sheets. A bank
remove assets from its balance sheet by creating a CDO and transferring assets to the CDO's portfolio. Suc
CDO is called a balance sheet CDO. Removing assets from its balance sheet can be advantageous for a b
when it calculates its regulatory capital requirement.
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4. CDOStructuresCDO is a broad term that can refer to several different types of products. They can be categorized
several ways. The primary classifications are as follow:
Source of funds cash flow vs. market value
Arbitrage CDOs can be further broken down into cash flow and market value categories.
Focus: In a cash flow issue, the structure uses cash generated by a pool of corporate loans and bonds to sati
its payment obligations. Since cash flow CDOs will hold assets with varying terms, the portfolio manager m
ensure that payment obligations can be satisfied with incoming cash flows. In contrast, a market value CD
portfolio manager focuses on the pool's prospects for appreciation and high yield.
Strategy: A cash flow portfolio manager's strategy will typically be buy-and-hold (essentially matching as
flows with liability flows), whereas a market value CDO's portfolio manager actively trades the pool to enhan
total return.
Rating agencys perception: In addition, rating agencies review and monitor each structure differently. I
cash flow CDO, rating agencies will monitor overcollateralization (excess asset value) by comparing the pres
value of the pool's cash flows to the present value of the trust's obligations. A rating agency monit
overcollateralization in a market value CDO by considering the portfolio's market or liquidation value ver
the trust's obligations.
Fundingcash vs. synthetic
Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities
mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a spec
purpose vehicle) issuing the CDOs tranches. The risk of loss on the assets is divided among tranches in reve
order of seniority. Cash CDO issuance exceeded $400 billion in 2006.
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Under such
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at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in hi
quality, liquid assets or placed in a GIC (Guaranteed Investment Contract) account that offers a return that
few basis points below LIBOR. The return from these investments plus the premium from the sw
counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit event occurs
a payout to the swap counterparty is required, the required payment is made from the GIC or reserve acco
that holds the liquid investments. In contrast, senior tranches are usually unfunded since the risk of loss is m
lower. Unlike cash CDO, investors in a senior tranche receive periodic payments but do not place any capita
the CDO when entering into the investment. Instead, the investors retain continuing funding exposure and m
have to make a payment to the CDO in the event the portfolio's losses reach the senior tranche. Fund
synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time
create. Cash assets do not have to be purchased and managed, and the CDOs tranches can be precis
structured.
Figure42SyntheticCDOMechanism[Source:BionicTurtle.com]
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Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio o
hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional ass
A portion of the proceeds from the funded tranches is invested in cash assets and the remainder is held
reserve to cover payments that may be required under the credit default swaps. The CDO receives payme
from three sources: the return from the cash assets, the GIC or reserve account investments, and the CD
premiums.
Single-tranche CDOs
The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke CDOs) wh
the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches
never sold but held by the dealer based on valuations from internal models. Residual risk is delta-hedged by
dealer.
Table41ComparisonbetweenSingleTrancheSyntheticCDOsandTraditionalSyntheticCDOs
Single-Tranche Synthetic CDO Multi-Tranche Synthetic CDO
Synthetic risk transference via single name credit
default swaps is used to create the underlyingcollateral pool.
Synthetic risk transference via single name cre
default swaps is used to create the underlycollateral pool.
Usually between 50 and 100 high-grade names in thecollateral pool.
Typically around 100 high-grade names in collateral pool.
Only one tranche is placed with an investor. Theremaining tranches are retained by the dealer and theassociated risk is actively managed (delta hedged).
Majorities of the tranches are placed with differinvestors and hedging is more straightforward thansingle tranche deals. Syndication may be involved.
Bilateral contract between protection buyer andprotection seller. No reliance or dependence on equitytranche investor or other parties as in traditionalCDOs. Client has ultimate flexibility in determining
the underlying portfolio, investment size, tranchestructure and desired rating.
Different investors will be attracted to differtranches depending on risk/ return preference. Lflexibility in determining underlying collateral pdepending on the type of investor.
Investor-driven, single-investor. Issuer-driven in traditional securitization or equinvestor/portfolio manager driven in case of arbitrCDO.
Potentially faster execution than full capital structuredeals, allowing the investor to capitalize on arbitrageopportunities between the CDS and cash markets, aswell as sweet spots in the capital structure.
Typically slower execution as all tranches need toplaced. Deals can collapse if the entire capstructure cannot be placed.
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5. TypesofCDOCDOs, which first appeared in the late 1980s, are considered to be the most important innovation in
structured finance market in the past two decades. There are many types of CDOs available in the market.
A) Based on the underlying asset:
Collateralized loan obligations (CLOs) CDOs backed primarily by leveraged bank loans.
Collateralized bond obligations (CBOs) CDOs backed primarily by leveraged fixed income securities.
Collateralized synthetic obligations (CSOs) CDOs backed primarily by credit derivatives.
Structured finance CDOs (SFCDOs) CDOs backed primarily by structured products (such as asset-bac
securities and mortgage-backed securities).
Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans,
only less than 10% of CDOs were backed by fixed income securities.
B) Other types of CDOs include:
Commercial Real Estate CDOs (CRE CDOs) backed primarily by commercial real estate assets
Collateralized bond obligations (CBOs) CDOs backed primarily by corporate bonds
Collateralized Insurance Obligations (CIOs) backed by insurance or, more usually, reinsurance contracts
CDO-Squared CDOs backed primarily by the tranches issued by other CDOs.
CDO^n Generic term for CDO3 (CDO cubed) and higher, where the CDO is backed by ot
CDOs/CDO2/CDO3. These are particularly difficult vehicles to model due to the possible repetition
exposures in the underlying CDO.
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6. TransactionparticipantsInvestors: have different motivations for purchasing CDO securities depending on which tranche they select
Underwriter: typically an investment bank, acts as the structurer and arranger of the CDO. Working with
asset management firm that selects the CDOs portfolio, the underwriter structures debt and equity tranches. T
includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality te
and working with the credit rating agencies to gain the desired ratings for each debt tranche.
The asset manager: plays a key role in each CDO transaction, even after the CDO is issued. An experien
manager is critical in both the construction and maintenance of the CDOs portfolio. The manager can maint
the credit quality of a CDOs portfolio through trades as well as maximize recovery rates when defaults on
underlying assets occur.
The trustee and collateral administrator: The trustee holds title to the assets of the CDO for the benefit of
investors. In the CDO market, the trustee also typically serves as collateral administrator. In this role,
collateral administrator produces and distributes note-holder reports, performs various compliance te
regarding the composition and liquidity of the asset portfolios in addition to constructing and executing
priority of payment waterfall models.
Accountants: The underwriter typically will hire an accounting firm to perform due diligence on the CD
portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread
each collateral security. In addition, the accountants typically calculate certain collateral tests and determ
whether the portfolio is in compliance with such tests.
Attorneys: Attorneys ensure compliance with applicable securities law and negotiate and draft the transact
documents. Attorneys will also draft an offering document or prospectus the purpose of which is to sati
statutory requirements to disclose certain information to investors.
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7. CDOLifeCycleIt is useful to view a CDO as having a lifecycle that consists of several phases. The first phase is
ramp-up phase, when the manager uses the proceeds from issuing the CDO to purchase the initial portfo
The CDO's governing documents generally specify parameters for the initial portfolio but not the ex
composition. For example, the terms of the CDO might require that the initial portfolio have a minim
average rating, a minimum average yield, a maximum average maturity, and a minimum degree
diversification. During the ramp-up phase, the manger must select assets so that the portfolio satisfies all
parameters.
The second phase is the revolving period, during which the manager actively manages the portfolio
reinvests cash flow from the portfolio. The reinvestment phase allows a CDO to remain outstanding with
amortization of the CDO's own bonds even though the assets in the underlying portfolio reach their matur
dates.
The third period is the amortization phase. During the amortization phase, the manager st
reinvesting cash flow from the portfolio. Instead, the manager must apply the cash flow toward repaying
CDO's debt securities.
A manager generally is required to follow certain rules in managing the portfolio. The rules prot
investors by somewhat limiting the manager's discretion. For example, one rule might require the manager
maintain the average yield or spread on the managed assets above a certain level. Another rule might require
manager to maintain the average maturity of the assets within a certain range.
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8. Pros&ConsAdvantages:
Different Tranches allow Investors to customize their Credit Risk exposure Efficient Mechanism for taking Diversified Credit Exposure Attractive Spreads relative to similarly rated Assets
Disadvantages:
Pricing is based on Rating Agency assigned default probabilities which may not reflect TrueUnderlying Risk
Expenses Origination & Management Fees reduce the economies to Investors9. CDOMarketGrowth
The first CDO was issued in 1987 by bankers at Drexel Burnham Lambert Inc. and a decade later, CD
emerged as the fastest growing sector of the asset-backed synthetic securities market. CDO issuance
grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, and then
declined back under $20 billion by Q1 2008.
Table91GlobalCDOIssuance[Source:sifma]
68 7883 87
158
251
456430
62
4 8 3
0
50
100
150
200
250300
350
400
450
500
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
GlobalCDOIssuance($billions)
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