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A collateralized debt obligation provides a means to create fixed-income securities from a pool of diversified debt instruments with differing yields and risks. It allows the issuance of securities with lower risks than the securities used to back the CDOs, and part of the recent surge in the sale of CDOs have been to finance leveraged buyouts. CDOs were first created in 1987 by Drexel Burnham Lambert, a defunct dealer in junk bonds. According to J.P. Morgan, $918 billion worth of CDOs were issued in 2006. According to Merrill Lynch & Co., the top 5 issuers of CDOs in 2006 were Cohen & Co.; Trust Company of the West; Goldman Sachs Group, Inc.; Duke Funding Management LLC; and Aladdin Capital Management LLC.
A CDO is an asset-backed security (ABS) that can be backed by investment-grade corporate bonds; high-yield corporate bonds; emerging market bonds; residential mortgage-backed securities (RMBS); commercial mortgage-backed securities; (CMBS); other asset-backed securities; real estate investment trusts (REITs); bank loans; special situation loans and distressed debt; and even other CDOs.
CDOs differ from collateralized mortgage obligations (CMOs) primarily in providing differing amounts of credit quality that is grouped into 3 or more tranches that have the same maturity. The senior tranches have the best credit quality and the lowest yield; the mezzanine tranches have slightly lower credit quality but a higher yield, and the subordinate or equity tranches (aka toxic tranches, toxic waste) generally receives residual payments, which is what is left over after the higher tranches have been paid. The equity tranches pay the highest yield, almost always more than 10%, but also have the greatest risk—in fact, these tranches have no credit rating and are the 1st tranches to suffer losses. A $500 million CDO will typically have at least $40 million in an equity tranche. The senior and mezzanine tranches usually have an investment-grade credit rating because they are usually over-collateralized with a diverse pool of bonds.
CDOs can be classified according to their underlying debt. Collateralized bond obligations (CBOs) are CDOs based on bonds. These include corporate bond-backed CDOs, emerging market-backed CDOs, and structured finance-backed CDOs, where the underlying assets are RMBS, CMBS, ABS, and REIT debt. Collateralized loan obligations (CLO) are CDOs based on bank loans. Many of the subprime loans have been packaged and sold as CLOs.
CDOs can also be classified as cash CDOs and synthetic CDOs. Cash CDOs are backed by cash-market debt instruments, whereas synthetic CDOs are backed by other credit derivatives.
Cash and synthetic CDOs can also be classified according to the goals of the sponsor. Balance-sheet CDOs allow the issuer to manage risk and get capital requirements relief by removing assets from its balance sheet to the CDO; whereas arbitrage CDOs allow the issuer to profit from the spread between what the CDOs yield and the interest rate of the debt used to finance them, and also allows the issuer to collect fees for managing the CDO, which usually ranges from 45 – 75 basis points of the CDO. For example, for a $500,000,000 CDO, a manager earning 50 basis points (= ½%) would collect $2.5 million annually.
Cash arbitrage CDOs also can be subdivided according to the means of credit protection for the investors. The safety of the cash-flow CDO is backed by principal repayment, and the after-default interest and recoveries. The safety of market-value CDO is backed by its assets, which can be sold to pay back investors. The 1st balance-sheet CDOs used a market-value credit structure, but since the 1990’s, only cash-flow balance-sheet CDOs have been issued because of changes in the accounting rules.
A CDO is usually formed by a bank or other financial firm by setting up a corporation specifically for the CDO that is located offshore in locations that don't tax corporations, such as the Cayman Islands. A trustee, usually a bank, is chosen to manage the CDO and issues monthly reports on the debt composition of the CDO to its investors after it is established.
The CDO manager buys asset-backed securities for collateral, then sells commercial paper, which is short-term debt, to other financial institutions. The commercial paper is based on the top-rated tranches, which may constitute up to 90% of the CDO. Often, CDO managers have agreements with 1 or more banks to buy the commercial paper if there are no takers in the market place.
To guarantee a good rating, the rating agencies—Fitch, Moody's, and S & P—help to assemble the CDO by specifying the requirements that must be met to obtain a top rating. The CDO manager consults and negotiates a credit rating for each tranche of the CDO. Because of the complexity of CDOs, rating agencies charge up to 3 times more money for rating CDOs than for rating bonds. Because of the close association of the rating agencies and the CDOs, and the profits that rating agencies make from CDOs, many money managers believe that it is risky to rely on credit ratings alone in assessing the safety of CDOs—it should be supported by scrutiny of the prospectuses and the monthly reports issued by the trustee.
Although CDOs pay high yields, there are greater risks investing in these vehicles, even when they have an investment grade rating. According to this Bloomsberg article, The Ratings Charade, CDOs with a Moody's investment grade rating of Baa had a 5-year default rate of 24%, while corporate bonds with the same rating had only an average 5-year default rate of 2.2% from 1983 - 2005. CDOs with a Ba rating had default rates of 25.3%.
CDOs also are almost impossible to value, and virtually impossible to even know what assets they are based on; however, it is becoming evident as many of them default that a good portion of their assets consists of subprime mortgages. Even more complex, unfathomable, and risky are CDO squareds, which are based on other CDOs, and CDO cubeds, which are based on CDO squareds, that contain thousands of securities.
So that some of the equity tranches can be sold to pension funds, which generally cannot invest in securities without an investment grade rating, some CDOs have offered principal protection, which involves investing a portion of the money into zero coupon government bonds and the remaining portion in a CDO equity tranche. At maturity, if all is lost in the equity tranche, then the principal remains when the zero coupon bonds mature. Of course, the fund will suffer a great opportunity cost, since, in such a scenario, no money has been earned during the time of the investment.
Moody’s offers new tools to value CDOs
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