CDOs (Collateralized Debt Obligations) are a type of investment vehicles, or in other words, unregulated asset-backed securities and integrated credit products. These CDOs are built from a portfolio of fixed income assets. Rating firms assess the value of these assets and divide them into dissimilar tranches: AAA (senior tranches), AA to BB (mezzanine tranches) and unrated (known as equity tranches). In CDOs, junior tranches offer higher interest rates (coupons). This mechanism is used to offset the additional default risk associated with it. Losses are adjusted in reverse order of seniority, ie equity tranches bear the first loss adjustment, then mezzanine tranches, and finally senior tranches.
Drexel Burnham Lambert Inc. was the first to issue collateralized debt obligations (CDOs) to a savings institution known as the Imperial Savings Association, which later failed and was taken over by Resolution Trust Corporation in the 1990s. But after a decade, with the introduction of Gaussian copula models, CDOs became one of the fastest growing investment vehicle sectors. Growth can be measured by the growing interest in CDOs among investors and asset managers, including investment funds, mutual fund companies, insurance companies, private banking institutions, pension fund managers, investment banks , commercial banks and other integrated CDOs and investment vehicles. The basic reason for such interest was higher profit margins.
CDO has a very broad definition and refers to different types of products. They can be classified in the following ways:
Source of funds: Cash flow (income) and Market value
o Cash flow CDOs pay principal and interest to noteholders using the income generated by the CDO assets. Its main focus is to manage the credit standard of the fundamental portfolio.
o Market value CDOs make periodic lucrative sales and transactions of collateral assets to increase investor income. The asset manager strives for capital gains on the underlying portfolio. They are more concerned with changes and developments in the market value of CDO portfolio assets.
Reason: Arbitration and Balance
o Arbitrage transactions seek to gain control over equity investors who are spread between lower-yielding liabilities and comparatively higher-yielding assets comprised of rated bonds. Most CDOs are asked for arbitration.
o On the contrary, balance sheet operations are mainly motivated by issuing entities to reduce the credit risk of their balance sheet. To offload loans and other assets from the balance sheet and improve your return on risky assets.
Financial Support: Cash and Synthetic
o Cash CDOs require a portfolio of cash value, such as corporate bonds, loans, mortgage-backed securities, or asset-backed securities. Possession of the assets is transferred to the legal person (SPV), the issuer of the CDO notes. The loss is distributed in reverse order of seniority.
o Synthetic CDOs earn on fixed income assets without ownership, through the mechanism of credit default swaps. Under this redemption mechanism, the CDO, the credit protection seller earns premiums (periodic cash payment) with an agreement that, in the event of a loss, it would be shared in reverse order of seniority tranches.
single slice
o Single tranche CDOs are constructed using the flexibility of credit default swaps. This CDO is specially designed for small groups of investors; the remaining sections are not sold but are kept by the concessionaire under agreed internal models.
The working patterns of all CDOs are almost the same but they differ in structure and underlying assets. Basically, a CDO is a collective entity formed to hold assets as collateral and sell income packages to investors. A CDO is based on the following lines:
o An SPV (special purpose entity) assumes a credit role. They typically hold assets such as commercial real estate debt, mortgage-backed securities, and high-yield corporate loans.
o The SPV issues different classes of shares and bonds and the payments are used to purchase the loan portfolio. Stocks and bonds are entitled to proceeds in accordance with the Payment Priority of predetermined transaction documents. The first income goes to the senior tranches along with the junior tranches and finally the principal tranches are paid. Therefore, the equity tranches bear the first loss, then the junior tranches, and lastly the senior tranches. In this way, all tranches have the same portfolio of debt securities, but offer different combinations of risk and return.
A CDO investor does not take a direct position in the underlying assets, but instead holds a position in an entity with defined reward and risk. Therefore, the investment is subject to the standard of measurements and assumptions involved in the risk-reward analysis of the notes.
Typically, the investment bank (issuer of the CDO) charges a commission at the time the CDO is issued, and management fees until the existence of the CDO. Investing in a CDO is an investment in the income from the assets and metric patterns of this intermediary, rather than a direct investment in asset-backed collateral.