Collateralized Debt Obligation - Concept

Concept

CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO is a type of asset-backed security. To create a CDO, a corporate entity is constructed to hold assets as collateral and to sell packages of cash flows to investors. A sequence in constructing a CDO is:

• A special purpose entity (SPE) is designed to acquire a portfolio of underlying assets. Common underlying assets held include mortgage-backed securities, commercial real estate bonds and corporate loans.

• The SPE issues bonds to investors in exchange for cash, which is used to purchase the portfolio of underlying assets. The bonds issued are in layers called tranches, each with different risk characteristics. Senior tranches are paid from the cash flows from the underlying assets before the junior tranches and equity tranches. Losses are first borne by the equity tranches, next by the junior tranches, and finally by the senior tranches.

One analogy is to think of the cash flow from the CDO's portfolio of securities (say mortgage payments from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, then junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash 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 only indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all asset-backed securities, enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated.

The issuer of the CDO, typically an investment bank, earns a commission at the time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. Economist Mark Zandi wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up, only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."

In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This explains why some CDOs became entirely worthless, as the equity layer tranches were paid last in the sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of which defaulted) to trickle down to the equity layers.