Collateralized debt obligation (CDO) is a term used to describe financial instruments that are structured asset-backed securities. It is a structured financial product backed by a pool of loans.
When a commercial or retail bank approves loans, such as credit cards, car loans, or mortgages to private individuals or companies, these loans are then sold on to an investment bank, which in turn repackages these loans to form investment products called CDOs, which investors then buy.
The interest and principle payments made on the loans are passed on to the investors in the pool. The collateral that gives the CDO’s value is the promised repayment on the loans in the pool, hence the term collateralized.
If the underlying loans go bad, banks transfer most of the risk to the investors. Typical CDO investors are hedge funds or pension funds.
CDOs consist of a portfolio of fixed income securities split into many different ‘tranches’ – one of a number of related securities offered as part of the same transaction.
The word ‘tranche’ comes from Old French literally meaning ‘slice’.
Tranches are divided into three different sections, according to the degree of risk taken by the investor:
- Equity tranches – these are the riskiest. They are usually purchased by a hedge fund manager, and are the first to bear the risk.
- Junior tranches – these are intermediaries. They are purchased by asset managers or investors.
- Senior tranches – these are the least risky. They are usually given an AAA rating by rating agencies and purchased by bond insurers.
A CDO tranche is comprised of:
- Portfolio of names
- Attachment point
- Detachment point
- Spread contract
- Maturity date
CDOs all vary in structure
However, they all share a similar basic structure:
A special purpose entity (SPV) acquires a portfolio of mortgage-backed securities or high-yield bonds.
The SPV sells bonds to investors. These bonds entitle the holder to the cash flows from the portfolio of the SPV. The distribution depends on the ranking of the bonds. Senior tranches are paid before the junior tranches and equity tranches.
Losses are distributed in reverse order of ratings, with equity tranches losing first and then junior tranches losing followed by senior tranches.
Source: “Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States“, p.128 figure 8.1
Types of CDOs
CDOs 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.
Other types of CDOs by assets/collateral:
- 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.
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