Collateral Debt Obligations. Thought of the Day 111.0

A CDO is a general term that describes securities backed by a pool of fixed-income assets. These assets can be bank loans (CLOs), bonds (CBOs), residential mortgages (residential- mortgage–backed securities, or RMBSs), and many others. A CDO is a subset of asset- backed securities (ABS), which is a general term for a security backed by assets such as mortgages, credit card receivables, auto loans, or other debt.

To create a CDO, a bank or other entity transfers the underlying assets (“the collateral”) to a special-purpose vehicle (SPV) that is a separate legal entity from the issuer. The SPV then issues securities backed with cash flows generated by assets in the collateral pool. This general process is called securitization. The securities are separated into tranches, which differ primarily in the priority of their rights to the cash flows coming from the asset pool. The senior tranche has first priority, the mezzanine second, and the equity third. Allocation of cash flows to specific securities is called a “waterfall”. A waterfall is specified in the CDO’s indenture and governs both principal and interest payments.


1: If coverage tests are not met, and to the extent not corrected with principal proceeds, the remaining interest proceeds will be used to redeem the most senior notes to bring the structure back into compliance with the coverage tests. Interest on the mezzanine securities may be deferred and compounded if cash flow is not available to pay current interest due.

One may observe that the creation of a CDO is a complex and costly process. Professionals such as bankers, lawyers, rating agencies, accountants, trustees, fund managers, and insurers all charge considerable fees to create and manage a CDO. In other words, the cash coming from the collateral is greater than the sum of the cash paid to all security holders. Professional fees to create and manage the CDO make up the difference.

CDOs are designed to offer asset exposure precisely tailored to the risk that investors desire, and they provide liquidity because they trade daily on the secondary market. This liquidity enables, for example, a finance minister from the Chinese government to gain exposure to the U.S. mortgage market and to buy or sell that exposure at will. However, because CDOs are more complex securities than corporate bonds, they are designed to pay slightly higher interest rates than correspondingly rated corporate bonds.

CDOs enable a bank that specializes in making loans to homeowners to make more loans than its capital would otherwise allow, because the bank can sell its loans to a third party. The bank can therefore originate more loans and take in more origination fees. As a result, consumers have more access to capital, banks can make more loans, and investors a world away can not only access the consumer loan market but also invest with precisely the level of risk they desire.


1: To the extent not paid by interest proceeds.

2: To the extent senior note coverage tests are met and to the extent not already paid by interest proceeds. If coverage tests are not met, the remaining principal proceeds will be used to redeem the most senior notes to bring the structure back into compliance with the coverage tests. Interest on the mezzanine securities may be deferred and compounded if cash flow is not available to pay current interest due.

The Structured Credit Handbook provides an explanation of investors’ nearly insatiable appetite for CDOs:

Demand for [fixed income] assets is heavily bifurcated, with the demand concentrated at the two ends of the safety spectrum . . . Prior to the securitization boom, the universe of fixed-income instruments issued tended to cluster around the BBB rating, offering neither complete safety nor sizzling returns. For example, the number of AA and AAA-rated companies is quite small, as is debt issuance of companies rated B or lower. Structured credit technology has evolved essentially in order to match investors’ demands with the available profile of fixed-income assets. By issuing CDOs from portfolios of bonds or loans rated A, BBB, or BB, financial intermediaries can create a larger pool of AAA-rated securities and a small unrated or low-rated bucket where almost all the risk is concentrated.

CDOs have been around for more than twenty years, but their popularity skyrocketed during the late 1990s. CDO issuance nearly doubled in 2005 and then again in 2006, when it topped $500 billion for the first time. “Structured finance” groups at large investment banks (the division responsible for issuing and managing CDOs) became one of the fastest-growing areas on Wall Street. These divisions, along with the investment banking trading desks that made markets in CDOs, contributed to highly successful results for the banking sector during the 2003–2007 boom. Many CDOs became quite liquid because of their size, investor breadth, and rating agency coverage.

Rating agencies helped bring liquidity to the CDO market. They analyzed each tranche of a CDO and assigned ratings accordingly. Equity tranches were often unrated. The rating agencies had limited manpower and needed to gauge the risk on literally thousands of new CDO securities. The agencies also specialized in using historical models to predict risk. Although CDOs had been around for a long time, they did not exist in a significant number until recently. Historical models therefore couldn’t possibly capture the full picture. Still, the underlying collateral could be assessed with a strong degree of confidence. After all, banks have been making home loans for hundreds of years. The rating agencies simply had to allocate risk to the appropriate tranche and understand how the loans in the collateral base were correlated with each other – an easy task in theory perhaps, but not in practice.

The most difficult part of valuing a CDO tranche is determining correlation. If loans are uncorrelated, defaults will occur evenly over time and asset diversification can solve most problems. With low correlation, an AAA-rated senior tranche should be safe and the interest rate attached to this tranche should be close to the rate for AAA-rated corporate bonds. High correlation, however, creates nondiversifiable risk, in which case the senior tranche has a reasonable likelihood of becoming impaired. Correlation does not affect the price of the CDO in total because the expected value of each individual loan remains the same. Correlation does, however, affect the relative price of each tranche: Any increase in the yield of a senior tranche (to compensate for additional correlation) will be offset by a decrease in the yield of the junior tranches.

Accelerating the Synthetic Credit. Thought of the Day 96.0


The structural change in the structured credit universe continues to accelerate. While the market for synthetic structures is already pretty well established, many real money accounts remain outsiders owing to regulatory hurdles and technical limitations, e.g., to participate in the correlation market. Therefore, banks are continuously establishing new products to provide real money accounts with access to the structured market, with Constant proportion debt obligation (CPDOs) recently having been popular. Against this background, three vehicles which offer easy access to structured products for these investors have gained in importance: CDPCs (Credit Derivatives Product Company), PCVs (permanent capital vehicle), and SIVs (structured investment vehicles).

A CDPC is a rated company which buys credit risk via all types of credit derivative instruments, primarily super senior tranches, and sells this risk to investors via preferred shares (equity) or subordinated notes (debt). Hence, the vehicle uses super senior risk to create equity risk. The investment strategy is a buy-and-hold approach, while the aim is to offer high returns to investors and keep default risk limited. Investors are primarily exposed to rating migration risk, to mark-to-market risk, and, finally, to the capability of the external manager. The rating agencies assign, in general, an AAA-rating on the business model of the CDPC, which is a bankruptcy remote vehicle (special purpose vehicle [SPV]). The business models of specific CDPCs are different from each other in terms of investments and thresholds given to the manager. The preferred asset classes CDPC invested in are predominantly single-name CDS (credit default swaps), bespoke synthetic tranches, ABS (asset-backed security), and all kinds of CDOs (collateralized debt obligations). So far, CDPCs main investments are allocated to corporate credits, but CDPCs are extending their universe to ABS (Asset Backed Securities) and CDO products, which provide further opportunities in an overall tight spread environment. The implemented leverage is given through the vehicle and can be in the range of 15–60x. On average, the return target was typically around a 15% return on equity, paid in the form of dividends to the shareholders.

In contrast to CDPCs, PCVs do not invest in the top of the capital structure, but in equity pieces (mostly CDO equity pieces). The leverage is not implemented in the vehicle itself as it is directly related to the underlying instruments. PCVs are also set up as SPVs (special purpose vehicles) and listed on a stock exchange. They use the equity they receive from investors to purchase the assets, while the return on their investment is allocated to the shareholders via dividends. The target return amounts, in general, to around 10%. The portfolio is managed by an external manager and is marked-to-market. The share price of the company depends on the NAV (net asset value) of the portfolio and on the expected dividend payments.

In general, an SIV invests in the top of the capital structure of structured credits and ABS in line with CDPCs. In addition, SIVs also buy subordinated debt of financial institutions, and the portfolio is marked-to-market. SIVs are leveraged credit investment companies and bankruptcy remote. The vehicle issues typically investment-grade rated commercial paper, MTNs (medium term notes), and capital notes to its investors. The leverage depends on the character of the issued note and the underlying assets, ranging from 3 to 5 (bank loans) up to 14 (structured credits).

Why in the first place is an SPV (Special Purpose Vehicle) even required? A miracle that cannot be disproved…

Consider a $1 billion collection of risky loan, obligations of borrowers who have promised to repay their loans at some point in future. Let us imagine them sitting on the balance sheet of some bank XYZ, but they equally well could be securities available on the market that the Bank’s traders want to purchase and repackage for a profit. No one knows whether the borrowers will repay, so a price is put on this uncertainty by the market, where thousands of investors mull over the choice of betting on these risky loans and the certainty of risk-free government bonds. To make them indifferent to the uncertainty these loans carry, potential investors require a bribe in the form of 20% discount at face value. If none of the loans default, investors stand a chance to earn a 25% return. A good deal for investors, but a bad one for the Bank, which does not want to sell the loans for a 20% discount and thereby report a loss.

Now imagine that instead of selling the loans at their market price of $800 million, the Bank sells them to an SPV that pays a face value of $1 billion. Their 20% loss just disappeared. Ain’t this a miracle? But, how? The SPV has to raise $1 billion in order to buy the loans from the Bank. Lenders in SPV will only want to put $800 million against such risky collateral. The shortfall of $200 million will have to be made up somehow. The Bank enters here under a different garb. It puts in $200 million as an equity investment so that the SPV has enough money now to buy the $1 billion of loans.

However, there is a catch here. Lenders no longer expect to receive $1 billion, or a 25% return in compensation for putting up the $800 million. SPV’s payout structure guarantees that the $200 million difference between face value and market value will be absorbed by the Bank, implying treating $800 million investment as virtually risk-free. Even though the Bank has to plough $200 million back into the SPV as a kind of hostage against the loans going bad, from Bank’s perspective, this might be better than selling the loans at an outright $200 million loss. this deal reconciles two opposing views, the first one being the market suspicion that those Bank assets are somehow toxic, and secondly the Bank’s faith that its loans will eventually pay something close to their face value.

So, SPVs become a joint creation of equity owners and lenders, purely for the purpose of buying and owning assets, where the lenders advance cash to the SPV in return for bonds and IOUs, while equity holders are anointed managers to look after those assets. Assets, when parked safely within the SPV cannot be redeployed as collateral even in the midst of irresponsible buying spree.