Collateralized Debt Obligation - CDO

A collateralized debt obligation (CDO) is a specific type of asset backed security that is created through the securitization of various fixed income products.  The basic purpose of this security is to hold assets as collateral and then sell the cash flow from the different tranches, or credit quality tiers, to investors.  Obviously, the lower the seniority in principal repayment renders a higher yield on investment to compensate for the added risk.  CDOs are divided into three different tranches: senior (triple A rated), mezzanine(AA to BB), and equity tranches which are unrated.  The equity tranche is also known as the "toxic waste" and is most vulnerable to default. 

The most common debt instruments within a CDO include mortgage backed securities, commercial real estate debt, corporate bonds, and REITs debt to name a few.  Investors that buy CDOs are entitled its interest income and principal. 

The CDO market has been at the forefront lately, taking credit for the credit crisis that has gripped the world markets.  CDOs allowed financial institutions to reclassify their debt obligations from debts to assets by pooling their debts into securities and bringing these securities back on their books as assets.  You can see how this would now hide their losses and at the same time inflate their earnings.

For what purpose are CDO's Issued?

CDOs are typically issued by institutions for the purposes of arbitrage or to remove the assets from their balance sheet.  This is often referred to as a balance sheet transaction. 

An arbitrage transaction, which is the predominant transaction, allows the issuing institution to profit from the spread between the yield of the collateral assets and payments made to the investors in each of the different tranches.  A balance sheet transaction is performed to remove the assets from the balance sheet for the purposes of lowering their capital requirements and credit risk.

Synthetic Collateralized Default Obligations

CDOs can be funded as cash CDOs or Synthetic CDOs.  We covered the basics of a cash CDO above.  Let's talk a bit about the synthetic counterpart.  Synthetic CDOs do not own any assets; rather, they expose themselvels to the credit markets by leveraging credit default swaps.  Remember, credit default swaps are a form of insurance.  Under this form of a swap, the seller of the protection will receive premiums in exchange for insuring the buyer against adverse credit events which can wipe out an asset. 

Synthetic CDOs basically take investor capital and invest it into high quality assets.  The interest from these investments, along with the premiums that the CDO is receiving on the CDS will pay the periodic cash flows to the investors. 

The real danger in synthetic CDOs is that they may be unfunded, meaning protection sellers may insure against an event that they may not have the funds to make good on a default.  This is a highly unregulated market and the exposure to these types of events is unknown because there is no true market on which these swaps are traded on.  Even more interesting is that senior tranches within a CDO do not have to be funded at all by the investors until a default situation arises.  These senior tranches are considered very low risk; however, as we have seen, the credit rating agencies are not doing their job well in identifying the risk associated to the CDO and CDS market and therefore are issuing credit ratings that do not take into account the real risk of these securities.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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