Collateralized debt obligation

Collateralized debt obligations (CDOs) are a type of asset-backed security or structured finance product. At a high-level, a CDO can be thought of as a mutual fund where the owners (i.e. the equity class(es)) leverage their investment by borrowing (by issuing debt) against the portfolio.

The term CDO is often used as a generic term that includes:

• Collateralized bond obligations (CBOs) -- CDOs backed primarily by bonds
• Collateralized loan obligations (CLOs) -- CDOs backed primarily by leveraged loans
• Structured finance CDOs (SFCDOs) -- CDOs backed primarily by asset-backed securities
• CDO-Squared -- CDOs backed primarily by securities issued by other CDO vehicles (there has also been some talk in the CDO market of CDO-Cubed (i.e. a CDO-Squared that invests in securities issued by CDO-Squared vehicles)).

Types of CDOs

CDOs can be categorized in several ways. The primary classifications are as follows:

• Source of funds -- cash flow vs. market value

Cash flow CDOs should be distinguished from the long-established, but less common market value CDO format. Whereas cash flow CDOs are managed to pay off liabilities from the interest and principal payments of collateral, market value CDOs are managed to pay off liabilities through the trading and sale of collateral. This means that cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio, while market value CDOs focus on the volatility of collateral portfolio's market value.

• Motivation -- arbitrage vs. balance sheet

Arbitrage transactions attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital.

• Funding -- cash vs. synthetic

"Cash CDOs" involve a pool of physical assets, such as loan contracts, corporate bonds, asset-backed securities or mortgage-backed securities, whose ownership is transferred to the legal entity issuing the CDO (known as a special purpose vehicle or SPV).

Some balance sheet transactions use credit derivatives to transfer the credit risk of assets from balance sheets to CDOs without the sale or transfer of the assets themselves. These structures, which may be non-funded or partially funded, are called "synthetic CDOs." Synthetic CDOs are formed from a large pool (usually 100 names) of CDSs. They have become very popular in recent years, especially in Europe where over 90% of deals are synthetic.

In the U.S., synthetic deals account for one third of all arbitrage CDOs. Synthetic CDOs allow more flexible structure than cash CDOs, thanks to the unique characteristics of CDS.

Collateral Asset Classes

Subject to investment guidelines set by each individual CDO the underlying assets may be static or revolving (i.e. the portfolio may allow for trading) and may consist of any variety and configuration of:

• corporate bonds;
• bank loans (alternatively referred to as leveraged loans);
• emerging-market sovereign debt;
• project finance debt;
• asset-backed securities (ABS) and other structured finance securities (such as CMBS, RMBS and HEL);
• trust preferred securites;

or

• credit derivatives (credit default swaps, etc.)

The underlying collateral may be static or may be managed by an asset manager (alternatively referred to as the "collateral manager" or "portfolio manager") who generally has demonstrated experience in managing the asset classes mandated by the transaction.

Transaction Participants

Investors

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Depending on the level of the capital structure in question, investors have different motivations for purchasing CDO securities. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities (e.g. corporate bonds) of a similar rating or credit profile. At the most subordinated levels, the investor achieves a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Where the CDO's portfolio is permitted to be actively managed, the investors are also able to take advantage of the expertise of a third-party asset manager.

Underwriter

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Rating Agencies

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The Asset Manager

The asset manager often has broad discretion to purchase and/or trade collateral and plays a key role in each CDO transaction. There are approximately 300 asset managers in the marketplace.

The Trustee

The trustee holds title to the assets of the CDO for the benefit of the noteholders. In the CDO market, the trustee also typically serves as collateral administrator (one notable exception to this is Virtus Partners which offers collateral administration services, but is not a trustee bank), and produces the required reporting for the investors. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:

• The Bank of New York (note: the Bank of New York recently also acquired the corporate trust unit of JP Morgan which is the market share leader)
• LaSalle Bank (note: operates in Europe under the name of its parent, ABN AMRO)
• Well Fargo
• Deutsche Bank
• US Bank (note: US Bank recently also acquired the corporate trust unit of Wachovia)
• Fortis Intertrust (note: currently serves the European market only; was formerly known as MeesPierson Intertrust)
• BNP Paribas Securities Services (note: currently serves the European market only)
• Investors Bank & Trust Company

Accountants

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Attorneys

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Capital Structure and Waterfall (Priority of Payments)

The securities issued by the CDO are split into rated and unrated classes of bonds and equity, where the rating of each bond class is determined by its position in the priority of payments and other rating criteria. Payments of interest and principal to the various bond classes (or liabilities) issued by a CDO are generally made sequentially, such that payment is first made to the most senior class and then to other classes, in the order of their subordination. These payments are made solely from the cash flows received from the underlying assets (including hedges).

The senior bonds are usually rated AAA to A and have first claim on cash flows. The mezzanine and subordinated bonds are usually rated BBB to B and have a subordinate claim on cash flows. The equity tranche, which occupies a first-loss position, is generally unrated and receives all or most of the residual interest proceeds of the collateral. The CDO equity represents a leveraged investment in the collateral; it has both a higher expected return (assuming of course that the expected return of the underlying return is positive, ie that expected losses are lower than coupon payments) and a higher volatility of return than the underlying assets.

The high risk of the equity tranche has led to allegations of mis-selling[1], with market commentators referring to this asset class as 'Toxic Waste' [2].

Market History and Growth

First issued in the late 1980s, CDOs emerged a decade later as the fastest growing sector of the asset-backed securities market. This growth reflects the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations and structured investment vehicles.

According to the Bond Market Association, gross global CDO issuance of all types totalled USD 157 billion in 2004, USD 251 billion in 2005, and USD 71 billion in the first quarter of 2006.