Securitize this! Collateralized debt obligations.

• Author: Stone, Charles A.
• Position: Letter from the Editors - Editorial

When two markets offer different values for the same or nearly the same commodity an arbitrage opportunity may present itself. An example of these one-commodity two-value-scenarios is the market for corporate loans and the market for securities backed by corporate loans--the market for collateralized loan obligations (CLOs). When the market for CLOs is more efficient than the corporate loan market itself the potential for an arbitrage opportunity exists. Transaction costs including any necessary hedging that locks in the price differential between the two markets must be factored into the arbitrage calculation. Strictly speaking an arbitrage profit is a risk free profit that is earned on zero net investment. Traders execute arbitrage transactions by selling the commodity or derivative of the commodity in the market where values are relatively high and covering the sale by purchasing the same commodity or derivative thereof in the relatively cheap market. In the mortgage market a banker can originate (buy) mortgages in the forward or cash market of the primary mortgage market and securitize (sell) the same mortgages in the forward market of the secondary mortgage market which is called the "to be announced or TBA" market. In the primary mortgage market a financial institution makes committed offers to borrowers for mortgage credit at a quoted rate for up to sixty days prior to the actual closing of the mortgage contract. This commitment to lend can be thought of as a forward purchase of mortgages in the primary market. In the secondary market the mortgage banker makes a commitment to deliver on a future date a pool of mortgages with a specified yield for a specified price to a bank or to FNMA or Freddie Mac. The mortgage pools delivered in the TBA market are used as collateral for mortgage backed securities which are issued in the TBA market. Delivery of mortgage pools to satisfy TBA commitments are transactions on the secondary mortgage market. In other words investors are making commitments to purchase MBS collateralized by pools of mortgages which fill the yield commitments of the forward sale of mortgages. This commitment to deliver the pool of mortgages is made before the mortgage collateral has been originated. Depending upon the timing of each leg of the transaction, forward markets in the primary and secondary mortgage markets can be used to hedge risk, to speculate in price changes across markets or to take advantage of temporary arbitrage opportunities.

It is possible and quite common to launch a CLO transaction before all the loans that will ultimately back the securities have been acquired by the collateral manager oil behalf of the special purpose entity (SPE) that issues the...