The CDO product.

AuthorCheng, Ken

Collateralized debt obligations, or CDOs, are structured vehicles that are similar to leveraged closed-end funds. Since their creation in the late 1980s, CDOs have evolved into three major classifications: cash flow CDOs; synthetic CDOs; and market value CDOs.

  1. OVERVIEW

    Collateralized debt obligations, or CDOs, are structured vehicles that are similar to leveraged closed-end funds. As discussed below, the majority are cash flow structures, a fair number are synthetic structures, and some use a market value structure. A majority of all CDOs are actively managed and invested in different asset classes. At the core of the CDO is a bankruptcy-remote, special-purpose entity (SPE) that issues securities to investors in the form of several classes that are tranched into differently rated and some unrated securities. Each class of securities represents a different level of risk and reward associated with the asset pool. The most senior securities have credit ratings higher than the average ratings of the collateral pool, with lower tranches being rated below the seniors. The first-loss tranche is equity (or preferred shares) that is typically not rated.

    The proceeds from the offering are typically used to purchase a portfolio of assets, or may be held in the SPE. Should some of the assets fall into default or trigger some of the transaction covenants, excess spread is first used to cover any losses. However, there might not be sufficient assets to cover these losses, and the lowest-level, or more junior securities may take a loss. Payments to each of the liability classes are dictated by a stipulated priority of payments that reallocates the risk and rewards associated with the assets. This allows the CDO issuer to tailor the liabilities to meet the risk/return profiles of a broad range of investors and to attract additional groups of investors.

    Since their creation in the late 1980s, CDOs have evolved into three major classifications: cash flow CDOs; synthetic CDOs; and market value CDOs. Standard & Poor's has rated CDOs from the inception of the asset type and continues to rate all three major classes of CDOs and their subgroups. Below is a brief explanation of the three major classifications.

    1. Cash Flow CDOs

      Cash flow CDOs are structured vehicles that issue different tranches of liabilities and use the net proceeds to purchase the pool of assets. The cash flows generated by the assets are then used to pay back investors generally in sequential order from the senior investors that hold the highest-rated (typically 'AAA') securities, to the "equity investors" that bear the first-loss risk and generally hold unrated securities. To compensate for the risk associated with bearing the first-loss position, the equity investors are generally paid most of the residual interest and may achieve a high annual rate of return. The money invested by the noteholders is used by the SPE to purchase the assets and cover the costs associated with executing the transaction. The par value of the securities at maturity is used to pay the notional amounts of the liabilities.

    2. Synthetic CDOs

      Synthetic CDOs are structured vehicles that use credit derivatives to achieve the same credit-risk transfer as cash flow CDOs, without physically transferring the assets. The risk is typically transferred to the investors by the entity holding the physical assets. The investors are the sellers of credit protection, since they take the risk of loss should the asset default. The institution holding the assets is the credit-protection buyer, since the risk of the loss was transferred to the investors.

      In its simplest structures, the SPE issues notes to the investors and sells credit protection on a reference pool of credits. The money paid by the investors is then held by the SPE to either repay the investors or to pay the buyer of the credit protection should an asset in the reference pool default. The credit-protection buyer pays a periodic premium to the SPE that, together with the interest earned on the money held by the SPE, is used to pay interest to the investors. If and as assets in the reference pool default, the SPE settles with the credit-protection buyer and makes payments. At the end of the transaction, the remaining money held by the SPE is paid back to the investors. Synthetic CDOs can also be used to "bundle" corporate or other credit exposure, not only the risks of traded debt instruments. As will be explained later, synthetic CDOs can be structured differently, may hold a combination of derivative and physical assets, and may be fully funded, partially funded, or unfunded.

    3. Market Value CDOs

      Market value CDOs are similar to cash flow CDOs, but the SPE does not issue liabilities based on the par of the assets. Rather, the SPE issues liabilities based on an advance rate associated with each type of asset purchased. The advance rate is specific to each asset and to each tranche of liability, and is based on historical price or return volatility for each asset type. The collateral pool is then marked to market on a periodic basis, and if the aggregate pool marks breach the pool advance rates, the collateral manager must sell collateral and pay down notes to bring the advance rates back in compliance. Market value transactions can be based on traditional corporate bonds and loans, or on instruments such as private equity or shares of hedge funds.

      Cash flow CDOs and synthetic CDOs have more in common with one another than with market value CDOs. This is because the payment of liabilities is strongly dependent on the credit risk of the underlying assets in these two structures, whereas the performance of market value CDOs is based upon the market pricing and returns of assets. Given their similarities, the criteria overlap between cash flow and synthetic CDOs is greater than its overlap with the market value type. This publication covers only Standard & Poor's cash flow and synthetic CDO criteria. The criteria for market value transactions can be found on RatingsDirect, Standard & Poor's Web-based credit analysis system, at www.ratingsdirect.com. It is also available at www.standardandpoors.com.

      Cash flow and synthetic CDO issuance is driven either by opportunities in capital market dislocations...

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