Collateralized debt obligations: structure, mechanisms, and market significance

¶ … Cdo, and How Big Is This Market

The Collateralized Debt Obligation 'is securities that represent a portfolio of bank loans and/or different financial instruments'. The Collateralized Debt obligation is 'security that represents a portfolio of different financial instruments or assets' (Olivier, 2005). The CDO is applicable on 'portfolio of bank loans and/or different financial instruments' (David, 2002). The financial institutions have offered increasingly-popular structured finance products in the form of part securitization instrument and part credit derivative through CDO schemes, the schemes have been launched on routine basis, which is responsible for the reduction of the cost of financing and the exploitation arbitrage opportunities or transference of the credit risk. The CDO are 'issued in different tranches that are tailored using securitization techniques; the process of trenching allows credit risk and returns on their underlying portfolio to be redistributed to investors in an ad hoc fashion'. The conversion of the credit risk into market commodity has been achievable through CDO, 'this process started with securitization, and was then sustained by the development of credit ratings and corporate bond markets and, more recently, by that of credit derivatives', it has been researched that 'CDO issuance represented at most the equivalent of a sixth of that of corporate bonds, the influence of these products has a far greater significance because of the amount of credit risk they allow to be transferred'. The credit derivatives are responsible for the steady growth in the synthetic structures, particularly in Europe. The development of the CDO has been rapid, and has 'improved non-bank investors' (Olivier, 2005) access to credit markets and has enabled them to overcome the obstacles posed by the size and limited diversification of the corporate bond market, notably in Europe where bank intermediation remains predominant' (David, 2002). The implementation of the scheme has provided the investors with the option to select their 'portfolios with specific risk-return profiles and take exposures to credit risk previously confined to banks' balance sheets, such as SME loans' (Schmidt, 2002).

The CDO is constituted of the credit risk transfer instrument, and is affiliated with the three mechanisms which are identical in all securitization structures i.e. The construction, 'by a financial institution, of a reference portfolio comprising a pool of bank loans and/or negotiable financial instruments (bonds, other debt securities, etc.), and/or credit derivatives' (Andersen, 2003). Previously the securitization transactions were supported by the 'portfolios of homogenous assets comprising exposures to a large number of obligors' (Frank, 2001). It has been observed that the CDO are supported by the 'heterogeneous exposures to a limited number of names' (Olivier, 2005). The second significant element of CDO is 'the de-linking of the portfolio's credit risk with that of the originator of the portfolio via the use of a Special Purpose Vehicle' (Olivier, 2005), which is responsible for the issuance of the CDO and monitor the underlying assets.

HOW DOES a CDO DIFFER FROM OTHER TYPES of ASSET BACKED SECURITIES

The CDO are considered to be credit risk transfer instruments which supports the facilitation of the 'redistribution of this risk within the financial and banking sector and even beyond, while increasing the degree of completeness of the credit market' (Frank, 2001), the CDO is expected to have positive influence on the financial stability. In the case of Synthetic CDO, the complex techniques are often employed which are however no attempted and practiced on major scale, therefore the investors and market participants are vulnerable to the losses of higher potential, 'this risk does not appear to be of a systemic nature given the size and relative newness of the market'. It has been predicted that if the growth rate of the market remains consistent, the interest of the investors is expected to get severe. The observations are applicable mainly in Europe which the emergence of the systemic risk is expected. The positive trend in the issuance of the CDO is responsible for the 'marked narrowing of spreads over past years in the credit market, this trend raised questions as to the links between the CDO market and the corporate bond and credit derivatives markets' (Olivier, 2005). The limited liquidity and transparency is responsible for the 'risk of the propagation and amplification' in the CDO market.

WHAT ARE the RISKS ASSOCIATED WITH a CDO (ISSUING or INVESTING in)

The portfolio also compensate the trenching of CDOs, 'each tranche has a specific seniority rank in terms of the rights to the cash flows generated by the underlying assets or credit derivatives'. The ranks of the senior, mezzanine, and equity tranches are different and insignificant, 'the risk and return offered by these tranches increase symmetrically' (Schmidt, 2002). The maturity period of the senior and mezzanine tranches are well-defined, and is less than five years, and upon the completion of the maturity period the bond-type returns are offered, whereas no specified maturity has been explained for the equity tranche and 'offers a return linked to the performance of the underlying portfolio, which has no upper or lower bound' (Frank, 2001). The sequential allocation of losses is evident through the division of the CDO in different tranches, 'which may be sustained by the underlying portfolio' (Olivier, 2005).

The equity tranche is able to absorb the losses 'in the event of one or more defaults in the portfolio, however in case the limit of the losses exceed the value of the particular tranche, the losses are catered by the mezzanine tranche. In the case of the existence of the significant number of defaults, 'the senior tranche may be affected and sustain losses that have not been absorbed by the other tranches' (Schmidt, 2002). This explained that the holder of the each tranche are not vulnerable to any of the risk from the loss because of any tranche, however the situation can be disastrous in the case of equity tranche. Special mechanism has been evolved for the dilution of the vulnerabilities associated with the senior and mezzanine tranches. The special mechanism is based upon the adoption of techniques such as 'the over-collateralizing of assets, reserve accounts or trapping excess spread' (Olivier, 2005). In such events, 'these credit enhancement techniques should allow the senior tranche to achieve a higher rating than the average rating of the underlying portfolio'. The classification of the CDO is based upon, 'the aim of the transaction: balance-sheet CDOs or arbitrage CDOs; the way in which the credit risk of the underlying portfolio is transferred: this transfer can be achieved through the sale of the pool of assets to the issuing entity, or synthetically, through credit derivatives referencing names or assets included the underlying portfolio; the composition of the underlying portfolio' (Olivier, 2005). The CDOs are supported by 'bank loans, corporate bonds or emerging sovereign bonds and, in the case of synthetic CDOs, credit derivatives' (Olivier, 2005).

The originator has been able to 'securitize assets such as bank loans or corporate bonds recorded on its balance sheet' through balance sheet CDOs. Furthermore, 'assets and/or credit risk can thereby be transferred to a separate legal entity, allowing the originator to manage its balance sheet: remove assets, free up regulatory capital, manage portfolio credit risk, diversify and reduce financing costs' (Schmidt, 2002). The originator has been able to avail the 'advantage of the positive spread between the average yield on the underlying portfolio and the interest rate paid on the tranches issued', through Arbitrage CDOs. It has been observed that, 'the originator of the transaction may or may not hold the underlying portfolio beforehand, and may construct it by purchasing the assets on the market, which means that the securities in question must be fairly liquid', which contradicts the balance sheet CDOs. It has been observed that, 'the yield on the underlying portfolio and the tranches issued does not offer an arbitrage opportunity this nevertheless remains a key factor in the financial viability of the transaction as it makes it possible to generate, after covering the costs of setting up the structure and in particular the payment of intermediation fees, an excess spread that can be used to compensate the equity tranche holders and if necessary to enhance the credit of the other tranches' (Olivier, 2005).

WHY WOULD YOU INVEST in or ISSUE a CDO

The single-tranche CDOs are 'recent but far-reaching financial innovation in the CDO market', and were launched in 2003. The CDOs are synthetic in nature; 'the arranger sells a single tranche at the mezzanine level to a single investor, instead of selling all the tranches i.e. equity, mezzanine and senior'. Such CDOs have following advantages i.e. 'they are attractive to investors because the tranche is tailored to the requirements of the buyer, which can choose the names in the underlying portfolio, the subordination level of the tranche and its size, this avoids some of the dangers of traditional CDO structures, such as the risks of moral hazard or adverse selection in the choice of the names in the portfolio or conflicting interests between the holders of the different tranches'. Furthermore, such CDOs 'are attractive to the arrangers because single-tranche CDOs are relatively easy to set up, unlike traditional CDOs, these save the cost and the time of selling different classes of tranches; moreover, selling costs are lower because in general the investor contacts the arranger, and not vice versa'. Previously, 'the arranger does not take the risk: its role is mainly to sell tranches, or to originate the transaction in the case of arbitrage CDOs. According to the current regulations, the risk is fully transferred to the investors via the SPV' (Schmidt, 2002). The arranger is the direct counterparty of the investor due to the absence of no vehicle structure. It has been researched that, 'the seller of the CDO and the buyer of protection on the single tranche of the CDO it sells, which makes it vulnerable to changes in credit spreads on the underlying portfolio of the CDO and to defaults on this portfolio' (Olivier, 2005). The Single-tranche CDOs is 'often presented as leveraged products, as the delta is higher than 1, which is between 5 to 10 for the mezzanine tranche, this leverage can be ascribed to the fact that much of the credit risk of the reference portfolio is concentrated in the subordinated tranches i.e. mezzanine and equity, due to the sequential allocation of losses' (Schmidt, 2002).

The financial evaluation of the CDO 'is apparent in the fact that the CDO's spread income from the reference portfolio can compensate investors in the CDO tranches and also cover transactions costs'. It is evident from the common and increased number of cases of adoption of the CDO technology by the credit investor that 'the cost of creating a CDO is less than the cost a credit investor would incur to assemble a portfolio of bonds and/or loans to meet the investor's diversification and risk-return targets' (Christian, 2003). The factors related to the high bid-ask spreads, which is expected to be exercised by the investor will be responsible for the 'high cost of investing directly in a portfolio of bonds or loans, reflecting the illiquidity of bond and loan markets'. It is general observation that well-designed and robust structures have supported CDOs, 'these can greatly facilitate the dispersion of credit risk across a wide range of investors; their underlying portfolio can span many names and economic sectors, with the share of each name and each sector in the portfolio remaining limited to a very low level'. Such factors have been critically evaluated by the credit rating agencies, and all such conditions have been reviewed 'which are determinant in the process of rating CDO tranches' (Olivier, 2005). The Synthetic CDOs 'enables investors to take positions on names that are not represented in the bond market, thus contributing to the completeness of the credit market and at the same time facilitating portfolio diversification'. In European countries, 'the corporate bond market is concentrated in a small number of sectors, which are often overweighed in portfolios' (Schmidt, 2002). The synthetic CDO tranches 'are therefore a way of obtaining a more balanced and diversified exposure, making it possible to appropriately weight given names or sectors within a portfolio' (Darrell, 2001).