The collateralized debt obligation market

¶ … 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 interest rate and excess spread are not proportional quantities, therefore larger excess spread is possible through lower interest rate offered on the tranches, 'which requires that the tranches be rated in the investment grade universe, in particular via the use of different ad hoc credit enhancement mechanisms. The differences between the balance sheet CDOs and arbitrage CDOs is not distinct, 'in the case of balance sheet CDOs, the originator of the assets may also attempt to take advantage of the excess spread by holding the equity tranche, which enables it to continue to capture a large part of the return on the assets transferred while improving its cost of financing, whereas in the case of both balance sheet CDOs and arbitrage CDOs, the credit risk on the portfolio may be transferred in two alternative or complementary ways: either via the true sale of assets and/or synthetically, by buying protection via credit default swaps with the vehicle issuing the CDO' (Olivier, 2005). The credit risk is transferred through true sale of assets; the practice is applicable in the case of cash-flow CDOs which is based upon the traditional securitization mechanisms.

The tranches of CDO are issued in different proportions in synthetic securitization structures, these structures are entirely funded, partially funded or unfunded, and 'the main considerations in the design of these funding structures are the cost and management of counterparty risk' (Schmidt, 2002). The fully funded structure is less vulnerable to any counterparty, but it bears higher investment, 'the CDO encompasses a series of securities whose issuance amount is equal to that of the reference portfolio'. The originator of the transaction and the SPV does not entail cash payments, and the credits defaults are exchanged between both the authorities, therefore ' proceeds from the sale of tranches are reinvested in risk-free assets, which in most of the cases is government bonds' (Olivier, 2005).

The non-occurrence of the credit event offer incentives to the issuing entity, such that 'the issuing entity can cover costs of setting up the structure as well as the interest payments to the tranche holders by using the interest from the collateral pool together from the CDS entered into by the SPV' (Amato, 2003). Such exercise shall be useful in offering compensation to the 'originator by selling part of the risk-free assets' by the SPV; however 'for the other tranche holders, this sale results in a loss in the form of a reduction in the repayment of the principal of the tranches' (Darrell, 2001). The CDO is supported by the CDS, in case of the unfunded structures. The financial ability of SPV can be estimated through the extent of compensation offer to the originator, 'if a credit event occurs which is dependable upon the creditworthiness of the buyers of CDOs' (Schmidt, 2002). The partially funded CDOs are the most common, where the 'risk is transferred to investors partly via CDS and partly through issuing securities, these structures generally comprise a CDS whose notional amount is large in relation to the tranches issued, known as a super senior swap as it benefits from the subordination of the senior tranche and is therefore the part of the structure best protected against losses' (Olivier, 2005).

The merit of such structure is with reference to the transfer of the significant amount of credit risk by the originating banks, and therefore the banks are independent enough 'free up large amounts of regulatory capital, at a much lower cost than that of funded CDOs thanks to the substantial reduction in the value of tranches to be placed with investors' (Li, 2000). The interest rate paid on AAA-rated senior tranche with reference to the credit risk is more than 'the cost of buying protection via a super senior tranche is much lower' (Schmidt, 2002).

WHY WOULD YOU INVEST in or ISSUE a CDO