Armed with CDO evaluation models of the rating agencies, CDO structurers have the advantage of doing a mix and match of assets to try and contrive a structure that under rating agencies’ assumptions, has minimal asset correlation. For example, if obligors from different industry clusters are selected as per the rating agencies’ definitions, the correlation is presumed to be either zero or minimal.⁶²

In situations of economic downturn, most often there are widespread intersector disturbances that cause generic losses to several segments. In adverse business cycles, the absence of correlations among industries will not hold, leading to a basic assumption being questioned.

Connected mismatches are mismatches in payment dates and payment periodicity. Managing a CDO, to an extent, is like managing an operating financial intermediation business and these mismatches are unavoidable. The mismatch spells a risk either way. If the assets repay more frequently than the liabilities, the transaction suffers from negative carry; if the assets repay less frequently than the liabilities, the transaction runs into liquidity problems. One possible solution is to enter into a total return swap receiving payments matching those on liabilities; however, the costs of the swap as well as the rating of the swap counterparty may both be issues of concern. If the swap counterparty is the issuer or an affiliate of the issuer, the swap will surely create problems of consolidation on bankruptcy.

High-yield transactions also suffer from spread compression risk, the risk of higher yielding investments either being called back or defaulting, while the reinvestment is in less yielding debt and thus reducing the arbitrage spread. This is partly mitigated by the fact the coupon on the liabilities is also a floating rate.

One of the ways usually adopted to minimize the liquidity problem is to ensure that when collateral is sold, the accrued interest portion inherent in the sale proceeds is not available for reinvestment but is retained for coupon payments. A certain minimum liquidity reserve may also be necessary.

The risks during the ramp-up period include the following:

Arbitrage transactions where ramp-up risks are significant use various methods to mitigate those risks. Among these are a staggered ramp-up period in which the aggregate ramp-up is divided into smaller segments each with a target ramp-up period. This is done so that if the ramp up is not achieved during that period, the excess must be returned.

On the other hand, reinvestment option introduces several risks. These risks are redressed by introducing the collateral tests (such as, OC, IC, and weighted average coupon tests) discussed earlier. Moreover, stringent criteria for selection of eligible collateral is followed which is also subject to authorization and surveillance of the trustees.

Increasingly in CDOs, CDO managers have made substantial investments in nonprime or illiquid assets. In periods of stress, when deleverage triggers have been applied, some of these CDOs have wound up with substantial losses.