KEY POINTS OF THE CHAPTER
• A collateralized debt obligation (CDO) employs securitization technology to pools assets and finance the purchase of those assets by the issuance of securities.
• A CDO is a generic name for collateralized loan obligations (the pool of assets consists of loans) and collateralized bond obligations (the pool of assets consists of bonds).
• A CDO may acquire assets in cash or synthetically.
• The cash asset CDO acquires assets in a traditional manner—raising the funding required equal to the size of the CDO and investing the same by acquiring the assets.
• The assets are acquired either from one originator (in the case of balance sheet CDOs) or from the market (in the case of arbitrage CDOs).
• For synthetic CDOs, the assets are acquired synthetically by using credit derivatives.
• The basic difference between cash and synthetic CDOs is the amount of funding raised and the manner of its investment: (1) a synthetic CDO does not have to pay for the assets it acquires unless it is required to do so as result of its position in a credit derivative; so funding is much less than in a cash CDO; and (2) in a cash CDO the assets are purchased while in a synthetic CDO the exposure to an asset is acquired by a position in a credit derivative.
• There are balance sheet and arbitrage CDOs and they may be of the cash or synthetic variety.
• The motivation for a balance sheet CDO is to transfer the risk of a particular pool of assets and thereby reduce the balance sheet size of the originator in order to obtain regulatory and/or economic capital relief.
• The motivation for an arbitrage CDO is to capture the spread between the return earned on the pool of assets that is the collateral for the CDO and the funding cost.
• Arbitrage CDOs are classified based on the type of collateral: investment-grade corporate bonds, noninvestment grade bonds, noninvestment grade loans, and structured finance products.
• The structured finance CDOs include the following types of securitized instruments: asset-backed securities, residential mortgage-backed securities, commercial mortgage-backed securities, and other CDOs, as well as REITs.
• CDOs may be actively managed or static CDOs.
• While a static CDO is one in which there is no need for any management of the pool because the selection of the assets is done at the CDO’s inception, in a managed CDO, a CDO manager is free to add and sell assets at his or her discretion due to downgrades, amortization or prepayment.
• The selection of the assets by the CDO manager is done so as to lead to a desired level of diversification.
• The credit enhancements typically used in CDOs would be subordination but there may be a level of excess spread that may be trapped in extraordinary situations.
• Structural protection in a CDO is primarily in the form of control on the leverage of the transaction.
• There are tests that must be satisfied for CDOs with respect to asset quality (overcollateralization tests) and leverage (interest coverage tests) before the manager reinvests the principal proceeds of the assets.
• The liability structure of a typical CDO is mostly sequential.
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