Collateralized Debt Obligations

Executive summary

This is a report on Collateralized Debt Obligations (CDO’s). The report defines collateralized debt obligations, identifies the features and operations of CDOs.

The report defines liquidity risk and also examines how collateralized debt obligations help the bank to avoid liquidity risk, and also how CDOs create more assets for the bank.

The report discusses the advantages and disadvantages of collateralized debt obligations, and also gives a conclusion on the role played by CDOs in helping the banks to avoid liquidity risk and create more assets, and also problems that they can create.

Definition of collateralized debt obligations

Collateralized Debt Obligations (CDO’s) are bonds that are backed by different types of mortgage loans, consumer loans, corporate loans, or corporate bonds (Lange, H. 2007). Such loans usually have some type of collateral behind them, hence the name collateralized.

Features of collateralized debt obligations

Collateralized Debt Obligations have various features depending on their structures, but generally, their features can be identified as follows:

1. Sponsors can either be financial institutions or investment managers.
2. Special purpose vehicles.
3. Tranches.

Operations of collateralized debt obligations

Collateral and issue securities are held in a special purpose vehicle established by the sponsor of the collateralized debt obligation. Cash flows to investors are net of all operating costs incurred by the special purpose vehicle (Saunders, A., & Cornett, M. 2008). Once the Investors pay for the bond, all credit risk of the collateral is transferred to them.

There are two types of collateralized debt obligations: collateralized loan obligations (CLOs), which are CDOs that hold only loans, and collateralized bond obligations (CBOs) which are CDOs that hold only bonds.

The several tranches of securities issued by the collateralized debt obligation have diverse maturity and credit risk characteristics, which determine their classification as either senior, mezzanine, or subordinated tranches. The subordinated tranche is also known as the equity tranche. Senior bonds have the same ranking as Treasury bills, but pay an interest rate that is at least double the interest rate Treasury bill (Saunders, A., & Allen, L. 2002).

Scheduled payments to a senior, mezzanine, and subordinated or equity are usually made in that order if there are defaults, or the CDO’s collateral otherwise underperforms. The credit quality of underlying collateral considered together with the amount of protection that the tranches that have a lower rating than a particular tranche afford that tranche, determine the rating of the tranche (Lange, H. 2007).

At the topmost rank in the credit spectrum is the ‘AAA-rated’ senior tranche, followed by the Mezzanine tranches, with ratings from ‘AA’ to ‘BB’ ratings, while the equity tranches appear at the bottom, with the lowest ratings. The amount of principal and interest that is received is determined by the rating of that tranche (Lange, H. 2007).

There are different structures, as follows:

Static versus managed deals

Static CDOs have fixed collateral throughout the life of the CDO, which is fully known to the Investors at the time of making the investment decision. Investors in such deals are only exposed to one type of risk, which is credit risk.

Managed CDOs, which are the majority of CDOs today, do not have any fixed collateral, but rather the collaterals change several times during the life of the CDO. Such deals have portfolio managers, mostly the sponsors, who are charged with the responsibility of managing the collateral of the CDO. At the time of making the investment decision, the collateral is not known; the only information that is available at that time is the identity of the portfolio manager and the investment guidelines that will influence his operations. Investors in Managed CDOs are also exposed to credit risk just as their counterparts who invest in Static CDOs, except that the former are exposed to the extra risk of the CDO not being managed properly, and they also have to pay portfolio management fees, which their counterparts do not pay (Lange, H. 2007).

There are three stages in the life of a managed CDO:

1. The Ramp-up period is the initial stage, during which the portfolio manager re-invests all the cash flows he receives. The length of this period is usually about one year.
2. The next stage is the reinvestment or revolver period, during which the manager buys and sells assets, in addition to reinvesting the cash flows he receives. This stage usually lasts at least five years.
3. The final stage is where the collateral matures or is, and the Investors are paid off.

Cash-flow versus market-value deals

Cash-flow CDOs use only money generated from collateral to settle investors’ dues. If there are insufficient cash flows to pay all the investors, then investors are paid in tranches according to seniority. Any payments that are due to a given tranche are only made after dues to more senior tranches have been settled.

Market value CDOs use money generated from collateral and from selling collateral to settle investors’ dues. As long as the market value of the collateral is sufficient to settle the investors’ dues, the dues are settled whether or not the cash flows are adequate. Payments to the equity tranche are the first to be suspended, followed by more senior tranches if the market value of the collateral falls below a predetermined level. Market value CDOs afford the portfolio manager added flexibility because he or she does not have to match the cash flows of collateral to those of the various tranches.

Balance-sheet versus arbitrage CDOs

The motivation of the sponsoring organization determines whether a CDO is a balance sheet or arbitrage CDO.

A balance sheet CDO is sponsored by a financial institution whose primary motive is to eliminate from its balance sheet, loans or debt that it already owns, or which it intends to acquire. It is through the CDO that the financial institution eliminates the loans or debt.

An arbitrage CDO is sponsored by an organization whose primary motive is to repackage collateral into tranches to add value. Such CDOs provide a theoretical arbitrage to reconcile the market values of securities of a CDO and its underlying collateral (Van Grinsven, J. 2010).

Cash versus synthetic CDOs

Investors in Cash CDOs are exposed to credit risk by the fact that the likelihood of default on the collateral held by such CDOs is very high, unlike the collateral that is held by synthetic CDOs on which the likelihood of default is very low. It is only the credit default swaps that are added to the collateral that expose the investors in synthetic CDOs to credit risk. There are static, managed, balance-sheet, and arbitrage Synthetic CDOs.

Banks may sometimes wish to retain ownership of debt while benefiting from capital relief through CDSs, due to regulatory or practical considerations. This gives rise to the need for Arbitrage synthetic deals. In such a case, a reference portfolio is formed, which is a portfolio of obligations held by the sponsoring bank. The portfolio is retained by the bank, but its credit risk is offloaded by transacting CDSs with the CDO.

The following are the advantages of arbitrage synthetic deals:

1. Managed deals have an abbreviated ramp-up period
2. At the lower end of the credit spectrum, it is less expensive to sell protection through CDSs than to buy the underlying bonds directly.

The major advantage with Synthetic CDOs is that they can be partially funded, i. e, they don’t have to be fully funded, for example, credit exposure to one million US Dollars in obligations might be supported by just one hundred and fifty thousand US Dollars in high-quality collateral (Hull, J. 2009).

The major disadvantage with cash CDOs is that they must be fully funded. For example, credit exposure to one million US Dollars in obligations must be supported by one million US Dollars in collateral.

Higher capital relief is achieved by partial funding in arbitrage deals than is achieved by full funding under the Basel capital requirements.

For synthetic deals, it is generally more expensive to fund the super senior tranche than it is to sell that tranche as a CDS (Fabozzi, F., Modigliani, F., & Jones, F. 2009).

Liquidity risk

Liquidity risk refers to the risk of security payments not being serviced on schedule due to Shortfalls or timing differences in cash flow from assets in a pool (Schroeck, G. 2002).

Advantages of collateralized debt obligations

The following are some of the advantages of collateralized debt obligations:

1. CDO’s enable financial institutions to minimize risk due to the diversification associated with them.
2. CDO’s offer financial institutions the opportunity to earn additional income from the management fee and also from the difference in interest charged.
3. It improves the liquidity position of the economy, in that when financial institutions sell off debt, they can free up funds, which they can then invest or lend to customers.
4. It has offered financial institutions the opportunity to hold investments, which they had been denied by financial regulators.
5. It is a cheaper way of raising money.
6. Synthetic CDOs can be partially funded.
7. Managed deals have an abbreviated ramp-up period

How CDOs create more assets for the bank

CDOs create more assets for the bank because of the collateral associated with those CDOs. Since Collateralized Debt Obligations are bonds that are backed by different types of mortgage loans, consumer loans, corporate loans, or corporate bonds, the collateral behind loans usually belong to the bank, so the bank treats them as assets.

The CDOs are also usually carried in the balance sheet of the bank as assets. In some cases, banks normally carry these assets in their balance sheets at inflated values, as was the case of Lehman Brothers.

Disadvantages of collateralized debt obligations

The following are some of the disadvantages of collateralized debt obligations:

1. The fact that the loans are now owned by other investors tends to make the originators of the loans relax on their strict lending standards and even avoid having to collect on them when they become due.
2. Since collateralized debt obligations are difficult to analyze, investors are often forced to rely on their trust of the bank selling the CDO without doing their research to determine the true worth of the package. As a result, investors have ended up with very high percentages of losses as was the case during the collapse of Lehman Brothers Holdings Inc. and Icelandic banks.
3. Collateralized debt obligations may be difficult to resell since sellers can easily lose their trust in the product over unfounded fears. This is mainly caused by the opaqueness and complexity of CDOs. Such was one of the main causes of the banking liquidity crisis in 2007.
4. CDOs are very difficult to analyze, since they are composed of an entire portfolio of credits that must be analyzed, and also in the case of managed deals, an investor cannot tell the exact collateral that will be purchased. The tranching must also be analyzed, which adds to the complexity.
5. CDOs are greatly exposed to the risk of being manipulated or abused by the sponsors. In the case of Lehman Brothers, the Product Control Group failed to double-check the valuations of assets held by trading desks.
6. Cash CDOs must be fully funded.

Conclusion

Although CDOs may create some problems for banks, the benefits that banks gain from these CDOs outweigh the problems, and therefore they are a good tool. Since they spread risk among a very large number of investors, in the end, everyone benefits. It is the Investors in the lowest tranches who lose first in case of default, but they are compensated for this extra risk since as long as there is no default, they get the highest payouts. Investors in the highest tranches get the lowest payouts, but they are the last to lose in case of default. This clearly shows that the banks set to gain more than they set to lose and therefore banks should use this as a tool to make more profits.

References

Fabozzi, F., Modigliani, F., & Jones, F. (2009). Foundations of Financial Markets and Institutions. Australia: Pearson Higher Education.

Hull, J. (2009). Risk Management and Financial Institutions. Australia: Pearson Higher Education

Lange, H. (2007). Financial institutions management. Australia: McGraw-Hill.

Saunders, A., & Allen, L. (2002). Credit risk measurement: new approaches to value at risk and other paradigms. United States: John Wiley and Sons.

Saunders, A., & Cornett, M. (2008). Financial institutions management: A risk management approach. New York: McGraw Hill/Irwin.

Schroeck, G. (2002). Risk management and value creation in financial institutions. United States: John Wiley and Sons.

Van Grinsven, J. (2010). Risk Management in Financial Institutions. Amsterdam: Delft University Press.