Collateralized debt obligations (CDOs) are securitized interests in pools of non-mortgage debt assets. Assets—called collateral—usually comprise loans or debt instruments. The collateralized debt obligation market grew in the loose credit years leading up to the 2008 financial crisis and then contracted sharply. “Credit rating shopping” and other abuses tainted collateralized debt obligations.
A collateralized debt obligation may be called a collateralized loan obligation (CLO) or collateralized bond obligation (CBO) if it holds only loans or bonds. Investors bear the credit risk of the collateral. Multiple tranches of securities are issued by the collateralized debt obligation, offering investors various maturity and credit risk characteristics. Tranches are categorized as senior, mezzanine or subordinated/equity, according to their degree of perceived credit risk. If there are defaults or the collateralized debt obligation’s collateral otherwise underperforms, scheduled payments to senior tranches take precedence over those of mezzanine tranches, and scheduled payments to mezzanine tranches take precedence over those to subordinated/equity tranches. Each tranche receives its own credit rating, reflecting both the credit quality of underlying collateral as well as how much protection a given tranch is afforded by tranches that are subordinate to it. Senior tranches of a collateralized debt obligation backed by low-quality debt can receive a AAA rating due to the protection of subordinate tranches.
A collateralized debt obligation has a sponsoring organization, which establishes a special purpose vehicle to hold collateral and issue securities. Sponsors can include banks, other financial institutions or investment managers, as described below. Expenses associated with running the special purpose vehicle are subtracted from cash flows to investors. Often, the sponsoring organization retains the most subordinate equity tranch of a collateralized debt obligation.
Collateralized debt obligations can be static or managed deals. With the former, collateral is fixed through the life of instrument. Investors can assess the various tranches with full knowledge of what the collateral will be. The primary risk they face is credit risk. With a managed CDO, a portfolio manager is appointed to actively manage the collateral. This adds the risk of the investment manager making poor investments as well as moral hazard. There is also the expense of the investment manager’s fees. Immediately prior to the 2008 market crisis, most collateralized debt obligations were managed deals. In many cases, the portfolio manager was the sponsor.
collateralized debt obligations can be structured as cash-flow or market-value deals. The former is analogous to a traditional CMO. Cash flows from collateral are used to pay principal and interest to investors. If such cash flows prove inadequate, principal and interest is paid to tranches according to seniority. At any point in time, all immediate obligations to a given tranch are met before any payments are made to less senior tranches.
With a market value deal, principal and interest payments to investors come from both collateral cash flows as well as sales of collateral. Payments to tranches are not contingent on the adequacy of the collateral’s cash flows, but rather the adequacy of its market value. Should the market value of collateral drop below a certain level, payments are suspended to the equity tranch. If it falls even further, more senior tranches are impacted. With a market value CDO, the portfolio manager is not constrained by a need to match the cash flows of collateral to those of the various tranches.
Another distinction can be made between balance-sheet CDOs and arbitrage CDOs. These names correspond to respective motivations of the sponsoring organization. With a balance sheet deal, the sponsoring organization is a bank or other institution that holds—or anticipates acquiring—loans or debt that it wants to remove from its balance sheet. Similar to a traditional ABS, the collateralized debt obligation is a vehicle for it to do so. Arbitrage deals are motivated by the opportunity to make a profit by repackaging collateral into tranches that sell for a higher total price. Because a tranch’s credit rating largely determines its price, this lead to “credit rating shopping” during the early 2000s. Credit rating agencies have been accused of essentially selling high credit ratings to make fee income. The performance of many AAA-rated securitizations in 2007-2008 is damning evidence of such behavior.
In addition to balance-sheet and arbitrage CDOs, TruPS CDOs represented a third, smaller segment of the market.
Collateralized debt obligations are mostly about repackaging and transferring credit risk. While it is possible to issue a collateralized debt obligation backed entirely by high-quality bonds, the structure is more relevant for collateral comprised partially or entirely of marginal obligations. This leads us to another important distinction: that between cash and synthetic CDOs. So far, we have been discussing cash CDOs. These expose investors to credit risk by actually holding collateral that is subject to default. By comparison, a synthetic deal holds high quality or cash collateral that has little or no default risk. It exposes investors to credit risk by adding credit default swaps (CDSs) to the collateral. Synthetic CDOs can be static or managed. They can be balance-sheet or arbitrage deals.
Banks claimed that arbitrage synthetic deals were motivated by regulatory or practical considerations that might make a bank want to retain ownership of debt while achieving capital relief through CDSs. In retrospect, the motivation appears to have been to sell short CDOs. A bank that structured a synthetic arbitrage CDO and sold it to clients held no offsetting collateral. The bank was essentially betting against the very instrument it was assembling and promoting to its clients.
Synthetic CDOs don’t have to be fully funded. For a cash CDO to have credit exposure to USD 100MM of bonds, it must attract USD 100MM in investments, so it can buy those bonds. With a synthetic deal, credit exposure to USD 1,000MM in obligations might be supported by just USD 150MM in high-quality collateral. In such a partially-funded deal, the entire USD 1,000MM reference portfolio is tranched, but only the lower-rated tranches are funded. In this example, the most senior USD 850MM tranch would be called a super senior tranch. It might be retained by the sponsor or sold off as a CDS. The funded piece might comprise USD 100MM of investment grade tranches and USD 50MM of mezzanine and unrated tranches. In arbitrage deals, partial funding offered higher capital relief than full funding under the Basel II capital requirements. For synthetic deals, it was generally less expensive to sell the super senior tranch as a CDS than to fund that tranch.
Analyzing collateralized debt obligations is difficult. Not only is there an entire portfolio of credits to analyze, in managed deals, an investor won’t know how collateral might change over time. On top of this is the added complexity of the tranching, which must also be analyzed. Even sophisticated portfolio credit risk models proved inadequate for assessing collateralized debt obligation risk prior to the 2008 crisis. Collateralized debt obligations pose significant risk for manipulation or abuse by sponsors.