Case Study – CDO CREATIVE BALANCE SHEET RISK MANAGEMENT: VALUE CREATION?
1) What is a CDO? Who buys CDOs?
CDOs are a type of asset backed security composed of bonds issued by special purpose vehicles (a corporate entity that holds the assets as collateral, packages them and sells the resulting notes to investors). Normally, the bonds issued are divided into tranches with different risk characteristics and debt rating. Each tranche carries a different rating which determines the interest and cash flow for each layer. There are several types of underlying assets that the special vehicle can buy. The most typical are corporate bonds, corporate loans, trust preferred stocks, mortgage-backed securities and commercial real estate bonds. Those described above are conventional CDOs. Banks also created synthetic CDOs. The main characteristic is that the credit risk is transferred by a derivative (credit default swap, normally) but the originating bank retains the underlying pool of assets in the balance sheet. Nevertheless, with synthetic CDOs credit risk is transferred and the originating bank obtains an important relief in capital requirements. There are several investors interested in buying CDOs. The motivations for those investors are different depending on the tranches they buy. In general, investors buy CDO assets with certain rating that offer a higher return than more traditional securities and benefit from the theoretical diversification buying a CDO portfolio. Risk adverse investors such as mutual funds and pension funds will buy the senior tranches in order to obtain a higher return than buying treasury bonds. Senior tranches pay a spread above LIBOR even if they are rate AAA. Other investors, such as hedge funds, banks or private banking organizations can sometimes prefer junior tranches such as mezzanine notes and equity notes, tranches offering yields normally not available in other fixed income products.
2) Who sell CDO and why?
CDO is a form of...
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