Cdo Basic Structure

Topics: Collateralized debt obligation, Structured finance, Subprime mortgage crisis Pages: 24 (6413 words) Published: February 17, 2010

• Introduction to CDOs

• Types of CDOs

• Transaction Structure & Mechanics

• Evaluation of CDOs

• Risk associated with Investing in CDOs

• Fair spread estimation with Monte Carlo Simulation


• CDO in Subprime Mortgage Crisis

Introduction to Collateralized Debt Obligations (CDOs)

A CDO is an asset-backed security whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loans. A CDO cash-flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection of CDO securities, called as tranches. While there are many variations, a standard prioritization scheme is simple subordination: Senior CDO notes are paid before mezzanine and lower-subordinated notes are paid, with any residual cash flow paid to an equity piece.

A cash-flow CDO is for which the collateral portfolio is not subjected to active trading by the CDO manager, implying that the uncertainty regarding interest and principal payments to the CDO tranches is determined mainly by the number and timing of defaults of the collateral securities.

A market-value CDO is one in which the CDO tranches receive payments based essentially on the mark-to-market returns of the collateral pool, as determined in large part by the trading performance of the CDO manager.

The trustee of the CDO is responsible for monitoring the contractual provisions of the CDO.

Tranches are categorized as senior, mezzanine, and subordinated/equity, according to their degree of credit risk. If there are defaults or the CDO'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. Senior and mezzanine tranches are typically rated, with the former receiving ratings of A to AAA and the latter receiving ratings of B to BBB. The ratings reflect both the credit quality of underlying collateral as well as how much protection a given tranche is afforded by tranches that are subordinate to it.

CDO: Life of a Static & Managed Deal

One important distinction is that between static and managed deals. With the former, collateral is fixed through the life of the CDO. Investors can assess the various tranches of the CDO 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 of the CDO. The life of a managed deal can be divided into three phases:

• Ramp-up lasts about a year, during which the portfolio manager initially invests the proceeds from sales of the CDO's securities.

• The reinvestment or revolver period lasts five or more years. The manager actively manages the CDO's collateral, reinvesting cash flows as well as buying and selling assets.

• In the final period, collateral matures or is sold. Investors are paid off.

At the time they purchase the CDO's securities, investors in a managed deal do not know what specific assets the CDO will invest in, and those assets will change over time. All investors know is the identity of the portfolio manger and the investment guidelines that he will work under. Accordingly, investors in managed CDOs face both credit risk as well as the risk of poor management. Investors have the added burden of paying portfolio management fees. Today, most CDOs are managed deals. In many cases, the portfolio manager is the sponsor.

CDOs can be structured as cash-flow or market-value deals. The former is analogous to a 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...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Case Study Cdos Essay
  • Basic Structure of the California Courts Essay
  • Basic Distribution Channel Structure Essay
  • Three Basic Structures of Structured Programming Essay
  • Basic Structure of an APA Style Paper
  • The Integumentary System Basic Structure of the Skin Essay
  • Essay on Basic Accounting Concepts and Business Structures
  • Five basic market structures in mikroeconomics Essay

Become a StudyMode Member

Sign Up - It's Free