C D O s E X P L A I N E D

Understanding Collateralized Debt Obligations

Collateralized debt obligations (“CDOs”) were Chart 1

first created in the late 1980’s. CDOs Sale of Assets Sale of Securities

themselves are a form of asset-backed security, Bank SPE Investor

meaning that the value of the CDO is derived Cash for Assets Cash for Securities

from its claim on some pool of assets. The

underlying pool of assets can be anything from CDOs provide investors with an investment
boat loans, to mortgages, to credit card vehicle like a mutual fund, allowing them to
receivables, or even other CDOs. purchase a share of a diversified underlying

The assets that will form the CDO are usually portfolio. Unlike a mutual fund, the securities

collected by an investment bank or other party, sold to the investors depicted above are

and then sold to a special purpose entity. The generally tranched, meaning that the securities

special purpose entity has been set up by the are divided into different classes with varying

bank to purchase the assets, thereby removing claims on the cash flows produced by the

them from the bank’s balance sheet. In order to underlying assets. At typical tranching scheme
is shown in Chart 2.
fund the purchase of assets from the bank, the
special purpose entity sells securities to
investors. The simple diagram to the right
explains this process (Chart 1).

Greg Kyle Alex Russell

COLLATERALIZED DEBT OBLIGATIONS EXPLAINED

Chart 2 Cash Flow CDOs

Senior A cash flow CDO is one in which the cash flows

generated by the underlying assets of the CDO
are sufficient to cover all of the payments made
Mezzanine
to investors in each tranche. This is most similar
to a regular asset-backed security, in that the
Equity
pool of underlying assets is selected to meet the
liabilities owed to investors. These types of
The senior tranches of the CDO carry the lowest CDOs are the most common, but there are also
risk, and hence the lowest possibility for return. market value CDOs, in which the pool of
The equity tranche is the highest risk portion of underlying assets is actively managed, in an
the CDO, it is the first position to bear any attempt to generate additional returns via the
losses occurring in the underlying asset pool, profitable sale and purchase of securities.
and receives income only after all other tranches
Motivations for CDO issuance can be divided
of the security have been satisfied. The cash
into two categories, balance sheet and arbitrage.
flows generated by the underlying assets are
A balance sheet CDO is the most like typical
like a waterfall; payments are prioritized first to
securitization (and is almost always a cash flow
highest tranches, and anything remaining is paid
CDO); the primary reason for issuing the CDO is
out to tranches that appear progressively lower
to remove assets from the bank’s balance sheet.
in the hierarchy. If cash flows should prove
While allegations surfaced during the aftermath
insufficient, the lower tranches may not be paid
of the Credit Crisis in 2008 that banks had used
at all. This subordination structure allows
CDOs as a ‘dumping ground’ for ‘toxic’ assets, a
investors to choose the level of exposure that
desire to remove assets from the balance sheet
fits their needs. For example, loss sensitive
does not carry with it necessarily sinister
institutions that normally prefer AAA rated debt
connotations. By selling assets a bank frees up
will invest in the safer (but lower yielding) senior
capital with which it can undertake new
tranches. In this way, the credit risk of the
investments, allowing it to better fulfill the capital
underlying securities is unbundled and sold
allocating function the industry is supposed to.
piece by piece to investors according to their
preferences.
Arbitrage CDOs
The assets that the special purpose entity holds
An arbitrage CDO is one in which the CDO
can either be actively or passively managed by
issuer seeks to profit from the spread between
the CDO manager, depending on the motivation
the yield on the assets underlying the CDO and
behind creating the CDO, and the investors who
the yields paid out to investors in the CDO. For
purchased it.
example, if the total yield required by investors
in the CDO is only 10%, but the underlying

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COLLATERALIZED DEBT OBLIGATIONS EXPLAINED

assets are capable of yielding a 15% return, making it difficult to locate. In this case, there is
then the issuer of the CDO can capture a profit a ready demand for CDOs backed by a certain
of 5% simply by creating (and sometimes type of collateral, and the limit on issuing these
managing) the CDO. These are most frequently CDOs (and earning the fees for issuing and/or
market value CDOs, but they can be structured managing them) is finding the collateral.
as cash flow CDOs as well.
Credit Default Swaps (“CDS”) or Total Return
Swaps (”TRS”) can be used to gain exposure to
Synthetic CDOs
the underlying assets, without actually owning
A third type of CDO is called a synthetic CDO, them. To dramatically simplify, the cash flow
which usually falls under the arbitrage CDO stream to the writer of a CDS or TRS is the
category. Unlike both cash flow and market same as the cash flow stream realized by the
value CDO structures, the synthetic CDO does owner of the underlying asset. So, rather than
not actually have to own any underlying assets buying assets, the special purpose entity simply
at all. sells CDS protection, and then sells the cash

To understand how this might work it helps to flows from the CDS contracts onto investors, just

take a step back and examine what purpose a like a regular CDO.

CDO serves. In its most basic format a CDO This enables investors to get the exposure they
provides investors with a way to achieve want, without running into the scarcity limit
exposure to a diversified group of assets, at a created by highly demanded collateral. Of
specified level of risk. What is important to course, it also meant that the CDOs became
investors is that they are able to purchase a vastly more complex, as they now relied on the
claim on the specific risk and return capacity of the CDS counterparty to ensure that
characteristics that the cash flows from a payments were met. Additionally, the presence
tranche within the CDO will produce. It often of CDS contracts meant that numerous CDOs
times does not matter to the investor whether or could reference the exact same underlying
not the CDO actually owns the underlying asset, meaning that if that asset were to default,
assets, but rather that the CDO can pay out it would have an outsized impact on the CDO
cash flows to them as if it did own them. From marketplace.
the perspective of the CDO issuer, there is an
Chart 3 shows the issuance of CDOs from 2000
easier way to do this than owning the underlying
to 2010, specifically the rise in issuance through
assets.
2007, followed by the subsequent collapse
Collecting a pool of assets for inclusion in a brought on by the credit crisis. Because CDOs
CDO can be difficult. Just like trying to replicate were a relatively opaque asset class, investor
an index, there are often practical limits to demand fell rapidly during the credit crisis, as all
finding and buying each individual security. This but the safest and simplest assets were viewed
problem is exasperated when there is a certain with skepticism.
type of collateral that is highly in demand,

June 2012 |3
COLLATERALIZED DEBT OBLIGATIONS EXPLAINED

Chart 3 Source: SIFMA

The impact of CDS and other securitized assets

on the CDO market can be more clearly seen in
Chart 5. The collateral that backed the CDOs
shifted over time from primarily a mixture of high
yield loans and investment grade bonds, to high
yield loans and structured finance.

Chart 5

Source: SIFMA

Data relating to the type of CDO issued is also

provided by SIFMA beginning in 2005, but
unfortunately the break down makes it difficult to
see the rising importance of synthetic CDOs
within the marketplace. SFIMA captures both
Cash Flow and Hybrid CDOs into a single
category; Hybrid CDOs being those that use a
Source: SIFMA
mixture of cash assets and CDS contracts to
Forecasting the performance of CDOs can be
support their tranches. As seen below in Chart
complicated because of the presence of different
4, synthetic CDOs represented about 21% of
forms of collateral, the possibility that the
issuance in 2007, at a minimum (since we
underlying asset pool will change, and the
cannot properly analyze the Hybrid category).
increased use of already pooled and securitized
Chart 4 assets as collateral. Investors considering the
purchase of a CDO tranche would be best
served by seeking advice from an informed
advisor before they do so.

June 2012 |4
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