Collateralized debt obligation
Encyclopedia
Collateralized debt obligations (CDOs) are a type of structured
asset-backed security
(ABS) with multiple "tranches"
that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed-income underlying assets. CDO securities are split into different risk classes, or tranche
s, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon
payments (and interest rates) or lower prices to compensate for additional default risk.
In simple terms, think of a CDO as a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first.
CDOs can be created as long as global investors are willing to provide the money to purchase the pool of bonds the CDO owns. CDO volume grew significantly between 2000–2006, then declined dramatically in the wake of the subprime mortgage crisis
, which began in 2007. Many of the assets held by these CDOs had been subprime mortgage-backed bonds. Global investors began to stop funding CDOs in 2007, contributing to the collapse of certain structured investments held by major investment banks and the bankruptcy of several subprime lenders.
A few academics, analysts and investors such as Warren Buffett
and the IMF
's former chief economist Raghuram Rajan
warned that CDOs, other ABSs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the subprime mortgage crisis in 2007, this view has gained substantial credibility. Credit rating agencies
failed to adequately account for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs with the highest possible grade.
Many CDOs are valued on a mark to market basis and thus experienced substantial write-downs
as their market value collapsed during the subprime crisis, with banks writing down the value of their CDO holdings mainly in the 2007-2008 period.
Inc. for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation
on June 22, 1990. A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund
companies, unit trust
s, investment trust
s, commercial banks, investment banks, pension fund
managers, private banking
organizations, other CDOs and structured investment vehicle
s.
CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Economist Mark Zandi
of Moody's Analytics
wrote that various factors had kept interest rates low globally in the years CDO volume grew, due to fears of deflation, the bursting of the dot-com bubble
, a U.S. recession, and the U.S. trade deficit. This made U.S. CDO backed by mortgages a relatively more attractive investment versus say U.S. treasury bonds or other low-yielding, safe investments. This search for yield by global investors caused many to purchase CDOs, trusting the credit rating and without fully understanding the risks.
CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDOs declined from 2000–2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets. In addition, financial innovation
s such as credit default swaps and synthetic CDO
enabled speculation on CDOs. This dramatically increased the amount of money that moved among market participants. In effect, multiple insurance policies or wagers could be stacked on the same CDO. If the CDO did not perform per contractual requirements, one counterparty (typically a large investment bank or hedge fund) had to pay another. Michael Lewis
referred to this speculation as part of the "Doomsday Machine" that contributed to the failure of major banking institutions and smaller hedge funds, at the core of the subprime mortgage crisis
. There are allegations that at least one hedge fund encouraged the creation of poor quality CDOs so bets could be made against them.
Willingness to create CDOs and sell them to investors may also reflect the greater profit margins that CDOs provide to their originators, such as major investment banks and other participants in the shadow banking system
, as well as in the traditional depository banking system. Investment banking and credit rating agency profits increased dramatically in the years leading up to the crisis. From 2000-2006, structured finance (which includes CDOs) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase sixfold and its earnings grew by 900%.
Further, depository banks used CDO as a form of securitization
, meaning that the bank did not have to hold the loans it originated on its books and could transfer them (along with related risk) to investors. This in turn enabled the banks to lend again, remaining in compliance with capital requirement laws and generating additional origination fees.
Another factor in the growth of CDOs was the 2001 introduction by David X. Li
of Gaussian copula models, which allowed for the rapid pricing of CDOs.
In late 2005 research firm Celent estimated the size of the global CDO market at USD 1.5 trillion and projected that the market would grow to nearly USD 2 trillion by the end of 2006. Synthetic CDO
also expanded under the tenure of Federal Reserve chairman, Alan Greenspan
who later expounded on the previously unrecognized risk of these devices in his testimony to a Congressional investigative committee on April 7, 2010.
. To create a CDO, a corporate entity
is constructed to hold assets as collateral
and to sell packages of cash flow
s to investors. A CDO is constructed as follows:
One analogy is to think of the cash flow from the CDO's portfolio of securities (say mortgage payments from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, then junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranch investors face the losses first.
The risk and return for a CDO investor depends directly on how the tranches are defined, and only indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all asset-backed securities
, enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated.
The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. Economist Mark Zandi
wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility
was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."
In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This explains why some CDO became entirely worthless, as the equity layer tranches were paid last in the sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of which defaulted) to trickle down to the equity layers.
Source of funds—cash flow vs. market value
Motivation—arbitrage vs. balance sheet
Funding—cash vs. synthetic
Single-tranche CDOs
Variants
In addition, a safe harbor protects CDO issuers that do actively trade in securities, even though trading in securities technically is a business, provided the issuer’s activities do not cause it to be viewed as a dealer in securities or engaged in a banking, lending or similar business.
CDOs are generally taxable as debt instruments except for the most junior class of CDOs which are treated as equity and are subject to special rules (such as PFIC and CFC reporting). The PFIC and CFC reporting is very complex and requires a specialized accountant to perform these calculations and tax reporting.
Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans, and only less than 10% of CDOs were backed by fixed income securities.
B) Other types of CDOs include:
allowed banks to also participate.
Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Mezzanine notes and equity notes offer yields that are not available in most other fixed income securities. Investors include hedge funds, banks, and wealthy individuals.
, typically an investment bank, acts as the structurer and arranger of the CDO. Working with the asset management firm that selects the CDOs portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche.
The key economic consideration for an underwriter that is considering bringing a new deal to market is whether the transaction can offer a sufficient return to the equity noteholders. Such a determination requires estimating the after-default return offered by the portfolio of debt securities and comparing it to the cost of funding the CDOs rated notes. The excess spread must be large enough to offer the potential of attractive IRRs to the equityholders.
Other underwriter responsibilities include working with a law firm and creating the special purpose legal vehicle (typically a trust incorporated in the Cayman Islands
) that will purchase the assets and issue the CDOs tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading restrictions that will be included in the CDOs transaction documents and other files.
The final step is to price the CDO (e.g. set the coupons for each debt tranche) and place the tranches with investors. The priority in placement is finding investors for the risky equity tranche and junior debt tranches of the CDO. It is common for the asset manager to retain a piece of the equity tranche. In addition, the underwriter was generally expected to provide some type of secondary market liquidity for the CDO, especially its more senior tranches.
According to Thomson Financial
, the top underwriters before September 2008 were Bear Stearns
, Merrill Lynch
, Wachovia
, Citigroup
, Deutsche Bank
, and Bank of America Securities
. CDOs are more profitable for underwriters than conventional bond underwriting due to the complexity involved. The underwriter is paid a fee when the CDO is issued.
With the credit crisis of 2007-2008, the lack of understanding of the vast majority of financial managers of the risks of CDOs, asset-backed securities, and other new financial instruments became apparent, and moreover the lax diligence from the major credit rating agencies became clear. CDOs were heavily downgraded across the board, and the value of these instruments dropped dramatically.
In theory,the asset manager should add value in the manner outlined below, although in practice, this did not occur during the credit bubble of the mid-2000s. In addition, it is now understood that the structural flaw in all asset-backed securities (originators profit from loan volume not loan quality) make the roles of subsequent participants peripheral to the quality of the investment.
The asset manager's role begins before the CDO is issued. Months before a CDO is issued, a bank will usually provide financing to enable the manager to purchase some of the collateral assets that may be used in the forthcoming CDO in a process called warehousing.
Even by the issuance date, the asset manager often will not have completed the construction of the CDOs portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend for several months after the CDO is issued. For this reason, some senior CDO notes are structured as delayed drawdown notes, allowing the asset manager to drawdown cash from investors as collateral purchases are made. When a transaction is fully ramped, its initial portfolio of credits has been selected by the asset manager.
However, the asset manager's role continues even after the ramp-up period ends, albeit in a less active role. During the CDOs "reinvestment period", which usually extends several years past the issuance date of the CDO, the asset manager is authorized to reinvest principal proceeds by purchasing additional debt securities. Within the confines of the trading restrictions specified in the CDOs transaction documents, the asset manager can also make trades to maintain the credit quality of the CDOs portfolio. The manager also has a role in the redemption of a CDOs notes by auction call.
The manager's prominent role throughout the life of a CDO underscores the importance of the manager and his or her staff.
There are approximately 300 asset managers in the marketplace. CDO Asset Managers, as with other Asset Managers, can be more or less active depending on the personality and prospectus of the CDO. Asset Managers make money by virtue of the senior fee (which is paid before any of the CDO investors are paid) and subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative business for asset managers. These fees, together with underwriting fees, administration{approx 1.5 - 2%} by virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.
, which offer collateral administration services, but are not trustee banks. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:
The firm may also perform a cash flow tie-out in which the transaction's waterfall is modeled per the priority of payments set forth in the transaction documents. The yield and weighted average life of the bonds or equity notes being issued is then calculated based on the modeling assumptions provided by the underwriter. On each payment date, an accounting firm may work with the trustee to verify the distributions that are scheduled to be made to the noteholders..
winning program, CPM
correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation
such as the mortgage-backed security
(MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. A sample of 735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.
An early indicator of the crisis was the failure of two Bear Stearns
hedge funds in July 2007. The assets held by these hedge funds had declined in value, due in large part to increasing defaults on subprime mortgages. Investors demanded their money back under contractual arrangements referred to as margin calls. The now defunct Bear Stearns
, at that time the fifth-largest U.S. securities firm, said July 18, 2007 that investors in its two failed hedge funds will get little if any money back after "unprecedented declines" in the value of securities used to bet on subprime mortgages, despite investment-grade ratings from rating agencies.
On 24 October 2007, Merrill Lynch
reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations. A week later Stan O'Neal
, Merrill Lynch's CEO, resigned from his position, reportedly as a result. On 4 November 2007, Charles (Chuck) Prince
, Chairman and CEO of Citigroup
resigned and cited the following reasons : "...as you have seen publicly reported, the rating agencies have recently downgraded significantly certain CDOs and the mortgage securities contained in CDOs. As a result of these downgrades, valuations for these instruments have dropped sharply. This will have a significant impact on our fourth quarter financial results. I am responsible for the conduct of our businesses. It is my judgment that the size of these charges makes stepping down the only honorable course for me to take as Chief Executive Officer. This is what I advised the Board."
The new issue pipeline for CDOs backed by asset-backed
and mortgage-backed securities slowed significantly in the second-half of 2007 and the first quarter of 2008 due to weakness in subprime collateral, the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds, and a general downturn in the global credit markets. Global CDO issuance in the fourth quarter of 2007 was US$ 47.5 billion, a nearly 74 percent decline from the US$ 180 billion issued in the fourth quarter of 2006. First quarter 2008 issuance of US$ 11.7 billion was nearly 94 percent lower than the US$ 186 billion issued in the first quarter of 2007. Moreover, virtually all first quarter 2008 CDO issuance was in the form of collateralized loan obligation
s backed by middle-market or leveraged bank loans, not by home mortgage ABS.
This trend has limited the mortgage credit that is available to homeowners. CDOs purchased much of the riskier portions of mortgage bonds, helping to support issuance of nearly $1 trillion in mortgage bonds in 2006 alone. Rating agencies were strongly criticized by regulators and other experts, including economist Joseph Stiglitz, for their role in enabling the origination of enormous amounts of low-quality debt packaged in CDOs with erroneous, high-quality credit ratings. In the first quarter of 2008 alone, rating agencies announced 4,485 downgrades of CDOs. Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners who are trying to refinance out of mortgages that are experiencing payment shock (e.g. adjustable-rate mortgages with rising interest rates).
Structured finance
Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid lawsStructured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws...
asset-backed security
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
(ABS) with multiple "tranches"
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...
that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed-income underlying assets. CDO securities are split into different risk classes, or tranche
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...
s, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon
Coupon (bond)
A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
payments (and interest rates) or lower prices to compensate for additional default risk.
In simple terms, think of a CDO as a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first.
CDOs can be created as long as global investors are willing to provide the money to purchase the pool of bonds the CDO owns. CDO volume grew significantly between 2000–2006, then declined dramatically in the wake of the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
, which began in 2007. Many of the assets held by these CDOs had been subprime mortgage-backed bonds. Global investors began to stop funding CDOs in 2007, contributing to the collapse of certain structured investments held by major investment banks and the bankruptcy of several subprime lenders.
A few academics, analysts and investors such as Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
and the IMF
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
's former chief economist Raghuram Rajan
Raghuram Rajan
Raghuram Govind Rajan is currently the Eric J. Gleacher Distinguished Service Professor of Finance at the Booth School of Business at the University of Chicago. He is also an honorary economic adviser to Prime Minister of India Manmohan Singh and the current President of the American Finance...
warned that CDOs, other ABSs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the subprime mortgage crisis in 2007, this view has gained substantial credibility. Credit rating agencies
Credit rating agency
A Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...
failed to adequately account for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs with the highest possible grade.
Many CDOs are valued on a mark to market basis and thus experienced substantial write-downs
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
as their market value collapsed during the subprime crisis, with banks writing down the value of their CDO holdings mainly in the 2007-2008 period.
Market history and growth
The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham LambertDrexel Burnham Lambert
Drexel Burnham Lambert was a major Wall Street investment banking firm, which first rose to prominence and then was forced into bankruptcy in February 1990 by its involvement in illegal activities in the junk bond market, driven by Drexel employee Michael Milken. At its height, it was the...
Inc. for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation
Resolution Trust Corporation
The Resolution Trust Corporation was a United States Government-owned asset management company run by Lewis William Seidman and charged with liquidating assets, primarily real estate-related assets such as mortgage loans, that had been assets of savings and loan associations declared insolvent by...
on June 22, 1990. A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
companies, unit trust
Unit trust
A unit trust is a form of collective investment constituted under a trust deed.Found in Australia, Ireland, the Isle of Man, Jersey, New Zealand, South Africa, Singapore, Malaysia and the UK, unit trusts offer access to a wide range of securities....
s, investment trust
Investment trust
An Investment trust is a form of collective investment found mostly in the United Kingdom. Investment trusts are closed-end funds and are constituted as public limited companies....
s, commercial banks, investment banks, pension fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
managers, private banking
Private banking
Private banking is banking, investment and other financial services provided by banks to private individuals investing sizable assets. The term "private" refers to the customer service being rendered on a more personal basis than in mass-market retail banking, usually via dedicated bank advisers...
organizations, other CDOs and structured investment vehicle
Structured investment vehicle
A structured investment vehicle was an operating finance company established to earn a spread between its assets and liabilities like a traditional bank...
s.
CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Economist Mark Zandi
Mark Zandi
Mark Zandi is an Iranian American economist and co-founder of Moody's Economy.com, a widely-cited source of economic analysis.. Moody's Economy.com is part of Moody's Analytics. Prior to founding Economy.com, Zandi was a regional economist at Chase Econometrics.He was born in Atlanta, Georgia of...
of Moody's Analytics
Moody's Analytics
Moody’s Analytics provides capital markets and risk management professionals with credit analysis, economic research, financial risk management software, and advisory services...
wrote that various factors had kept interest rates low globally in the years CDO volume grew, due to fears of deflation, the bursting of the dot-com bubble
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
, a U.S. recession, and the U.S. trade deficit. This made U.S. CDO backed by mortgages a relatively more attractive investment versus say U.S. treasury bonds or other low-yielding, safe investments. This search for yield by global investors caused many to purchase CDOs, trusting the credit rating and without fully understanding the risks.
CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDOs declined from 2000–2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets. In addition, financial innovation
Financial innovation
There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...
s such as credit default swaps and synthetic CDO
Synthetic CDO
A Synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid...
enabled speculation on CDOs. This dramatically increased the amount of money that moved among market participants. In effect, multiple insurance policies or wagers could be stacked on the same CDO. If the CDO did not perform per contractual requirements, one counterparty (typically a large investment bank or hedge fund) had to pay another. Michael Lewis
Michael Lewis (author)
Michael Lewis is an American non-fiction author and financial journalist. His bestselling books include The Big Short: Inside the Doomsday Machine, Liar's Poker, The New New Thing, Moneyball: The Art of Winning an Unfair Game, The Blind Side: Evolution of a Game, Panic and Home Game: An...
referred to this speculation as part of the "Doomsday Machine" that contributed to the failure of major banking institutions and smaller hedge funds, at the core of the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
. There are allegations that at least one hedge fund encouraged the creation of poor quality CDOs so bets could be made against them.
Willingness to create CDOs and sell them to investors may also reflect the greater profit margins that CDOs provide to their originators, such as major investment banks and other participants in the shadow banking system
Shadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
, as well as in the traditional depository banking system. Investment banking and credit rating agency profits increased dramatically in the years leading up to the crisis. From 2000-2006, structured finance (which includes CDOs) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase sixfold and its earnings grew by 900%.
Further, depository banks used CDO as a form of securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
, meaning that the bank did not have to hold the loans it originated on its books and could transfer them (along with related risk) to investors. This in turn enabled the banks to lend again, remaining in compliance with capital requirement laws and generating additional origination fees.
Another factor in the growth of CDOs was the 2001 introduction by David X. Li
David X. Li
David X. Li is a quantitative analyst and a qualified actuary who in the early 2000s pioneered the use of Gaussian copula models for the pricing of collateralized debt obligations...
of Gaussian copula models, which allowed for the rapid pricing of CDOs.
In late 2005 research firm Celent estimated the size of the global CDO market at USD 1.5 trillion and projected that the market would grow to nearly USD 2 trillion by the end of 2006. Synthetic CDO
Synthetic CDO
A Synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid...
also expanded under the tenure of Federal Reserve chairman, Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
who later expounded on the previously unrecognized risk of these devices in his testimony to a Congressional investigative committee on April 7, 2010.
| USD bil. | |
|---|---|
| 2004 | 157.4 |
| 2005 | 251.3 |
| 2006 | 520.6 |
| 2007 | 481.6 |
| 2008 | 61.9 |
| 2009 | 4.3 |
| 2010 | 8.0 |
Concept
CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO is a type of asset-backed securityAsset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
. To create a CDO, a corporate entity
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
is constructed to hold assets as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
and to sell packages of cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s to investors. A CDO is constructed as follows:
- A special purpose entitySpecial purpose entityA special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives...
(SPE) is designed to acquire a portfolioPortfolio (finance)Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
of underlying assets. Common underlying assets held include mortgage-backed securities, commercial real estate bonds and corporate loans.
- The SPE issues bondsBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
to investors in exchange for cash, which is used to purchase the portfolio of underlying assets. The bonds issued are in layers with different risk characteristics called tranches. Senior tranches are paid from the cash flows from the underlying assets before the junior securities and equity securities. Losses are first borne by the equity securities, next by the junior tranches, and finally by the senior tranches.
One analogy is to think of the cash flow from the CDO's portfolio of securities (say mortgage payments from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, then junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranch investors face the losses first.
The risk and return for a CDO investor depends directly on how the tranches are defined, and only indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all asset-backed securities
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
, enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated.
The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. Economist Mark Zandi
Mark Zandi
Mark Zandi is an Iranian American economist and co-founder of Moody's Economy.com, a widely-cited source of economic analysis.. Moody's Economy.com is part of Moody's Analytics. Prior to founding Economy.com, Zandi was a regional economist at Chase Econometrics.He was born in Atlanta, Georgia of...
wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."
In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This explains why some CDO became entirely worthless, as the equity layer tranches were paid last in the sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of which defaulted) to trickle down to the equity layers.
Structures
CDO is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follow:Source of funds—cash flow vs. market value
- Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDOs assets. Cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio.
- Market value CDOs attempt to enhance investor returns through the more frequent trading and profitable sale of collateral assets. The CDO asset manager seeks to realize capital gains on the assets in the CDOs portfolio. There is greater focus on the changes in market value of the CDOs assets. Market value CDOs are longer-established, but less common than cash flow CDOs.
Motivation—arbitrage vs. balance sheet
- Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. The majority, 86%, of CDOs are arbitrage-motivated.
- Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A bank may wish to offload the credit risk in order to reduce its balance sheet's credit risk.
Funding—cash vs. synthetic
- Cash CDOs involve a portfolio of cash assets, such as loans, corporate bondCorporate bondA corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date...
s, asset-backed securitiesAsset-backed securityAn asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
or mortgage-backed securitiesMortgage-backed securityA mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
. Ownership of the assets is transferred to the legal entity (known as a special purpose vehicle) issuing the CDOs tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006. - Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOSynthetic CDOA Synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid...
s gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss on a specific asset in the event that asset experiences a default or other credit eventCredit eventA credit event is the financial term used to describe either:* A general default event related to a legal entity's previously agreed financial obligation. In this case, a legal entity fails to meet its obligation on any significant financial transaction...
.) Like a cash CDO, the risk of loss on the CDOs portfolio is divided into tranches. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche receives a periodic payment (the swap premium), with the junior tranches offering higher premiums.
-
- A synthetic CDO tranche may be either funded or unfunded. Under the swap agreements, the CDO could have to pay up to a certain amount of money in the event of a credit event on the reference obligations in the CDOs reference portfolio. Some of this credit exposure is funded at the time of investment by the investors in funded tranches. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in high-quality, liquid assets or placed in a GIC (Guaranteed Investment ContractGuaranteed Investment ContractA guaranteed investment contract is a contract that guarantees repayment of principal and a fixed or floating interest rate for a predetermined period of time. Guaranteed investment contracts are typically issued by life insurance companies and marketed to institutions qualified for favorable tax...
) account that offers a return that is a few basis points below LIBOR. The return from these investments plus the premium from the swap counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit event occurs and a payout to the swap counterparty is required, the required payment is made from the GIC or reserve account that holds the liquid investments. In contrast, senior tranches are usually unfunded since the risk of loss is much lower. Unlike a cash CDO, investors in a senior tranche receive periodic payments but do not place any capital in the CDO when entering into the investment. Instead, the investors retain continuing funding exposure and may have to make a payment to the CDO in the event the portfolio's losses reach the senior tranche. Funded synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time to create. Cash assets do not have to be purchased and managed, and the CDOs tranches can be precisely structured.- Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional assets. A portion of the proceeds from the funded tranches is invested in cash assets and the remainder is held in reserve to cover payments that may be required under the credit default swaps. The CDO receives payments from three sources: the return from the cash assets, the GIC or reserve account investments, and the CDO premiums.
- A synthetic CDO tranche may be either funded or unfunded. Under the swap agreements, the CDO could have to pay up to a certain amount of money in the event of a credit event on the reference obligations in the CDOs reference portfolio. Some of this credit exposure is funded at the time of investment by the investors in funded tranches. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in high-quality, liquid assets or placed in a GIC (Guaranteed Investment Contract
Single-tranche CDOs
- The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke CDOs) where the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches are never sold but held by the dealer based on valuations from internal models. Residual risk is delta-hedged by the dealer.
Variants
- Unlike CDOs, which are terminating structures that typically wind-down or refinance at the end of their financing term, Structured Operating Companies are permanently capitalized variants of CDOs, with an active management team and infrastructure. They often issue term notes, commercial paperCommercial paperIn the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations , and is only backed by an issuing bank or...
, and/or auction rate securitiesAuction Rate SecurityAn auction rate security typically refers to a debt instrument with a long-term nominal maturity for which the interest rate is regularly reset through a dutch auction. Since February 2008, most such auctions have failed, and the auction market has been largely frozen...
, depending upon the structural and portfolio characteristics of the company. Credit Derivative Products Companies (CDPC) and Structured Investment VehiclesStructured investment vehicleA structured investment vehicle was an operating finance company established to earn a spread between its assets and liabilities like a traditional bank...
(SIV) are examples, with CDPC taking risk synthetically and SIV with predominantly 'cash' exposure.
Taxation of CDOs
CDOs are bonds issued by special purpose vehicles that are backed by pools of bonds, loans or other debt instruments. CDOs are typically issued in classes or “tranches” with some being senior to others in the event of a shortfall in the cash available to make payments on the bonds. The issuer of a CDO typically is a corporation established outside the United States to avoid being subject to U.S. federal income taxation on its global income. These corporations must restrict their activities to avoid U.S. tax; corporations that are deemed to engage in trade or business in the U.S. will be subject to federal taxation. However, the U.S. government will not tax foreign corporations that only invest in and hold portfolios of U.S. stock and debt securities because investing, unlike trading or dealing, is not considered to be a trade or business, regardless of its volume or frequency.In addition, a safe harbor protects CDO issuers that do actively trade in securities, even though trading in securities technically is a business, provided the issuer’s activities do not cause it to be viewed as a dealer in securities or engaged in a banking, lending or similar business.
CDOs are generally taxable as debt instruments except for the most junior class of CDOs which are treated as equity and are subject to special rules (such as PFIC and CFC reporting). The PFIC and CFC reporting is very complex and requires a specialized accountant to perform these calculations and tax reporting.
Types of CDOs
A) Based on the underlying asset:- Collateralized loan obligationCollateralized loan obligationCollateralized loan obligations are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches...
s (CLOs) — CDOs backed primarily by leveraged bank loans. - Collateralized bond obligations (CBOs) — CDOs backed primarily by leveraged fixed incomeFixed incomeFixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable....
securities. - Collateralized synthetic obligations (CSOs) — CDOs backed primarily by credit derivativeCredit derivativeIn finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
s. - Structured finance CDOs (SFCDOs) — CDOs backed primarily by structured products (such as asset-backed securitiesAsset-backed securityAn asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
and mortgage-backed securities).
Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans, and only less than 10% of CDOs were backed by fixed income securities.
B) Other types of CDOs include:
- Commercial Real Estate CDOs (CRE CDOs) — backed primarily by commercial real estate assets
- Collateralized bond obligations (CBOs) — CDOs backed primarily by corporate bonds
- Collateralized Insurance Obligations (CIOs) — backed by insurance or, more usually, reinsurance contracts
- CDO-Squared — CDOs backed primarily by the tranches issued by other CDOs.
- CDO^n — Generic term for CDO3 (CDO cubed) and higher, where the CDO is backed by other CDOs/CDO2/CDO3. These are particularly difficult vehicles to model due to the possible repetition of exposures in the underlying CDO.
Types of collateral
The collateral for cash CDOs include:- Structured financeStructured financeStructured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid lawsStructured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws...
securities (mortgage-backed securitiesMortgage-backed securityA mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
, home equity asset-backed securitiesAsset-backed securityAn asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
, commercial mortgage-backed securities) - Leveraged loansLeverage (finance)In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
- Corporate bondCorporate bondA corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date...
s - Real estate investment trustReal estate investment trustA real estate investment trust or REIT is a tax designation for a corporate entity investing in real estate. The purpose of this designation is to reduce or eliminate corporate tax. In return, REITs are required to distribute 90% of their taxable income into the hands of investors...
(REIT) debt - Commercial real estate mortgage debt (including whole loans, B notes, and Mezzanine debt)
- Emerging-market sovereign debtEmerging Market DebtEmerging market debt is a term used to encompass bonds issued by less developed countries. It does not include borrowing from government, supranational organizations such as the IMF or private sources, though loans that are securitized and issued to the markets would be included...
- Project finance debt
- Trust Preferred securities
Transaction participants
Participants in a CDO transaction include investors, the underwriter, the asset manager, the trustee and collateral administrator, accountants and attorneys. Beginning in 1999, the Gramm-Leach-Bliley ActGramm-Leach-Bliley Act
The Gramm–Leach–Bliley Act , also known as the Financial Services Modernization Act of 1999, is an act of the 106th United States Congress...
allowed banks to also participate.
Investors
Investors have different motivations for purchasing CDO securities depending on which tranche they select. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities (e.g. corporate bonds) of a similar rating. In some cases, investors utilize leverage and hope to profit from the excess of the spread offered by the senior tranche and their cost of borrowing. This is because senior tranches pay a spread above LIBOR despite their AAA-ratings. Investors also benefit from the diversification of the CDO portfolio, the expertise of the asset manager, and the credit support built into the transaction. Investors include banks and insurance companies as well as investment funds.Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Mezzanine notes and equity notes offer yields that are not available in most other fixed income securities. Investors include hedge funds, banks, and wealthy individuals.
Underwriter
The underwriterUnderwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
, typically an investment bank, acts as the structurer and arranger of the CDO. Working with the asset management firm that selects the CDOs portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche.
The key economic consideration for an underwriter that is considering bringing a new deal to market is whether the transaction can offer a sufficient return to the equity noteholders. Such a determination requires estimating the after-default return offered by the portfolio of debt securities and comparing it to the cost of funding the CDOs rated notes. The excess spread must be large enough to offer the potential of attractive IRRs to the equityholders.
Other underwriter responsibilities include working with a law firm and creating the special purpose legal vehicle (typically a trust incorporated in the Cayman Islands
Cayman Islands
The Cayman Islands is a British Overseas Territory and overseas territory of the European Union located in the western Caribbean Sea. The territory comprises the three islands of Grand Cayman, Cayman Brac, and Little Cayman, located south of Cuba and northwest of Jamaica...
) that will purchase the assets and issue the CDOs tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading restrictions that will be included in the CDOs transaction documents and other files.
The final step is to price the CDO (e.g. set the coupons for each debt tranche) and place the tranches with investors. The priority in placement is finding investors for the risky equity tranche and junior debt tranches of the CDO. It is common for the asset manager to retain a piece of the equity tranche. In addition, the underwriter was generally expected to provide some type of secondary market liquidity for the CDO, especially its more senior tranches.
According to Thomson Financial
Thomson Financial
Thomson Financial was an arm of The Thomson Corporation, which was one of the world's leading information companies, focused on providing integrated information solutions to business and professional customers...
, the top underwriters before September 2008 were Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
, Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
, Wachovia
Wachovia
Wachovia was a diversified financial services company based in Charlotte, North Carolina. Before its acquisition by Wells Fargo in 2008, Wachovia was the fourth-largest bank holding company in the United States based on total assets...
, Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
, Deutsche Bank
Deutsche Bank
Deutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
, and Bank of America Securities
Bank of America
Bank of America Corporation, an American multinational banking and financial services corporation, is the second largest bank holding company in the United States by assets, and the fourth largest bank in the U.S. by market capitalization. The bank is headquartered in Charlotte, North Carolina...
. CDOs are more profitable for underwriters than conventional bond underwriting due to the complexity involved. The underwriter is paid a fee when the CDO is issued.
The asset manager
The asset manager plays a key role in each CDO transaction, even after the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDOs portfolio. The manager can maintain the credit quality of a CDOs portfolio through trades as well as maximize recovery rates when defaults on the underlying assets occur.With the credit crisis of 2007-2008, the lack of understanding of the vast majority of financial managers of the risks of CDOs, asset-backed securities, and other new financial instruments became apparent, and moreover the lax diligence from the major credit rating agencies became clear. CDOs were heavily downgraded across the board, and the value of these instruments dropped dramatically.
In theory,the asset manager should add value in the manner outlined below, although in practice, this did not occur during the credit bubble of the mid-2000s. In addition, it is now understood that the structural flaw in all asset-backed securities (originators profit from loan volume not loan quality) make the roles of subsequent participants peripheral to the quality of the investment.
The asset manager's role begins before the CDO is issued. Months before a CDO is issued, a bank will usually provide financing to enable the manager to purchase some of the collateral assets that may be used in the forthcoming CDO in a process called warehousing.
Even by the issuance date, the asset manager often will not have completed the construction of the CDOs portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend for several months after the CDO is issued. For this reason, some senior CDO notes are structured as delayed drawdown notes, allowing the asset manager to drawdown cash from investors as collateral purchases are made. When a transaction is fully ramped, its initial portfolio of credits has been selected by the asset manager.
However, the asset manager's role continues even after the ramp-up period ends, albeit in a less active role. During the CDOs "reinvestment period", which usually extends several years past the issuance date of the CDO, the asset manager is authorized to reinvest principal proceeds by purchasing additional debt securities. Within the confines of the trading restrictions specified in the CDOs transaction documents, the asset manager can also make trades to maintain the credit quality of the CDOs portfolio. The manager also has a role in the redemption of a CDOs notes by auction call.
The manager's prominent role throughout the life of a CDO underscores the importance of the manager and his or her staff.
There are approximately 300 asset managers in the marketplace. CDO Asset Managers, as with other Asset Managers, can be more or less active depending on the personality and prospectus of the CDO. Asset Managers make money by virtue of the senior fee (which is paid before any of the CDO investors are paid) and subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative business for asset managers. These fees, together with underwriting fees, administration{approx 1.5 - 2%} by virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.
The trustee and collateral administrator
The trustee holds title to the assets of the CDO for the benefit of the noteholders (i.e. the Investor). In the CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and distributes noteholder reports, performs various compliance tests regarding the composition and liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall models. Two notable exceptions to this are Virtus Partners and Wilmington Trust Conduit Services, a subsidiary of Wilmington TrustWilmington Trust
Wilmington Trust was founded on July 8, 1903 as a banking, trust, and safe deposit company by DuPont president T. Coleman du Pont.On November 1, 2010, Wilmington Trust announced a merger with M&T Bank, of Buffalo, NY. The deal values 107-year-old Wilmington Trust at $3.84 a share, or 46 percent...
, which offer collateral administration services, but are not trustee banks. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:
- ATC Capital Markets
- Bank of New York MellonBank of New York MellonThe Bank of New York Mellon Corporation is a global financial services company formed on July 1, 2007 as result of the merger of The Bank of New York and Mellon Financial Corporation...
(note: the Bank of New York Mellon recently also acquired the corporate trust unit of JP Morgan which is the market share leader) - BNP ParibasBNP ParibasBNP Paribas S.A. is a global banking group, headquartered in Paris, with its second global headquarters in London. In October 2010 BNP Paribas was ranked by Bloomberg and Forbes as the largest bank and largest company in the world by assets with over $3.1 trillion. It was formed through the merger...
Securities Services (note: currently serves the European market only) - CitibankCitibankCitibank, a major international bank, is the consumer banking arm of financial services giant Citigroup. Citibank was founded in 1812 as the City Bank of New York, later First National City Bank of New York...
- Deutsche BankDeutsche BankDeutsche Bank AG is a global financial service company with its headquarters in Frankfurt, Germany. It employs more than 100,000 people in over 70 countries, and has a large presence in Europe, the Americas, Asia Pacific and the emerging markets...
- Equity Trust
- Intertrust GroupIntertrust GroupIntertrust Group is one of the largest providers of Trust and Corporate Services in the world. Intertrust operates with more than 1,000 employees worldwide in over 20 countries...
(note: until mid 2009 was known as Fortis Intertrust) - HSBCHSBCHSBC Holdings plc is a global banking and financial services company headquartered in Canary Wharf, London, United Kingdom. it is the world's second-largest banking and financial services group and second-largest public company according to a composite measure by Forbes magazine...
- LaSalle BankLaSalle BankLaSalle Bank Corporation was the holding company for LaSalle Bank N.A. and LaSalle Bank Midwest N.A. . With $116 billion in assets, it was headquartered at 135 South LaSalle Street in Chicago, Illinois...
(Recently acquired by Bank of AmericaBank of AmericaBank of America Corporation, an American multinational banking and financial services corporation, is the second largest bank holding company in the United States by assets, and the fourth largest bank in the U.S. by market capitalization. The bank is headquartered in Charlotte, North Carolina...
Purchased by US Bank late 2010) - Sanne Trust
- State Street Corporation
- US Bank (note: US Bank recently also acquired the corporate trust unit of [Wachovia] in 2008 and Bank of America in September 2011)
- Wells FargoWells FargoWells Fargo & Company is an American multinational diversified financial services company with operations around the world. Wells Fargo is the fourth largest bank in the U.S. by assets and the largest bank by market capitalization. Wells Fargo is the second largest bank in deposits, home...
- Wilmington TrustWilmington TrustWilmington Trust was founded on July 8, 1903 as a banking, trust, and safe deposit company by DuPont president T. Coleman du Pont.On November 1, 2010, Wilmington Trust announced a merger with M&T Bank, of Buffalo, NY. The deal values 107-year-old Wilmington Trust at $3.84 a share, or 46 percent...
- Wilmington shut down their business in early 2009.
Accountants
The underwriter typically will hire an accounting firm to perform due diligence on the CDOs portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread, of each collateral security. Source documents or public sources will typically be used to tie-out the collateral pool information. In addition, the accountants typically calculate certain collateral tests and determine whether the portfolio is in compliance with such tests.The firm may also perform a cash flow tie-out in which the transaction's waterfall is modeled per the priority of payments set forth in the transaction documents. The yield and weighted average life of the bonds or equity notes being issued is then calculated based on the modeling assumptions provided by the underwriter. On each payment date, an accounting firm may work with the trustee to verify the distributions that are scheduled to be made to the noteholders..
Attorneys
Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction documents. Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory requirements to disclose certain information to investors. This will be circulated to investors. It is common for multiple counsels to be involved in a single deal due to the number of parties to a single CDO from asset management firms to underwriters.Subprime mortgage crisis
The CDO played a pivotal role in financing the housing bubble that peaked in the U.S. during 2006. The CDO provided a key link between the global pool of fixed income investor capital and the U.S. housing market. In a Peabody AwardPeabody Award
The George Foster Peabody Awards recognize distinguished and meritorious public service by radio and television stations, networks, producing organizations and individuals. In 1939, the National Association of Broadcasters formed a committee to recognize outstanding achievement in radio broadcasting...
winning program, CPM
Chicago Public Media
Chicago Public Media is a not-for-profit media company that operates as the primary National Public Radio member organization for Chicago. It owns 3 non-commercial educational FM broadcast stations and 1 FM translator, and produces the programs Wait Wait... Don't Tell Me! for NPR stations, This...
correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation
Financial innovation
There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.- Why does financial innovation occur? :...
such as the mortgage-backed security
Mortgage-backed security
A mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
(MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. A sample of 735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.
An early indicator of the crisis was the failure of two Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
hedge funds in July 2007. The assets held by these hedge funds had declined in value, due in large part to increasing defaults on subprime mortgages. Investors demanded their money back under contractual arrangements referred to as margin calls. The now defunct Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
, at that time the fifth-largest U.S. securities firm, said July 18, 2007 that investors in its two failed hedge funds will get little if any money back after "unprecedented declines" in the value of securities used to bet on subprime mortgages, despite investment-grade ratings from rating agencies.
On 24 October 2007, Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations. A week later Stan O'Neal
Stanley O'Neal
Earnest Stanley O'Neal is an American business executive. He is the former President, Chief Executive Officer and Chairman of the Board of Merrill Lynch & Co. Inc., having served in numerous senior management positions at the company prior to this appointment. O'Neal was one of the first...
, Merrill Lynch's CEO, resigned from his position, reportedly as a result. On 4 November 2007, Charles (Chuck) Prince
Charles Prince
Charles O. "Chuck" Prince, III is an American former chief executive officer and chairman of Citigroup. He succeeded Sandy Weill as the CEO of the firm in 2003, and as the Chairman of the Board in 2006...
, Chairman and CEO of Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
resigned and cited the following reasons : "...as you have seen publicly reported, the rating agencies have recently downgraded significantly certain CDOs and the mortgage securities contained in CDOs. As a result of these downgrades, valuations for these instruments have dropped sharply. This will have a significant impact on our fourth quarter financial results. I am responsible for the conduct of our businesses. It is my judgment that the size of these charges makes stepping down the only honorable course for me to take as Chief Executive Officer. This is what I advised the Board."
The new issue pipeline for CDOs backed by asset-backed
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
and mortgage-backed securities slowed significantly in the second-half of 2007 and the first quarter of 2008 due to weakness in subprime collateral, the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds, and a general downturn in the global credit markets. Global CDO issuance in the fourth quarter of 2007 was US$ 47.5 billion, a nearly 74 percent decline from the US$ 180 billion issued in the fourth quarter of 2006. First quarter 2008 issuance of US$ 11.7 billion was nearly 94 percent lower than the US$ 186 billion issued in the first quarter of 2007. Moreover, virtually all first quarter 2008 CDO issuance was in the form of collateralized loan obligation
Collateralized loan obligation
Collateralized loan obligations are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches...
s backed by middle-market or leveraged bank loans, not by home mortgage ABS.
This trend has limited the mortgage credit that is available to homeowners. CDOs purchased much of the riskier portions of mortgage bonds, helping to support issuance of nearly $1 trillion in mortgage bonds in 2006 alone. Rating agencies were strongly criticized by regulators and other experts, including economist Joseph Stiglitz, for their role in enabling the origination of enormous amounts of low-quality debt packaged in CDOs with erroneous, high-quality credit ratings. In the first quarter of 2008 alone, rating agencies announced 4,485 downgrades of CDOs. Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners who are trying to refinance out of mortgages that are experiencing payment shock (e.g. adjustable-rate mortgages with rising interest rates).
See also
- Asset-backed securityAsset-backed securityAn asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
- Collateralized mortgage obligationCollateralized mortgage obligationA collateralized mortgage obligation is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie Mac. A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first...
(also known by initials CMO) - Collateralized fund obligationCollateralized Fund ObligationA collateralized fund obligation is a form of securitization involving private equity fund or hedge fund assets, similar to collateralized debt obligations...
- Inside Job (film)Inside Job (film)Inside Job is a 2010 documentary film about the late-2000s financial crisis directed by Charles H. Ferguson. The film is described by Ferguson as being about "the systemic corruption of the United States by the financial services industry and the consequences of that systemic corruption." In five...
, a 2010 Oscar-winning documentary film about the financial crisis of 2007–2010 by Charles H. Ferguson - List of CDO managers
- Credit default swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
- Single-tranche CDO
- Synthetic CDOSynthetic CDOA Synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid...
External links
- How a CDO is like a bottle of Champagne. From Marketplace
- Global Pool of Money and CDOs (NPR radio)
- The Story of the CDO Market Meltdown: An Empirical Analysis-Anna Katherine Barnett-Hart-March 2009-Cited by Michael Lewis in "The Big Short"
- CDO Diagram-Bionic Turtle
- CDO and RMBS Diagram-FCIC and IMF
- "Investment Landfill"
- Portfolio.com explains what CDOs are in an easy-to-understand multimedia graphic
- The Making of a Mortgage CDO multimedia graphic from The Wall Street Journal
- JPRI Occasional Paper No. 37, October 2007 Risk vs Uncertainty: The Cause of the Current Financial Crisis By Marshall Auerback
- Collateralized debt obligations: who's to blame when the market blows up? - Summer, 2007
- How credit cards become asset-backed bonds. From Marketplace
- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1016854Vink, Dennis and Thibeault, André (2008). "ABS, MBS and CDO Compared: An Empirical Analysis" The Journal of Structured FinanceJournal of Structured FinanceThe Journal of Structured Finance is a quarterly academic journal on structuring and investing in all types of structured finance, such as asset-backed securities, mortgage-backed securities, collateralized debt and loan obligations, and life settlements...
] - "A tsunami of hope or terror?", Alan Kohler, Nov 19, 2008.
- CDO Presentation-Innovation in integrating cash and synthetic markets-Choudry-April 2003 Moorad Choudhry YieldCurve.com
- Collateralized Debt Obligations at Wikinvest