Review of Subprime Crisis (Part 1) – CDOs

The financial crisis had begun 13 months ago. Till date, the situation has not been improved but is worsening and taken a new turn which shake the financial world. With the latest fallout from AIG, consumers were losing confidence and every distress banks was asking for “bail out” from the U.S. government. Central banks from all over the world were pouring hundreds and billions of dollars into the global market. In order to understand the problems, it was worthwhile to examine the products that led to this subprime crisis – Collateralized Debt Obligation (CDO).

Collateralized debt obligation

Collateralized debt obligations (CDOs) are an unregulated type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets and rated by the rating firms to assess their value. Since 1987 (Black Monday), CDOs have become an important funding vehicle for fixed-income assets.

Structures

Generally, CDO is a broad term refers to several different types of products in which their usage categorizing in several ways as follow:

1. Source of fund

a. Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDO’s assets

b. Market value CDOs attempt to enhance returns by realizing the capital gains on the trading and profitable sale of collateral assets.

2. Motivation

a. Arbitrage transactions attempt to capture for equity investors the spread between the relatively high yielding assets and lower yielding liabilities represented by the rated bonds. The majority of CDOs (86%) are arbitrage-motivated (SIFMA, 2007).

b. Balance sheet transactions are used by issuing institutions to remove loans and other assets from their balance sheets to reduce their regulatory capital requirements and improve their return on risk capital.

3. Funding

a. Cash CDOs involve a portfolio of cash assets such as loans, corporate bonds, asset-backed securities or mortgage-backed securities.

b. Synthetic CDOs gain credit exposure for the above assets without owning those with credit default swaps.

c. Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs, therefore its portfolio includes both cash assets as well as swaps.

4. Single-tranche CDOs

a. Single-tranche CDOs are constructed from credit default swaps in which it is especially structured specifically for a single or small group of investors. The dealers hold the remaining tranches and their values are based on valuations from internal models.

Type of CDOs

A) Based on the underlying asset:

• Collateralized loan obligations (CLOs): CDOs backed primarily by leveraged bank loans.
• Collateralized bond obligations (CBOs): CDOs backed primarily by leveraged fixed income securities.
• Collateralized synthetic obligations (CSOs) : CDOs backed primarily by credit derivatives.
• Structured finance CDOs (SFCDOs) : CDOs backed primarily by structured products, e.g. asset-backed or mortgage-backed 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.

BIBLIOGRAPHY

1. Securities Industry and Financial Markets Association (2007). Global CDO Market Issuance Data: SIFMA : USA.

2. Wikipedia (2007). Collateralized Debt Obligations. http://en.wikipedia.org/wiki/Collateralized _debt_obligations, 21 Sep 2008.