What is CDO (Collateralized Debt Obligation)?
Collateralized Debt Obligation or CDO is a financial product that brings together assets that can generate cash flow and repackages into ‘tranches’ that can be sold off to potential investors. The reason why this obligation is collateralized is because the assets involved such as bonds and mortgages serve as collateral. These are typically purchased by insurance companies, hedge funds and other institutions that are willing to take risks in order to gain.
The risk profile of the tranches or portions can differ but senior ones are safer in comparison since they get to pick first in case of a default. That is why they have higher credit rating along with lower rates in coupons.
A breakdown of CDO
A total of 5 parties take part in creating a CDO. These are:
- Firms specializing in securities who approve the collateral chosen and convert the notes in tranches which are forwarded to investors.
- Managers who are responsible for selecting collateral and may also manage the CDO profile.
- Rating agencies which examine the CDOs and give them credit ratings accordingly.
- Guarantors who promise investors that they will not be liable for or be affected by any losses on the tranches when they pay premium payments.
- Investors such as those for hedge and pension funds.
An obligation such as the CDO is often supported by mortgage based securities in the residential property industry but it is also sometimes backed by commercial securities, bank loans bonds and other products.
The role of CMO (Collateralized Mortgage Obligation)
In order to create a CMO (Collateralized Mortgage Obligation), a financial institution such as a loan bank pools home loans that share similar characteristics into a saleable security.
On the other hand, the one who purchases the CMO can be at risk by factors such as prepayments, credit risks, seesawing interest rates and other anomalies. If for instance the interest rate rises, most CMO tranches will drop in value in the market. Plus, if the life of the CMO is increased, rising rates can compel the investor to remain committed for longer than anticipated.
Even though equity tranches can provide higher returns when the economy is faring well, their value can plummet drastically if the economy suffers or if mortgage defaults.
- The CDO market Functioning and implications in terms of financial stability – ideas.repec.org [PDF]
- The alchemy of CDO credit ratings – www.sciencedirect.com [PDF]
- Did credit rating agencies make unbiased assumptions on CDOs? – www.aeaweb.org [PDF]
- CDOs and the financial crisis: Credit ratings and fair premia – www.sciencedirect.com [PDF]
- Copula dynamics in CDOs – www.tandfonline.com [PDF]
- Assessing the credit risk of CDOs backed by structured finance securities: Rating analysts' challenges and solutions – jsf.pm-research.com [PDF]
- Does credit securitization reduce bank risk? Evidence from the European CDO market – papers.ssrn.com [PDF]
- Hedge funds, CDOs and the financial crisis: An empirical investigation of the “Magnetar trade” – www.sciencedirect.com [PDF]