Collateralized Debt Obligations: An Introductory Primer

An article by New York Institute of Finance instructor Mayra Rodriguez Valladares.

There has been tremendous schadenfreude by many journalists and market participants about recent lawsuits against Standard and Poor’s and Morgan Stanley.  Allegedly, Standard and Poor’s kept doling out good ratings to Residential Mortgage Backed Securities (RMBSs) and Structured Finance Collateralized Debt Obligations (SFCDOs) issues even whilst rating analysts’ musings in colorful e-mails and even musical videos show that they knew that the collateral of these structured products was less than credit worthy.

Morgan Stanley is being sued by Chinese and Taiwanese banks for allegedly selling CDOs whilst knowing that the US housing market was imploding, something that they demonstrated in a baptism competition to name their structured products. There has been and will continue to be plenty of commentary about both of these companies’ alleged fraudulent behavior, not to mention their penchant to use e-mail at work, where there never has been an expectation of privacy. What is missing from the press reports is an explanation of the mechanics and risks of CDOs.

A CDO is a fixed income product that is structured. If it is a cash CDO, it is being backed by a wide range of debt such as commercial, leveraged or mezzanine loans. A cash CDO can also be backed by just about any type of bond imaginable including an RMBS which is being backed by residential mortgage loans.  A synthetic CD is backed by credit derivatives.  Both cash and synthetic CDOs are tranched, a word coming from the French which means a slice.  In a CDO, each tranche represents a different level of risk; hedge funds, for example, might buy the riskiest tranche precisely because it has a higher yield. If you are a more risk adverse investor, you would buy the top tranches, which are less risky and hence have a lower coupon.

Like in a Russian novel, there are numerous actors in structuring a deal.  You have a sponsor who typically is a big bank. That institution sponsors a Special Purpose Vehicle, which is bankruptcy and legally remote from the sponsor, and issues the CDOs to investors. This means that if the CDOs decline in value due to credit, market, liquidity or operational risks, dissatisfied investors have legal recourse only to the typically thinly capitalized SPV and not the sponsor.  The SPV usually has a manager who is responsible for overseeing the whole transaction and for conducting roadshows for potential investors.  S/he also oversees the buying and selling of collateral that backs the CDO issue. The collateral is bought from the sponsor or from smaller, regional banks. There is a servicer who receives interest from the collateral and pays a portion to the investors in the form of coupon. There is a trustee who is the only actor who is on the investor’s side; her/his responsibility is to make sure to receive information from the services as to the credit quality of the collateral and to send a report, usually monthly, to the investors. Sometimes there are also swap counterparties, bond counsel and numerous other actors.

It is important to note that because a CDO is a fixed income product, it has to be registered in a jurisdiction. The SPV has to publish financial reports. There will also be a prospectus and offering literature. These documents are key, because this is what potential and existing investors should read thoroughly to understand the nuances and risks of the structure. In these documents, there is typically a diagram that details who the participants are and what their role in the transaction is. These documents will often also show that a sponsor is typically quite involved in most facets of the deal. Undeniably, it is the responsibility of the investor to obtain his/her own legal, accounting, and financial advice to understand the transaction.

Rating agencies play a key role in this market, because issuers, who pay the rating agencies for the ratings of all bond issuers, will go to the rating agencies as they are structuring a deal. Depending on what they hear at those meetings, an issuer may go back to the drawing board and restructure a transaction.   In order to obtain the highest ratings possible, an issuer has access to internal and external credit enhancements. Internal credit enhancements can be how each tranche is subordinated to another. That subordination is at the heart of CDOs and other structured finance products such as MBSs and Asset Backed Securities(ABSs). If you are at the top of the waterfall, you receive the most protection from other tranche holders who have bought the riskier tranches.  Typically, if a credit even happens, they typical waterfall rules dictate that top tranche holders get paid ahead of other investors.

Another internal credit enhancement can be a short- or long-term liquidity facility that an issuer can set up for the whole transaction or only some tranches. An issuer would then have access to those facilities if a liquidity shortfall were to materialize. If the assets are paying fixed and the issuer is paying a floating rate to investors, then the issuer can set up an interest rate swap to minimize interest rate risk; that too is an internal credit enhancement.  Any of these internal credit enhancements would likely elicit a higher rating for the tranche which is covered by them as opposed to a tranche that does not have access to these enhancements. External credit enhancements are guarantees from a financial institution or monoline insurance, which given the demise of some the bond insurers, is rarely used.

Like all other fixed income products, CDO investors are exposed to credit, market, operational, and liquidity risks. It is essential that CDO investors use not only credit agency reports but also all other public information to make their investment and portfolio allocation decisions.  Moreover, bond prices and credit default spreads are also useful market signals for investors. Ratings are only one tool available for investors. At the end of the day, it always has and always will be caveat emptor.

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