A collateralized debt obligations (CDO) is a debt security that is collateralized by a set of debt instruments, such as bonds or mortgages. The CDO is a credit derivative.
The issuer of the CDO (protection buyer) generally uses it to hedge a portfolio of assets with credit risk. Although it can also be used to enter a short position against that debt.
The process that transforms these individual assets into a CDO is securitization, taking place off the bank’s balance sheet, for which a special company is created in order to manage, structure and administer the risky assets.
Therefore, CDOs have cash flows that are backed by a portfolio of assets with debt, which can be any debt instrument, public and private bonds, mortgages, loans and even another type of CDO. CDOs that are backed by other CDOs are known as synthetic CDOs.
Structure of CDOs
When structuring debt assets, the resulting CDOs may have better or worse credit quality than structured debt, depending on how the structuring is carried out.
Imagine that you have just started a business to buy and sell houses. When you have bought your first home and you are renting it to someone else, you may not have enough money to buy a second home, because with the payment you receive from the rent it would take years to gather the money necessary to get another one. What you could do would be to mortgage the home you bought and with that money buy a second home. Well, banks do something similar, but when it comes to mortgaging the house, what they do to get money is to securitize that house, by issuing bonds backed by that house. That is, if they cannot pay the bonds because the bank fails, the buyers of those bonds keep the house.
To create title bonds or CDOs, a bank creates a company that is responsible for buying those bonds that the bank has issued to securitize the previous house and other houses. Afterwards, the company securitizes all those bonds (or debt instruments), issuing new bonds that are backed by the previous bonds, that is, if the company cannot pay, we keep the bonds, the ones that are backed by the houses.
To create these CDOs, the issuer packages debt instruments and divides them into different classes, which could be assimilated to different tiers (or tranches ). Each tranche has a different order of priority compared to the portfolio (collateral) to which they are linked, in addition to the different exposure to a default risk of the portfolio assets.
But these bonds are not made only with home debt, but with many other types of assets.
Types of securitization bonds (CDOs)
Depending on the securitized asset, there are different CDOs:
- Collateralized bond obligations (CBO) → bonds.
- Collateralized loan obligations (CLO) → loans.
- Residential mortgage-backed securities (RMBS) → home mortgages.
- Commercial mortgage-backed securities (CMBS) → commercial mortgages.
- Asset-backed securities (ABS) → include different assets (for example, credit cards).
It is very common to find a CDO with the structure that appears in the diagram below. Where there are different tiers ( tranches ): senior debt, mezzanine debt and shares. Each of them will respond differently depending on the rung they are on.
- Senior debt: They will be those with the best credit quality, the least risky and the safest. They usually have a AAA rating .
- Mezzanine debt: They will be a little more risky than the previous ones, therefore, they will pay a higher coupon .
- Actions: It is the step with the highest risk. Therefore, it is the first to incur losses. It has no rating.
In the structuring process, the portfolio (collateral) is first bought from the bank, in the example it contains 200 million euros that are paid for the sale of the different bonds that have been structured (the different tiers).
In this case, we have three steps:
- Senior debt with a AAA rating that promises an interest rate of 4% (160 million euros).
- Mezzanine debt with a BB rating that promises an interest rate of 7% (30 million euros).
- Shares that are not rated (10 million euros).
The cash flows that come from the asset portfolio (collateral) will be paid based on the order of priority, that is, what is known as the “cascade of cash flows”. In this example, the bonds will pay interest of 12 million euros annually, assuming there is no default and covering the commissions, to later pay the interest to the different levels and end up in the shares.
Therefore, we have senior debt (4% x 160 million = 6.4 million) and mezzanine debt (7% x 30 million = 2.1 million). For the part of the shares will be then (12 million – 6.4 million – 2.1 million), that is, 3.5 million.
In the event that a default occurs in the portfolio, the order of losses is the opposite of the cascade of cash flows.