Basics of Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are backed by a portfolio of bonds or loans.  They can be split into collateralized bond obligations (CBOs) and collateralized loan obligations (CLOs).  A CDO deal is structured with a special purpose vehicle (SPV) that is legally domiciled in Delaware or Massachusetts.  The SPV is isolated financially from the sponsor through "bankruptcy remote".  If the sponsor goes bankrupt, the SPV is unaffected.  The SPV buys bonds and loans from banks, insurance companies, etc. and issues new securities against the collateral.  The payment flows of the original bonds and loans are used to pay the interest and dividends on the new securities.  The principal is paid at the end of the SPV's life by selling the bonds and loans.  The new securities of the CDO have different classes called tranches - senior, mezzanine and equity.  Cash flows from the collateral are used to pay of the obligations of the senior tranche first, then mezzanine and equity.  The securities are issued privately to institutional investors.

Banks receive six main benefits from CDOs:

• Reducing regulatory capital - This is based on the amount of outstanding loans of a bank.  By selling the loans to an SPV removed it from the regulatory capital calculation.
• Increasing loan capacity - If the bank sells its loans to an SPV, it may take the proceeds to make new loans
• Improving ROE/ROA - The bank can take the proceeds of loan sales to pay down its debt, reduce its capital base and increase the amount of high yield assets
• Reducing capital concentration - By selling loans to an SPV, the bank can increase its loan capacity to sell to a particular industry when it has reached its credit exposure limit.  It also can help manage their exposure to leveraged loans.
• Preserving customer relationships - A bank may own too much debt from a client.  It may be sold to a SPV.  Since the bank is running the portfolio for the SPV, the client does not know that the loan has been sold.  The client does not get upset with the bank.
• Competitive positioning - CDOs with high yields attract institutional investors

CDOs usually have credit enhancement to receive an investment grade credit rating from Standard & Poor's, Moody's or Fitch's.  However, the interest rate on these CDOs are lower and less attractive to investors.  They are:

• Subordination - When lower level tranches provide credit support to more senior tranches
• Overcollaterization - When lower level tranches proved additional collateral to a senior tranche
• Spread enhancement - Funds used to cover losses in a CDO.  If there are no losses, the funds go to the equity (lowest) tranche.
• Reserve account / cash collateral - Excess cash in US Treasuries or commercial paper used to support credit
• External credit enhancement - CDO manager may purchase credit default swaps, put options or an insurance contract to protect against defaults in the loan portfolio

We will look at the different types of CDOs in later articles.