In simple terms a CDO is the debt issued by a specially incorporated entity (SPV) to finance the purchase of assets.( CDO also refers to the SPV ). Typically the assets are bonds, loans, mortgages and receivables. Entity holds the assets as collateral and sells packages of cash flows to investors.
CDO has 4 aspects:-
- Assets (underlying of CDO)
- Tranches (Capital structure)
- Credit structure
Here is some varities of CDOs
Based on the underlying asset-CDL,CBO, CSOs backed by credit derivatives, SFCDO’s backed by structured products (ABS, MBS)
Based on how the assets gain exposure: cash purchase and synthetic CDO
Based on the purpose:-arbitrage and balance sheet
Based on the credit structure:-market value and cash flow
Why would any one issue CDO : Advantages to the originator:-
Reduction of credit risk and capital usages as assets are removed from originator’s balance sheet
Long term funding of assets at reduced cost of funding
Diversification of funding sources
Transfer of risk to investors
Generation of fee income
Why would anyone invest in CDO given the amount of risk and leverage :Advantages to the investor:-
Provides various choices to choose from very safe to risky instruments to invest in and accordingly returns.
Relatively higher yields when compared to corporate and asset backed securities of same maturity and ratings
Exposure to a new asset class.
The financial crisis :
Mainly due to:-
CDO’S backed by RBMS, CMBS, sub prime mortgages
Borrowers defaulted on their payments due to falling housing prices, foreclosure, decrease in their home equity and problems associated with refinancing
Payments to investors holding the CDO cannot be made
Also due to complicated leveraged, synthetic structures involving CDS and CLN, taking a bet on reference entity
Defaulting of holders of sub prime mortgages –due to increased interest and principal payments, falling housing prices, increase in foreclosures, downturn in real estate market prices and bursting of the housing bubble, inability of the holders of loans to refinance the same due to falling home equity.
Rise in sub prime mortgage defaults linked to rise in default rates of CDO
Cause for creation of housing bubble.
Economic cause (linking it to actual real economy).
Lenders misjudged (CDO, price)
Downgrading of securities due to borrowers defaulting
Mark to marketing of assets-leading to massive write downs
Ultimate investors in debt turn off
Role of credit ratings-credit rating conflict of interest since it was issuer funded ratings
Role of investment bankers (CDOs).
Speculative use of CDS and CDO-example of AIG failure very imp can take it as case study)
Insurance industry issues