History of collateralized debt obligation

The Changing Structure and Impacts of Collateralized Debt Obligations

Collateralized debt and bond obligations (CDO and CBO) have had a tenuous history since their introduction in the late 1980’s. Since their initial small-scale usage by commercial banks to remove assets from balance sheets to their widespread usage as a security by investors, commercial banks, and mortgage companies, CDOs have had mostly negative impacts on the global financial landscape.

If history is any indication of past performance, then the history of CDOs has proved that their performance has had a pronounced cyclical pattern. In the past the search for high-yielding collateral would provide alpha returns for those CDO managers who found it first. Others would notice the higher returns and bid up the price of collateral, lowering yield spreads for CDO investors. In order to achieve the same returns, CDO investors would have to lower their standards for collateral. A wave of defaults would hit and the search for a new collateral asset class would begin, leaving institutional investors, insurance companies and banks with nothing to show for their CDO investments.

It is hard to think of anyone not directly linked with the impact CDOs have had on the financial system. Home loans extended to borrowers of all types are packaged into CDOs, insurance policies are hedged with CDO assets, credit card receivables and municipal parking ticket receivables are often packaged and sold to CDO investors as well. Individual CDOs that invest in seemingly unrelated sectors of the economy link them together and pass on the good and the bad to CDO investors. As has been shown in the past, and in the present with the 2007 mortgage crisis, this can have both positive and negative implications.

Collateralized Debt Obligations: An Explanation and Early Structures

Introduction

A collateralized debt obligation is similar to a mutual fund that buys bonds, however it differs from a mutual fund in that it issues bonds instead of shares in the fund, and uses the money to purchase high-yield bonds, leveraged loans and alternative types of assets such as residential mortgages and receivables. Payments from the CDO collateral assets are used to pay back the investors who buy the CDO securities (Jacob 2004).

The CDO presence has grown in the financial landscape since its introduction in the early 1990s. Since 1998, the annualized growth rate of global CDO issuance has averaged 150% per year, transforming the CDO market from what was a $50 billion industry in 1990 into a $2 trillion industry in 2007 (Celent 2007) (see table 1). This rapid growth can largely be attributed to conditions within the economy and financial markets that have made CDOs an attractive investment option.

There are many specific details that differ between CDOs, however the common characteristic that binds them is a process known as “credit tranching.” This refers to creating multiple classes, or “tranches” of securities, each of which has a different seniority relative to others. This crucial aspect of CDOs defines them and has provided the versatility that has promoted their growth in the 1990s and early 2000’s.

Capital Structure

A CDO may issue four tranches of securities known as 1) senior debt, 2) mezzanine debt, 3) subordinate debt and 4) equity. Each tranche will protect the tranches issued above it (or, “senior” to it) from losses on the underlying portfolio. The CDO sponsor, usually a bank or an investment management firm will size each tranche so that it can attain a desired rating from a credit rating agency such as Standard & Poor’s or Moody’s. Sizing each tranche is an important step in designing a CDO because it creates the CDO “arbitrage,” the spread between yield earned on collateral and the amount paid to CDO note holders. This amount is the profit earned by the CDO and is used to pay the CDO sponsor and maintenance fees (Jacob 2004).

Source: Jacob

Shown above is a typical cash flow CDO, with each class or “tranche” listed in descending order with respect to seniority. The “Amount” of each tranche is the principal value that each investor must pay to invest in that CDO tranche. The “Amount,” in turn, accounts for the amount of collateral that each tranche is backed by. As can be seen the Class A tranche is the largest tranche in the deal: it accounts for 81% of the collateral bought by the CDO. Should defaults exceed $57 million, the principal value of this tranche would be eaten away at. The Class A tranche is the senior-most tranche in the capital structure. This means that if collateral defaults occur, it receives the most default protection of any tranche within the capital structure. The protection afforded to this tranche is given the term “subordination.” Subordination is expressed as a percentage and indicates the amount of collateral that will have to default in order for a given tranche to experience principal losses. In this example, 19% of the collateral would have to default in order for the Class A tranche to start taking principal losses. Thus, the Class A tranche has 19% subordination in the capital structure.

The principal losses would occurs as follows. Assuming a 19% loss on the collateral, the first 5% of defaults would be absorbed by the equity tranche: it is the subordinate-most tranche in the transaction. It’s value is $15 million; the first $15 million, or (5%) of defaults would wipe-out the principal value of this tranche. This would occur if the collateral that backs this tranche, be it bonds or loans, have defaulted, and the borrower cannot repay the principal amount of the loan. The equity tranche references this collateral, so a default on the collateral has the same affect, from the point of view of an investor, as a default on the equity tranche itself. As can be seen from the diagram, the equity tranche’s tenuous position as the first loss absorber means that it receives the lowest possible rating in the CDO capital structure, “not rated.”

After the first $15 million of defaults, losses on the collateral assets would work upward through the capital structure. Should losses exceed 5% of the collateral, next in line to take losses would be the subsequently most junior tranche, in this case Class E. As can be seen, because the Class E tranche is the second most tenuous in the structure, it receives the second lowest rating within the structure, BB. If losses were to exceed 8%, the class D tranche would then proceed to take losses. This tranche is not as risky as the two lower tranches and is therefore given a higher rating than the two subordinate to it. There is an inverse relationship between each tranche’s rating and it’s subordination. The greater the subordination, the lower the rating.

The incremental process of each subordinate-most tranche absorbing losses on the collateral will continue indefinitely until each tranche is valueless. When this occurs, the CDO notes themselves are said to have “defaulted,” and note holders leave the transaction having lost principal plus foregone interest. While this is occurring however, note holders have the option of selling their tranches in the secondary market at a discount. When defaults start to hit, however, credit rating agencies will downgrade the value of the notes, making them less liquid and therefore harder to sell. Naturally, CDO investors demand compensation for the amount of risk they are taking on by investing in a low tranche in the capital structure (Jacob 2004). Conversely, investors require less yield for investing in higher tranches. Each tranche’s coupon reflects the amount of risk it carries. Riskier tranches in the low end of the structure will carry higher coupons with greater default risk, while senior tranches, considered to be safer investments will carry lower coupons.

Motivation

There are many different reasons why a company might sponsor a CDO transaction. The majority of firms who sponsor CDOs are investment management firms who earn fees based on the amount of assets they manage. When these firms create CDOs they increase their income by increasing the amount of assets the have under management. These are called “arbitrage transactions,” because they are created with the intention of earning a positive spread between the yield from the collateral and payments made to note holders. Within arbitrage transactions, the majority of the profit received (if any) is received by the equity tranche with some amount going to the CDO manager as a performance-based incentive (Jacob 2004).

CDOs are also utilized by banks to remove assets from their balance sheets. A bank can remove assets from its balance sheet by creating a CDO and transferring the assets to the CDO’s portfolio. This is useful for banks under pressure to meet regulatory capital requirements. It also increases the amount of cash on hand and allows them to extend more loans. These transactions are called “balance sheet CDOs” and differ from arbitrage transactions in that they are created as a tool for banks to manage risk as opposed to being created solely for the purposes of investment as a financial instrument.

Diversification

In principal, a sponsor who creates an arbitrage CDO tries to buy a well-diversified portfolio of assets to back the CDO structure. The intention behind this is that hopefully the diversification will make the CDO structure more valuable than just the sum of it’s parts (Jacob 2004). The idea of diversification is the premise behind assessing the risk of each CDO transaction. Rating agencies and CDO managers run computer simulations to test correlation between the different types of portfolio collateral. Bonds in the CDO portfolio that are issued by companies in different industries are assumed to have little correlation. Bonds issued by companies in the same industry are assumed to have greater correlation. The same concept holds when assessing risks between asset-backed-securities sectors, which are even more complex due to the uncertainty surrounding their collateral assets, this was a major challenge within the shifting CDO landscape in 2003. The correlation between assets in a CDO portfolio is an important assumption for assessing the risk of each CDO and predicting it’s performance. Increased diversification will allow the CDO manager to get a higher credit rating on the senior tranches. A higher rating means that investors will perceive the tranche as a safer investment and will therefore demand a lower coupon than if the tranche were to a lower rating. The lower coupon increases the CDO manager’s profit by increasing the difference between yield on the collateral and the coupon paid on CDO notes.

Improper assumptions about a CDO’s diversification can misstate performance and lead to incorrect assumptions by managers and credit rating agencies about the strength of the structure. In the past, the complexity of these assessments led to downgrades on CDO tranches by credit rating agencies and forced agencies to rethink their assumptions about correlation between assets in different industries. From 1995-1999 CDOs invested primarily in low-rated, high-yielding bonds with the hope that adequate diversification would enhance the credit quality of the underlying portfolio. The ratings of individual bonds didn’t matter as much as the diversification that was needed to improve ratings on senior tranches. Improved ratings would allow for lower coupons and would therefore provide positive spread between collateral and CDO notes. Heavy high-yield bond investment from CDOs was a byproduct of high-yield bonds issued in the late 1980s that were maturing toward the end of the 1990s and were becoming suitable for CDO investment. In 2001, the massive investment in high-yield assets officially ended due to defaults that occurred as a result of decreasing spreads and downgrades on CDOs that held those assets. At that time, many thought that CDO managers focused too broadly on achieving diversity in the CDO portfolio without paying enough attention to the credit quality of the individual assets. From 2001-2003, the opposite occurred, and CDO managers focused on investing in high-rated investment grade debt, sacrificing short term yield for longer term safety of principal (Gibson 2005) .

While it may seem that greater diversity, ceteris paribus, can be beneficial to the CDO, in actuality, it benefits only senior note holders. As was proven in the late 1990s with high-yield debt, low correlation reduces portfolio volatility, which protects senior note holders from defaults on bonds in the portfolio from any one sector of the economy. Should defaults occur in a portfolio with high correlation, junior tranches might not have enough size to cushion the blow of defaults on the entire portfolio. A senior note holder in a $200 million CDO structure invested solely in bonds of retail companies faces a greater risk than a senior note holder in a CDO with 10% collateral invested in retail company bonds. If retail bonds were to default, the value of the senior note holder’s tranche in the 100% retail bond structure would be downgraded and the senior tranche would lose 100% of it’s value. The note holder in the diversified portfolio may experience a downgrade due to less subordination as well, but the value of his note stays intact because subordinate tranches would absorb the losses.

The opposite holds for equity investors. Due to the nature of correlation and equity investment, these investors tend to seek volatility due to the possibility of greater returns. Using the same example, if the owner of an equity tranche calculated a 65% probability of a $50 million upside on the collateral, and a 35% probability of default, he would view the tranche as a good investment as his profit is directly linked to the $32.5 million expected capital gain on the portfolio. When the cash is received the equity investor will receive the residual cash after the senior tranches receive coupons. However the senior tranches will receive the same payments regardless of whether or not the collateral had appreciated in value. The equity tranche holders participate in this upside due to their participation as equity investors, while senior note holders do not because they are debtors. The volatility of the portfolio therefore presents the opportunity for capital gains, and therefore greater returns, for the subordinate tranche. This explains equity tranches as popular investment channels for hedge-funds and high-yield debt funds with greater appetites for risk, and conversely the role of senior tranches as conservative investments held by the likes of insurance companies and pension funds.

The Life of a CDO and Performance Tests

The inexperience of banks with CDOs during the 1990s created the need for benchmark tests to ensure the safety for investors. These tests have evolved over time. Currently the CDO investment must conform to the following principles. The assets purchased by the CDO manager must meet predefined parameters specified in the contract terms of the CDO. These parameters ensure that the CDO manager purchases assets that provide adequate diversification to protect senior tranches while at the same time yielding enough spread over note coupons to make the transaction profitable. For example, a CDO manager may be required to maintain a minimum average rating, a minimum average yield, and a maximum average maturity that falls within these guidelines. All these parameters must be satisfied or else the safety and the performance of the CDO may be compromised and the CDO may be forced into receivership by note holders. This period of investing in the initial portfolio assets, which lasts from two to three months is called the ramp-up phase (Jacob 2004).

When the CDO is fully vested, the manager actively manages the underlying portfolio by placing trades and reinvesting cash flows from the amortization of bonds and the maturity of assets within the portfolio. This is called the reinvestment phase because all cash received from the underlying assets is reinvested in collateral instead of being used to repay note holders. The manager is only allowed to invest in assets that meet the specified minimum requirements laid out in the CDO contract and is therefore subject to constraints that may limit his ability to find assets appropriate for investment as CDO collateral. For example, a CDO manager unable to invest in bonds within a particular industry due to diversity requirements, will be forced to invest cash in low-yielding short-term assets while he’s searching for assets suitable as CDO collateral. During this time, note holders may suffer from “negative arbitrage,” whereby the yields on the collateral assets will not be enough to pay tranche coupons.

After the reinvestment phase, which lasts from three to five years, the CDO must repay it’s own securities with cash generated from the collateral. This is known as the “amortization phase,” and it is the last phase in the life of a CDO. Instead of reinvesting proceeds on eligible collateral assets the manager must apply the cash toward its own notes, ending the CDO transaction (Gibson 2005).

Often times, however, defaults and missed interest payments may reduce the value of the collateral below certain predefined limits. For example, most transactions require “overcollateralization ratios,” set forth in the contract, that require the par value of collateral to exceed the par value of notes by a certain amount. Transactions also have “interest coverage tests” which specify that interest cash flow generated by the collateral exceed that paid to notes by predetermined amounts. When either of these two ratios slip below the required limit, signaling that the CDO’s performance has deteriorated, the CDO enters the amortization phase in a process known as early amortization. At this point, the CDO manager is no longer able to invest cash proceeds in collateral, but must use the proceeds to repay CDO’s notes and end the transaction. This is generally a huge disappointment for investors and sponsors alike as early amortization results in million dollars losses associated with legal fees, taxes, salaries and transactions costs assumed in order to acquire collateral assets.

These type of CDO transactions account for 85% of CDOs outstanding (SIFMA 2007). Since the beginning of their widespread use as financial instruments, CDOs have taken on different forms characterized by structural characteristics and types of collateral assets. Beginning with the first CDO issuance in 1987 the CDO structure has grown in complexity to include a wide range of assets from asset back securities to high-yielding leveraged loans.

The CDO structure has taken two forms that have characterized its presence since its inception. From 1990-1995 the basic “cash flow structure” was utilized, whereby cash raised by issuing CDO notes was used to purchase collateral. (Gibson 2005) During these years, the CDO market averaged $1.4 billion outstanding; comparatively small when considering that in 1999, the total value of CDOs outstanding was estimated to be around $120 billion (Celent 2007). The drastic increase can be attributed to the rising popularity in “synthetic” CDOs; CDOs that make use of a credit derivative instrument known as a “credit default swap (Jacob 2004).” Whereas before 1995 the CDO market was driven solely by cash flow structures backed by high-yield debt, popularity started to decline due to decreasing yield spreads that made these types CDOs unprofitable. The resurgence in the popularity of CDOs between 1995 and 2000 can be attributed to growth in synthetic CDOs, which in 2003 accounted for 75% of all CDOs outstanding (Tavakoli 2003).

In a synthetic CDO the senior-most, called the “super-senior” tranche will be unfunded and will indirectly reference collateral assets through a credit default swap, whereby the senior tranche holder will enter into an agreement with a bondholder to pay the bondholder the principal amount of a particular bond should his bonds default (Tavakoli 2003). In return for taking on this risk, the senior-most tranche receives periodic interest payments from the bond holder. These interest payments will in some way index the payments on the bond referenced by the credit default swap transaction and will be used to pay coupons on the tranches in the CDO transaction.

The senior note in a synthetic transaction is “unfunded,” meaning that the note holder does not pay cash to buy into the CDO. There isn’t any collateral to buy. Instead, the note holder will receive periodic interest payments from the swap agreement and will have to repay the owner of the referenced bonds should defaults occur.

Conversely, the subordinate tranches in a synthetic transaction will be funded and will purchase low-risk, investment-grade assets which will serve to protect the senior tranche from losses. Should the assets referenced by the credit default swap, default, the losses would work up the capital structure the same way they would in a cash flow CDO, wiping out the value of the subordinate tranches. In return for payments on referenced assets, the subordinate note holders and unfunded senior note holders must pay the credit default swap protection buyer the full amount of defaulted principal, which will come from sales of collateral purchased by subordinate tranches. However, selling this collateral wipes out the value of subordinate tranches. For investors in a synthetic CDO, the occurrence of a default under the credit default swap agreement has the same effect as a collateral default in a cash flow transaction.

In order to understand the rising popularity of synthetic CDOs it is important to understand the motivation behind the transaction that distinguishes them from arbitrage cash flow transactions. Cash flow arbitrage transactions, such as the one described above are designed with the CDO investor in mind as a way of designing an asset that will provide above-market returns. Synthetics have been used as a way for commercial banks to remove assets from their balance sheets; except that instead of removing them from their balance sheets, they are mitigating their exposure to those assets by setting up a credit default swap and taking ownership in the un-funded senior tranche. When assets referenced by the credit default swap default, the losses are passed down to subordinate tranche holders. Loan defaults that occurred as result of the savings and loan crisis in the early 1990s presented a risk to subordinate tranche investors for this reason.

From the standpoint of CDO investment, the potential for moral hazard is greatly increased. In selling off assets that in are some way flawed the risk is transferred to investors at a lower price due to the senior tranche’s credit enhancement from subordinate tranches. Whereas an arbitrage cash flow transaction will buy a diversified pool of assets in the interests of investors, the subordinate tranches in a synthetic CDO act merely as a buffer to protect the senior tranches from losses on the credit default swap.

Janet Tavakoli, in her review of synthetic CDOs in the International Financing Review attributes the expansive growth of synthetics to two primary economic drivers. The first is the unfunded senior tranche which, due to its nature and its low price relative to AAA tranches that are priced below it, allow it to be large and provides for greater flexibility than tranches in cash deals. The second driver has been the equity tranche’s leveraged exposure to high-quality collateral assets. Because the senior tranches tend to be much larger than equity tranches relative to cash flow deals, the equity tranche benefits by gaining access to capital via the senior tranches. This makes it a popular investment medium for investors seeking higher returns than those offered by senior tranches. While the exact amount of growth experienced by unfunded synthetic CDOs is not known, the Securities Industry and Financial Markets Association has estimated the total volume of issuance in 2007 to be around $400 billion (SIFMA 2007). Traditionally, they have been lower-risk than the standard cash flow CDOs and therefore haven’t gained as much attention, but they still accounted for approximately 25% of CDOs issued in 2007 (SIFMA 2007).

The End of High Yield CDOs and Leveraged Loans

When heavy investment in high-yield debt became unpopular in 2001-2003 due to downgrading from large-scale defaults form corporations such as Enron and MCI WorldCom, structured products replaced them as the popular investment medium. As will be seen, the widespread involvement in structured finance products had implications that extended beyond Wall Street. The nature of structured products and their rise to popularity during this time later proved harmful to commercial banks, insurance companies and the American consumer during the 2007 credit crunch.

From 2001-2003, the United States was in a stage of economic uncertainty. Consumer confidence was low due to the events of 9/11 and investment in US equities halted due to uncertainty about corporate fraud and the future state of the United States economy. Americans stopped consuming and started channeling funds into Treasury bonds and savings accounts. The halt in consumer spending meant massive reductions in business revenue and an increase in unemployment while businesses were forced to write-down the value of large capital investments made in fiber-optic cable and information technology.

The companies most affected by these events were highly-leveraged tech-startups with uncertain credit histories. Many of these companies, faced with having to pay high interest rates to borrow money, defaulted on their borrowings. Because the companies borrowed at high interest rates due to their uncertain credit histories, the bonds they issued were given low ratings and were considered high yield. These companies were very sensitive to economic changes; when revenues declined, operating income didn’t sufficiently cover their interest payments, forcing them to halt payments or go into receivership.

CDO investors happened to be direct recipients of these defaults due to their status as investors of CDO notes backed by high-yield bonds. The nature of the CDO at the time as an instrument that sought to earn a spread between coupons on high-yield collateral and interest payments on inexpensive debt made them vulnerable to these adverse credit events and negative macroeconomic trends. The combination of defaults on these securities and decreasing spreads in 2002 created a substitution effect away from high-yield bonds and leveraged loans, forcing CDOs to “reinvent themselves” (Gibson 2004). Defaults and write-downs meant lower performance and negative arbitrages resulting in a search for higher-yielding collateral. Investment grade bonds gained popularity from 2002-2003 at a time of low interest rates (the fed funds rate at the time was 1.5%), however increased popularity quickly drove spreads down and forced CDO managers to continue their search.

Structured Finance CDOs Become Popular

Starting in late 2003, spending picked up as consumers took advantage of low interest rates. Specifically, consumers took advantage of attractive financing deals from mortgage lenders and captive financing from companies such as GMAC and FMCC, spending heavily on automobiles and homes. Mortgage lending had the biggest impact on consumer spending and sparked home sales and home-equity financing. Financing companies would package these loans and sell them as structured products to investors. From the perspective of CDO investment, these assets offered investment possibilities. A cyclical pattern developed; the demand for loans was high, brokers were more than willing to find borrowers because of their fee-based compensation and lenders could package loans and sell them to CDO investors at a very small discount from par value.

The most infamous type of mortgage deals that became popular during this time were 30-year adjustable rate mortgages. These mortgages were targeted toward low-income individuals with higher expected income in the future. Such mortgages charge an initial “teaser rate” (usually below 5%) for the first 1-5 years of the loan and then reset annually to the U.S. Treasury 1-Year Constant-Maturity Securities rate, the interest rate benchmark for mortgages. The potential for high yields during the interest rate adjustment period made these instruments popular investment collateral for CDOs. The demand from CDOs for these loans increased lending activity to the extent that lenders would recklessly extend adjustable-rate mortgages without having to take into account the borrower’s credit risk involved. From the perspective of the lender, the incentive to extend loans was driven by loan securitization fees from banks. The process of packaging loans and selling them to CDOs reduced the incentive for lenders to maintain lending standards because the default risk was transferred from lending companies to CDO investors.

Effects of CDOs on The 2007 Credit Crunch

The demand from CDOs for high-yield mortgage-backed collateral was a primary driver behind homes sales in early 2003-2004 and paved the way for defaults that occurred when rates started to reset in late 2006. Looking at table 2, it easy to see why waves of defaults in 2006-2007 occurred on adjustable-rate mortgages originated in 2003. Monthly payments based on 2003 benchmark rates of 1.5% were significantly lower than 2006 rates of close to 6%. On a $300,000 mortgage, the 4.5% difference equates to a difference in total yearly payments of $13,500. Resets similar to this have hurt young borrowers with limited disposable income who have been targeted by these lending practices.

The result of this lending activity has been negative for American consumers and businesses and has compromised the health of the American financial system. The massive defaults have forced banks to heighten their lending standards making it hard for businesses to obtain short-term credit and finance expansion. This has resulted in bankruptcies and cash injections from central banks in order to prevent a freeze in the financial system. Those businesses directly involved such as homebuilders, mortgage lenders, investment banks and money managers have had lay off entire divisions due to a drying up of business within their mortgage-related divisions.

The CDO structure can be blamed somewhat for the damage done. The nature of CDOs as an off-balance-sheet entity means that they aren’t subject to the SEC and FDIC regulations that large corporations are bound to. Whereas a mutual fund will have to disclose to investors and the SEC their holdings, and are bound by regulations to receive certain tax exemptions, CDOs exist as a means of bypassing these regulations. The original usage of CDOs in the early 1990s as a tool to remove junk bonds from the balance sheets of commercial banks, proves there innate flaws as a medium for investment.

Conclusion

The economic consequences of each individual’s role within a CDO transaction support failure as a likely outcome, given the conflicts of interest between CDO managers and senior debt holders. Senior debt holders buy senior tranches with the expectation that the total value of their principal plus interest will be paid back in timely fashion. They receive a modest coupon in return for their safe investment. Conversely, equity tranche holders wish the opposite, seeking capital gains from sales on the underlying assets (Gibson 2005). When sponsors of actively-managed arbitrage CDOs grant ownership of the equity tranche to CDO managers as an incentive-based fee, a conflict of interest results, usually to the detriment of the senior note holders with much more money at stake than sponsors solely vested in the equity tranche. It is in the best interest of the manager to buy risky assets that will result in capital gains to increase the amount of money he receives in the transaction. However, senior debt holders would rather protect their principal and receive coupon payments. In order for the two sides to co-exist, both must sacrifice their well-being for the good of all those involved transaction. Unfortunately, because the manager makes the investment decisions, the senior tranches will suffer. Losses on senior tranches will occur and major write-downs on these highly-rated securities will occur.

Since their introduction as an asset class, the AAA-rated senior tranches of CDOs have been advertised by CDO managers as bearing the same risk as AAA-rated corporate bonds while offering higher coupons. As can be shown from the $64 billion in CDO write-downs on senior and junior CDO tranches in 2007 (Bernstein 2007), such ratings serve only to mislead investors into thinking that they can achieve above-market returns from a mosaic of B-rated collateral, while still making a virtually risk-less investment. The ever-changing composition of CDO collateral has proven that this has only been possible for the managers who could exploit those valuable arbitrage opportunities first. As spreads tightened, managers were forced to buy progressively cheaper collateral in order to maintain arbitrage, leading to results that would be expected from this low-rated debt.

The nature of CDOs as entities designed to exploit market imperfections has had negative consequences on the economy and lends evidence to tremendous risks involved from the standpoint of CDO investment. One may argue that CDOs increase the availability of credit for businesses and consumers by taking on risk that would otherwise be off-limits to regulated banks. However, the history of CDO performance proves the dangers involved with bypassing these regulations that are set forth in the best interests of the players in the CDO markets themselves. The series of loan defaults in 2001-2003 and in 2007 serve as a microcosm of what could occur if players in the financial system are left to their own devices.

Tables

Table 1

Source: www.Celent.com Celent

Table 2

Source: Federal Reserve

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