History of collateralized debt obligation

The History of Collateralized Debt Obligations

Introduction

Anyone familiar with the terms CDO and CBO will probably link them with the 2007 mortgage crisis. But collateralized debt and bond obligations (which the terms CDO and CBO stand for) 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 into their widespread usage in the 21st century by investors, commercial banks, and mortgage companies, CDOs have transformed the financial landscape.

If history is any indication of past performance, then the history of CDOs have 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 the price of the collateral, lowering yields for CDO investors. In order to achieve the same returns, CDO investors would have to lower their standards. 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.

This paper will start with an introduction to the CDO structure as it started out in the early 1990s and then progress to 2007, introducing the changes that have occurred within the CDO structure and the implications these have had on the economy. Given the widespread usage of CDOs, it is important to understand the long-term and far-reaching impacts they have on the worldwide economy. It is hard to think of anyone who is not directly linked with CDOs or the asset securitization process. Home loans extended to borrowers of all types are packaged into CDOs, insurance policies are hedged with CDO assets, credit card receivables, 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

A collateralized debt obligation is similar to a mutual fund that buys bonds. A collateralized debt obligation 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.

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. from what was a $50 billion industry in 1990 (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.

File:CDOMARKET

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 create the CDO “arbitrage,” the spread between yield earned on collateral and the amount paid to CDO note holders. This spread represents that value-added by creating the CDO and is used to pay the CDO sponsor and maintenance fees. The following example will illustrate the structure of a CDO transaction.

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 buy 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 protection from the lower tranches in the capital structure. This 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 it 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 his loan. The equity tranche references this collateral, so a default on the collateral has the same affect of 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 work their way up the capital structure. When 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. Continuing on, ff losses were to exceed 8%, the class D tranche would then proceed to take losses. It is not as risky as the two lower tranches and it is therefore given a higher rating than the two below 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 wiped out. When this occurs, the CDO notes 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. However when defaults start to hit, credit rating agencies will downgrade the value of the notes, making them less liquid and 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. 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.