Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed-income underlying assets. CDO securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.
In simple terms, think of a CDO as a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first.
CDOs can be created as long as global investors are willing to provide the money to purchase the pool of bonds the CDO owns. CDO volume grew significantly between 2000–2006, then declined dramatically in the wake of the subprime mortgage crisis, which began in 2007. Many of the assets held by these CDOs had been subprime mortgage-backed bonds. Global investors began to stop funding CDOs in 2007, contributing to the collapse of certain structured investments held by major investment banks and the bankruptcy of several subprime lenders.[1][2]
A few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that CDOs, other ABSs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the subprime mortgage crisis in 2007, this view has gained substantial credibility. Credit rating agencies failed to adequately account for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs with the highest possible grade.
Many CDOs are valued on a mark to market basis and thus experienced substantial write-downs as their market value collapsed during the subprime crisis, with banks writing down the value of their CDO holdings mainly in the 2007-2008 period.
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The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation on June 22, 1990.[3][4][5] A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles.
CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Economist Mark Zandi of Moody's Analytics wrote that various factors had kept interest rates low globally in the years CDO volume grew, due to fears of deflation, the bursting of the dot-com bubble, a U.S. recession, and the U.S. trade deficit. This made U.S. CDO backed by mortgages a relatively more attractive investment versus say U.S. treasury bonds or other low-yielding, safe investments. This search for yield by global investors caused many to purchase CDOs, trusting the credit rating and without fully understanding the risks.[6]
CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDOs declined from 2000–2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets.[7] In addition, financial innovations such as credit default swaps and synthetic CDO enabled speculation on CDOs. This dramatically increased the amount of money that moved among market participants. In effect, multiple insurance policies or wagers could be stacked on the same CDO. If the CDO did not perform per contractual requirements, one counterparty (typically a large investment bank or hedge fund) had to pay another. Michael Lewis referred to this speculation as part of the "Doomsday Machine" that contributed to the failure of major banking institutions and smaller hedge funds, at the core of the subprime mortgage crisis.[8] There are allegations that at least one hedge fund encouraged the creation of poor quality CDOs so bets could be made against them.[9][10][11]
Willingness to create CDOs and sell them to investors may also reflect the greater profit margins that CDOs provide to their originators, such as major investment banks and other participants in the shadow banking system, as well as in the traditional depository banking system. Investment banking and credit rating agency profits increased dramatically in the years leading up to the crisis.[12] From 2000-2006, structured finance (which includes CDOs) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase sixfold and its earnings grew by 900%.[13]
Further, depository banks used CDO as a form of securitization, meaning that the bank did not have to hold the loans it originated on its books and could transfer them (along with related risk) to investors. This in turn enabled the banks to lend again, remaining in compliance with capital requirement laws and generating additional origination fees.
Another factor in the growth of CDOs was the 2001 introduction by David X. Li of Gaussian copula models, which allowed for the rapid pricing of CDOs.[14][15]
In late 2005 research firm Celent estimated the size of the global CDO market at USD 1.5 trillion and projected that the market would grow to nearly USD 2 trillion by the end of 2006. Synthetic CDO also expanded under the tenure of Federal Reserve chairman, Alan Greenspan who later expounded on the previously unrecognized risk of these devices in his testimony to a Congressional investigative committee on April 7, 2010.[16]
| USD bil. | |
|---|---|
| 2004 | 157.4 |
| 2005 | 251.3 |
| 2006 | 520.6 |
| 2007 | 481.6 |
| 2008 | 61.9 |
| 2009 | 4.3 |
| 2010 | 8.0 |
CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO is a type of asset-backed security. To create a CDO, a corporate entity is constructed to hold assets as collateral and to sell packages of cash flows to investors. A CDO is constructed as follows:
One analogy is to think of the cash flow from the CDO's portfolio of securities (say mortgage payments from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, then junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranch investors face the losses first.
The risk and return for a CDO investor depends directly on how the tranches are defined, and only indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all asset-backed securities, enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated.
The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. Economist Mark Zandi wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."[6]
In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This explains why some CDO became entirely worthless, as the equity layer tranches were paid last in the sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of which defaulted) to trickle down to the equity layers.
CDO is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follow:
CDOs are bonds issued by special purpose vehicles that are backed by pools of bonds, loans or other debt instruments. CDOs are typically issued in classes or “tranches” with some being senior to others in the event of a shortfall in the cash available to make payments on the bonds. The issuer of a CDO typically is a corporation established outside the United States to avoid being subject to U.S. federal income taxation on its global income. These corporations must restrict their activities to avoid U.S. tax; corporations that are deemed to engage in trade or business in the U.S. will be subject to federal taxation.[19] However, the U.S. government will not tax foreign corporations that only invest in and hold portfolios of U.S. stock and debt securities because investing, unlike trading or dealing, is not considered to be a trade or business, regardless of its volume or frequency.[20]
In addition, a safe harbor protects CDO issuers that do actively trade in securities, even though trading in securities technically is a business, provided the issuer’s activities do not cause it to be viewed as a dealer in securities or engaged in a banking, lending or similar business.[21]
CDOs are generally taxable as debt instruments except for the most junior class of CDOs which are treated as equity and are subject to special rules (such as PFIC and CFC reporting). The PFIC and CFC reporting is very complex and requires a specialized accountant to perform these calculations and tax reporting.
A) Based on the underlying asset:
Note: In 2007, 47% of CDOs were backed by structured products, 45% of CDOs were backed by loans, and only less than 10% of CDOs were backed by fixed income securities.[23]
B) Other types of CDOs include:
The collateral for cash CDOs include:
Participants in a CDO transaction include investors, the underwriter, the asset manager, the trustee and collateral administrator, accountants and attorneys. Beginning in 1999, the Gramm-Leach-Bliley Act allowed banks to also participate.
Investors have different motivations for purchasing CDO securities depending on which tranche they select. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities (e.g. corporate bonds) of a similar rating. In some cases, investors utilize leverage and hope to profit from the excess of the spread offered by the senior tranche and their cost of borrowing. This is because senior tranches pay a spread above LIBOR despite their AAA-ratings. Investors also benefit from the diversification of the CDO portfolio, the expertise of the asset manager, and the credit support built into the transaction. Investors include banks and insurance companies as well as investment funds.
Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Mezzanine notes and equity notes offer yields that are not available in most other fixed income securities. Investors include hedge funds, banks, and wealthy individuals.
The underwriter, typically an investment bank, acts as the structurer and arranger of the CDO. Working with the asset management firm that selects the CDOs portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche.
The key economic consideration for an underwriter that is considering bringing a new deal to market is whether the transaction can offer a sufficient return to the equity noteholders. Such a determination requires estimating the after-default return offered by the portfolio of debt securities and comparing it to the cost of funding the CDOs rated notes. The excess spread must be large enough to offer the potential of attractive IRRs to the equityholders.
Other underwriter responsibilities include working with a law firm and creating the special purpose legal vehicle (typically a trust incorporated in the Cayman Islands) that will purchase the assets and issue the CDOs tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading restrictions that will be included in the CDOs transaction documents and other files.
The final step is to price the CDO (e.g. set the coupons for each debt tranche) and place the tranches with investors. The priority in placement is finding investors for the risky equity tranche and junior debt tranches of the CDO. It is common for the asset manager to retain a piece of the equity tranche. In addition, the underwriter was generally expected to provide some type of secondary market liquidity for the CDO, especially its more senior tranches.
According to Thomson Financial, the top underwriters before September 2008 were Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America Securities. CDOs are more profitable for underwriters than conventional bond underwriting due to the complexity involved. The underwriter is paid a fee when the CDO is issued.
The asset manager plays a key role in each CDO transaction, even after the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDOs portfolio. The manager can maintain the credit quality of a CDOs portfolio through trades as well as maximize recovery rates when defaults on the underlying assets occur.
With the credit crisis of 2007-2008, the lack of understanding of the vast majority of financial managers of the risks of CDOs, asset-backed securities, and other new financial instruments became apparent, and moreover the lax diligence from the major credit rating agencies became clear. CDOs were heavily downgraded across the board, and the value of these instruments dropped dramatically.
In theory,the asset manager should add value in the manner outlined below, although in practice, this did not occur during the credit bubble of the mid-2000s (decade). In addition, it is now understood that the structural flaw in all asset-backed securities (originators profit from loan volume not loan quality) make the roles of subsequent participants peripheral to the quality of the investment.
The asset manager's role begins before the CDO is issued. Months before a CDO is issued, a bank will usually provide financing to enable the manager to purchase some of the collateral assets that may be used in the forthcoming CDO in a process called warehousing.
Even by the issuance date, the asset manager often will not have completed the construction of the CDOs portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend for several months after the CDO is issued. For this reason, some senior CDO notes are structured as delayed drawdown notes, allowing the asset manager to drawdown cash from investors as collateral purchases are made. When a transaction is fully ramped, its initial portfolio of credits has been selected by the asset manager.
However, the asset manager's role continues even after the ramp-up period ends, albeit in a less active role. During the CDOs "reinvestment period", which usually extends several years past the issuance date of the CDO, the asset manager is authorized to reinvest principal proceeds by purchasing additional debt securities. Within the confines of the trading restrictions specified in the CDOs transaction documents, the asset manager can also make trades to maintain the credit quality of the CDOs portfolio. The manager also has a role in the redemption of a CDOs notes by auction call.
The manager's prominent role throughout the life of a CDO underscores the importance of the manager and his or her staff.
There are approximately 300 asset managers in the marketplace. CDO Asset Managers, as with other Asset Managers, can be more or less active depending on the personality and prospectus of the CDO. Asset Managers make money by virtue of the senior fee (which is paid before any of the CDO investors are paid) and subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative business for asset managers. These fees, together with underwriting fees, administration{approx 1.5 - 2%} by virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.
The trustee holds title to the assets of the CDO for the benefit of the noteholders (i.e. the Investor). In the CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and distributes noteholder reports, performs various compliance tests regarding the composition and liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall models. Two notable exceptions to this are Virtus Partners and Wilmington Trust Conduit Services, a subsidiary of Wilmington Trust, which offer collateral administration services, but are not trustee banks. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:
The underwriter typically will hire an accounting firm to perform due diligence on the CDOs portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread, of each collateral security. Source documents or public sources will typically be used to tie-out the collateral pool information. In addition, the accountants typically calculate certain collateral tests and determine whether the portfolio is in compliance with such tests.
The firm may also perform a cash flow tie-out in which the transaction's waterfall is modeled per the priority of payments set forth in the transaction documents. The yield and weighted average life of the bonds or equity notes being issued is then calculated based on the modeling assumptions provided by the underwriter. On each payment date, an accounting firm may work with the trustee to verify the distributions that are scheduled to be made to the noteholders..
Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction documents. Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory requirements to disclose certain information to investors. This will be circulated to investors. It is common for multiple counsels to be involved in a single deal due to the number of parties to a single CDO from asset management firms to underwriters.
The CDO played a pivotal role in financing the housing bubble that peaked in the U.S. during 2006. The CDO provided a key link between the global pool of fixed income investor capital and the U.S. housing market. In a Peabody Award winning program, CPM correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain.[24] A sample of 735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.[25]
An early indicator of the crisis was the failure of two Bear Stearns hedge funds in July 2007. The assets held by these hedge funds had declined in value, due in large part to increasing defaults on subprime mortgages. Investors demanded their money back under contractual arrangements referred to as margin calls. The now defunct Bear Stearns, at that time the fifth-largest U.S. securities firm, said July 18, 2007 that investors in its two failed hedge funds will get little if any money back after "unprecedented declines" in the value of securities used to bet on subprime mortgages, despite investment-grade ratings from rating agencies.[26]
On 24 October 2007, Merrill Lynch reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations.[27] A week later Stan O'Neal, Merrill Lynch's CEO, resigned from his position, reportedly as a result.[28] On 4 November 2007, Charles (Chuck) Prince, Chairman and CEO of Citigroup resigned and cited the following reasons : "...as you have seen publicly reported, the rating agencies have recently downgraded significantly certain CDOs and the mortgage securities contained in CDOs. As a result of these downgrades, valuations for these instruments have dropped sharply. This will have a significant impact on our fourth quarter financial results. I am responsible for the conduct of our businesses. It is my judgment that the size of these charges makes stepping down the only honorable course for me to take as Chief Executive Officer. This is what I advised the Board."[29]
The new issue pipeline for CDOs backed by asset-backed and mortgage-backed securities slowed significantly in the second-half of 2007 and the first quarter of 2008 due to weakness in subprime collateral, the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds, and a general downturn in the global credit markets. Global CDO issuance in the fourth quarter of 2007 was US$ 47.5 billion, a nearly 74 percent decline from the US$ 180 billion issued in the fourth quarter of 2006. First quarter 2008 issuance of US$ 11.7 billion was nearly 94 percent lower than the US$ 186 billion issued in the first quarter of 2007.[30] Moreover, virtually all first quarter 2008 CDO issuance was in the form of collateralized loan obligations backed by middle-market or leveraged bank loans, not by home mortgage ABS.[31]
This trend has limited the mortgage credit that is available to homeowners. CDOs purchased much of the riskier portions of mortgage bonds, helping to support issuance of nearly $1 trillion in mortgage bonds in 2006 alone. Rating agencies were strongly criticized by regulators and other experts, including economist Joseph Stiglitz, for their role in enabling the origination of enormous amounts of low-quality debt packaged in CDOs with erroneous, high-quality credit ratings.[32][33] In the first quarter of 2008 alone, rating agencies announced 4,485 downgrades of CDOs.[31] Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners who are trying to refinance out of mortgages that are experiencing payment shock (e.g. adjustable-rate mortgages with rising interest rates).[34]
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