A collateralized debt obligation (English collateralized debt Obligations, CDO) is a title of debt you have as collateral a set of debt instruments such as bonds or mortgages. The CDO is a credit derivative .
The issuer of the CDO (protection buyer) generally uses it to hedge a portfolio of assets with credit risk . Although it can also be used to enter a short position against that debt. The process that transforms those individual assets into a CDO is through securitization , taking place off the bank’s balance sheet, for which a special company is created in order to manage, structure and administer the assets at risk.
Therefore, CDOs have cash flows that are backed by a portfolio of debt assets, which can be any debt instrument, public and private bonds, mortgages, loans and even other types of CDOs. CDOs that are backed by other CDOs are known as synthetic CDOs.
When structuring debt assets, the resulting CDOs may have better or worse credit quality than structured debt, depending on how the structuring is carried out.
Imagine that you have just started a business to buy and sell houses. When you have bought your first home and are renting it to someone else, you may not have enough money to buy a second home, because with the rent you receive it would take years to collect the money needed to get another one. What you could do would be to mortgage the home you bought and with that money buy a second home. Well, banks do something similar, but when it comes to mortgaging the house what they do to get money is to securitize that house, by issuing bonds backed by that house, that is, if they cannot pay the bonds because of bankruptcy the bank, the buyers of those bonds keep the house.
Para crear los bonos de titulación o CDOs, un banco crea una sociedad que se encarga de comprar esos bonos que ha emitido el banco para titularizar la casa anterior y otras casas más. Después, la sociedad titulariza todos esos bonos (o instrumentos de deuda), emitiendo nuevos bonos que están respaldados por los bonos anteriores, es decir, si la sociedad no puede pagar, nos quedamos con los bonos, los que están respaldados por las casas.
To create these CDOs, the issuer packages debt instruments and divides them into different classes, which could be assimilated to different tiers (or tranches ). Each tranches have a different order of priority over the portfolio ( collateral ) to which they are linked, in addition to the different exposure to default risk of the portfolio’s assets.
But these bonds are not only made with the debt of the houses, if not with many other types of assets.
Types of securitization bonds (CDOs)
Depending on the securitized asset, there are different CDOs:
- Collateralized bond obligations (CBO):
- Collateralized loan obligations (CLO):
- Residential mortage-backed securities (RMBS): home mortgages.
- Commercial mortage-backed securities (CBMS):commercial mortgages.
- Asset-backed securities (ABS):include different assets (for example, credit cards).
It is very common to find a CDO with the structure that appears in the diagram below. Where there are different steps ( tranches ): senior debt, mezzanine debt and stocks. Each of them will respond differently depending on the step they are on.
- Senior debt: they will be those with a better credit quality, the least risky and the most secure. They usually have anAAA rating .
- Mezzaninedebt : they will be a little more risky than the previous ones, therefore, they will pay ahigher coupon .
- Actions: it is the most risky step. Therefore, it is the first to incur losses. It has no rating.
In the structuring process, the portfolio (collateral) is first purchased from the bank, in the example it contains 200 million euros that are paid for the sale of the different bonds that have been structured (the different steps).
In this case, we have three steps:
- Senior debt with a AAA rating that promises an interest rate of 4% (160 million euros).
- Mezzanine debt with a BB rating that promises an interest rate of 7% (30 million euros).
- Shares that are not rated (10 million euros).
Cash flows from the asset portfolio (collateral) will be paid based on the order of priority, that is, what is known as the “cash flow cascade”. In this example, the bonds will pay an interest of 12 million euros annually, assuming that there is no default and covering the commissions, and then pay the interest to the different levels and end up in the shares.
Therefore, we have senior debt (4% x 160 million = 6.4 million) and mezzanine debt (7% x 30 million = 2.1 million). For the part of the shares it will be then (12 million – 6.4 million – 2.1 million), that is, 3.5 million.
In the event of a default in the portfolio, the order of losses is the opposite of the cascade of cash flows.