CDO - Collateralized Debt Obligations

What is a CDO?

CDOs are structured products created using financial engineering. These are products which are backed by cash flow from some sort of debt securities.

Securitization: It is a process of structuring the future cash flow in a more systematic manner such as getting coupons from bonds of various maturities and creating a single product with only one date for cash flow distribution to investors.

Under the CDO hood, anything can reside that has cash flow stream attached to it. You can think any bonds, loans such as credit card loans, auto-mobile loans, Mortgage loans etc.. can be used to create the CDO.

So, how is CDO created and structuring of cash flow works?

Usually a Bank has many loans with different customers. Banks want to get rid of these loans from their portfolio books. Some of these loans can be very risky but banks don't care about that part. They just want to get rid of these loans from their books. So, here is the process of creating the product.

1. Bank will bundle all the loans into one big chunk. Let's say the total value is 100 Million.

2. Bank will divide the bundle into multiple parts and these parts are called Tranches. The top most part is called Senior Tranche which usually has AAA rating. Other tranches are called Subordinate/Mezzanine tranches and will carry their own credit ratings.

3. Last tranche is called Equity tranche which almost never has any rating. Also, this tranche is usually still held in bank's books

Let's take a scenario where all the original 100 Million dollars loans were very risky loans and they all carried  BBB rating which means the loans might default any time. Now, banks use financial engineering process to create a AAA security from BBB security and that's innovation.

All the tranches carry 2 sources of income. Interest Income and/or Principal Income. They all carry one main Risk which is Default Risk and that is the most important risk.

Cash flows are distributed from the most senior tranche (AAA) to the most junior tranche (Equity). But losses are distributed from most junior (Equity) to the most senior (AAA) tranche.

Since BBB rating will provide higher yield than AAA due to its riskiness, banks usually try to create the AAA tranche with most amount of the CDO amount so that they have to pay the least interest to the tranche investors and can keep most of the interest income in the equity tranche (see below).

Let's imagine the original BBB bonds worth 100 Million were broken as follows under CDO:

60M - AAA (Senior Tranche) (Tranche A)                          Interest Offered (3%)

25M - BB (Second Tranche)  (Tranche B)                           Interest offered (6%)

15M - Equity Tranche (Usually Denoted as Tranche Z)          All residual goes here

Now the cash flow will be distributed as this:

Bank receives 8M in the interest income (8% of 100 M and considering no one has defaulted)

Bank will usually charge a service fee for processing payments (Can be anywhere 8-10% of yearly interests received)

Let's say Bank now has 7 Million to distribute

Bank will give 1.8M to Tranche A (3% of 60M)

Bank will give 1.5M to Tranche B   (6% of 25M)

Bank will give 3.7M to Equity Tranche so Equity tranche keeps on increasing in value

As you can see, banks love Securitization process. Why?? Because first they write bad loans and charge customers the loan origination, service fee and other fees plus some more fees. Now they package all these loans and sell them as CDOs and get their cash back that they lent to original customers plus they charge CDO investors also fee such as CDO origination fee, trustee fee, administration fee, and more fees. Additionally, with every cash distribution, they pay themselves first for processing the cash flow before investors see any cash. In the end, Banks make money while everyone else might be losing.

This securitization process was what caused CDO market collapse in America where CDO tranches were rated as AAA while underlying securities were BBB and AAA started to default which according to AAA definition should not have happened to that massive scale.

Key note is - Banks will find a way to offload their risk to another investor and make money. Bank love this process. So, be sure to understand the key characteristics of the underlying security before buying structured securities. Understand the Risk before understanding the Promised Returns

-Nitin