Collateralized Debt Obligation (CDOs): What is it and how it works

The corporate world is filled with tons of money-making techniques for investors all over the globe. Investors’ basic aim is to increase profits while engaging in varying business concerns that may be high-risk engaging ventures. 

Investors often possess a high disposable income and aim to gain profits by spreading their cash pool over a variety of investments that would in turn offer high-yielding profits. One such method through which investors gain profit while making risky investments is through the Collateralized debt obligation (CDO). This article offers all the insight on collateralized debt obligations. 

What are collateralized debt obligations?

CDOs are complex derivative investments that offer an investor a loan or other asset-backed securities as collateral for a risky financial product. 

This invariably means that the finance product offered under the CDO structured agreement derives its value from other underlying assets, which is the loan or asset securitized to the product. In addition, it is worth noting that CDOs underlying assets act as the collateral or security to the transaction, so when it fails, the investor can come for the underlying asset or collateral. 

How collateralized debt obligations work?

CDOs act basically to provide a pool of investment to an investor with the investment being backed by an asset-backed security structure. The CDO financing structure works with commercial and investment banks pooling varying cash-flow assets from loans to bonds, mortgages, debentures and other debt or income-pool-generating assets from the bank.

The bank classifies all the various cash-flow-generating assets into different classes or tranches; the varying classes are dependent on the risks involved with the payment of the debt as accessed by independent firms.

The grouped tranches classified into risk levels move on to become the overall finance product to be sold by the investment bank to the investor. The underlying asset securing the debt is a drive that pushes investors into acquiring the debt.

For instance, loans that are secured with properties are mortgage-backed securities, hence, the value of the property comparable to the loan would be a driving force to the investor to acquire the product. Same to asset-backed securities like corporate loans, the collateral assets used to secure the loan can influence the investors’ decision whether or not to acquire the product.

For instance, if a mortgage-backed secured loan is $5 million, the bank arranges the payment structure as follows:

DebtRatingCoupon (Interest)
SeniorAAA4%
MediumAA10%
JuniorBBB20%

From the table above, investors are free to choose from senior, medium or junior debtors; an investor choosing to be a senior debtor would pay higher for the purchase of the debt and have a high credit rating but a small coupon. The junior debtor who is the last on the list pays lower for the debt and has a low credit rating but a high coupon interest. 

Key players in the collateralized debt obligation market

There exist some significant players that work to see the CDO is created, these are: 

1. Security firms

These are firms engaged in the approval of the collateral selection, the subsequent structuring of these collaterals into tranches and the eventual sale of the tranches to the investors.

They are involved with all activities on the pre-sale structure of the CDO transaction before they are offered to the investor for sale. 

2. CDO managers

The CDO managers act as trustees to the transaction, and act among other things as middlemen between the investment bank and the investors.

They also go ahead to manage CDO portfolios of each debt tranche formed, this provides a sense of assurance or due diligence to the investor. 

3. Rating agencies

Rating agencies are tasked with the duty of checking the credit rating of the CDOs and revert to the investor on the possible success or otherwise of the transaction.

These rating agencies are professional liable institutions that observe detailed qualifiers to determine the expected success of the transaction in the future. 

In the Nigerian market, there exist only three rating agencies all over the country, these are DataPro Ltd, Agusto and Co., and Global Credit rating. 

4. Insurance companies

Insurance companies act similarly to financial guarantors offering cover to investors in case the CDO fails. This provides increased assurance to investors on the success of the transaction or the possibility of receiving its investment.

The investor makes payment in the form of a premium to the guarantors.

5. Investors

These are the major players in the CDO transaction. Investors offer to purchase the CDO in tranches and bear the risks in them.

Investors could be investment companies, high-net-worth individuals or hedge funds.

Pros and Cons of collateralized debt obligations

Pros

1. Eases debt growth: This is the most significant advantage of CDOs, the debt of banks and other financial institutions is reduced through this method. Investment banks can sell their debts to investors allowing for ease of operation and the provision of additional revenue for the bank to offer more loans.

2. Investment opportunity: The CDOs offer opportunities to investors to invest in the CDO tranches, thereby, offering the investors additional income at the end when the interest payable on each CDO tranche becomes payable. 

Cons

1. Risky: The risks involved in the CDO transaction structure are high. Most times, including times when the investor opts for a senior debt position, some low risks factors may still be evident.

2. Highly complex transaction: the transactions in the CDO structuring is a highly complex ones that can be extremely demanding and difficult to comprehend. Most investors have complained about the complex structures, the delays from extreme due diligence and the constant referral to some non-conventional business terms have all attributed to the various reasons investors get discouraged from entertaining the CDO.

Conclusion

The finance market is met with tons of money-making options for investors to grow their incomes in the long run while providing funding for investment banks and other individuals.

The CDO structure is a highly regarded financing structure that offers investors this opportunity as demanded. 

Frequently Asked Questions (FAQs)

What are subprime mortgages?

A subprime mortgage has a low credit rating ad is eventually a high-risk mortgage adventure.

What are synthetic CDOs?

Synthetic CDOs are similar to conventional CDOs but while conventional CDOs sell cash-flow debts like bonds, and mortgages, synthetic CDOs sell noncash finances like options etc.

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Richard Okoroafor

Richard Okoroafor

Richard is a brilliant legal content writer who doubles as a finance lawyer. He brings his wealth of legal knowledge in corporate commercial transactions to bear, offering the best value that exceeds expectations.

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