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Collateralized Debt Obligations

Collateralized Debt Obligations

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Collateralized debt obligation (CDO) is a generalized concept used to describe any form of credit-based securitization. The first types of assets that were securitized in such a manner were loans and bonds. Soon, as the advantages of these structures became clear to the sponsor banks, the banks began using them to securitize a variety of assets that were difficult for the bank on an economic level.
Collateralized debt obligation (CDO) is a generalized concept used to describe any form of credit-based securitization. The first types of assets that were securitized in such a manner were loans and bonds. Soon, as the advantages of these structures became clear to the sponsor banks, the banks began using them to securitize a variety of assets that were difficult for the bank on an economic level.

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Economics

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Sub: Economics Collateralized Debt Obligations

Topic: Micro Economics

Collateralized debt obligation (CDO) is a generalized concept used to describe any form of creditbased securitization. The first types of assets that were securitized in such a manner were loans and bonds. Soon, as the advantages of these structures became clear to the sponsor banks, the banks began using them to securitize a variety of assets that were difficult for the bank on an economic level. The first CDOs were therefore largely arranged by banks seeking to reduce their balance sheet exposures to any of a number of assets or derivatives that were often difficult to value. Additionally, the credit risk associated with the sponsor bank would also often be removed and replaced with various collateral assets. The bank could thereby benefit from the removal of credit risk from its balance sheet, and the investor could invest in specific risk divorced from the risk of the sponsor bank. The transition from securitizing loans and bonds to pooling multitudinous assets was accomplished through the employment of the credit-linked note structure as described in the preceding section. This allowed derivatives and other assets that were difficult to securitize directly to be referenced in a CDO portfolio. The CDO technology benefited investors greatly by allowing them not only to specify the type of asset classes in which they would like to invest, thus enabling the relative value plays and other asset allocation, but also to specify the level of credit risk associated with those referenced asset classes. This was accomplished through the tranching of the risk.

The traditional cash flow CDO may best be thought of as a miniature bank. The CDO has both an asset component and a liability component. On the asset side, the CDO invests in any of a wide array of assets and, generally, enters into various derivative agreements to hedge out market, currency, and other risks in order to isolate the credit risk component. The CDO may then be analyzed as a company with specific asset cash flows. In order to fund the purchase of the assets, as well as the required derivatives, the CDO then issues liabilities to investors. These liabilities are issued in credit risk slices (or tranches), the legal characterization of which ranges from equity and preference shares (at the

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Sub: Economics

Topic: Micro Economics

highest risk layer) to investment-grade and high-yield debt. While the needs of the sponsor banks were the primary motivating force behind the first CDOs to be issued, investor demand quickly increased in importance. This fundamental shift from balance sheet to arbitrage transactions changed the role of the sponsor bank from one of risk provider to that of structuring agent. Structuring CDOs requires the matching of investor demands with the bank’s ability to source risk at levels such that the associated parties to a transaction might be paid and investors left with suitable cash flow so as to warrant the investment. The main party to a transaction range is from investors, lawyers, rating agencies, and bankers to auditors and trustees. There are a number of features that are employed in CDO technology to divert cash flows to protect senior note holders and align the interests of a manager of the asset pool (if one exists) with that of the end investor(s).

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Sub: Economics

Topic: Micro Economics

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