YaleICFWorkingPaperNo.

0706

CollateralizedDebtObligationsandCreditRisk
Transfer
DouglasJ.Lucas,ExecutiveDirector,CDOResearch,UBS
LaurieS.Goodman,CoHead,GlobalFixedIncomeResearch,UBS
FrankJ.Fabozzi,ProfessorinthePracticeofFinance,YaleUniversity,
SchoolofManagementandInternationalCenterforFinance

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Collateralizeddebtobligationsandcreditrisktransfer
DouglasJ.Lucas, Executivedirectorand headofCDOResearch, UBS
LaurieS.Goodman,ManagingdirectorandCoHeadofGlobalFixed IncomeResearch,UBS
FrankJ.Fabozzi,ProfessorinthePracticeofFinance,SchoolofManagement,YaleUniversity

ABSTRACT
Severalstudieshavereportedhownewcreditrisktransfervehicles havemadeiteasierto reallocate large
amountsofcreditriskfromthefinancialsectortothenonfinancialsectorofthecapitalmarkets. Inthis
article,wedescribeoneofthesenewcredit risk transfervehicles,thecollateralizeddebtobligation.
Syntheticcreditdebtobligationsutilize creditdefaultswaps,anotherrelativelynewcreditrisktransfer
vehicle.

Financialinstitutionsfacefive majorrisks:credit,interestrate,price,currency,andliquidity.The
developmentof the derivativesmarkets priorto1990providedfinancialinstitutionswithefficientvehicles
forthetransferofinterestrate,price,andcurrencyrisks,aswellasenhancing theliquidity ofthe
underlying assets.However,itisonlyinrecentyearsthat themarketfortheefficienttransferofcreditrisk
hasdeveloped.Creditriskisthe risk that adebtinstrumentwilldeclineinvalueas aresultofthe
borrowersinability (realorperceived)tosatisfythecontractual termsof itsborrowingarrangement.Inthe
caseofcorporatedebtobligations,creditriskencompassesdefault,creditspread,and rating downgrade
risks.
Themostobviousway forafinancialinstitutiontotransferthe creditriskofaloanithasoriginated isto
sellit toanotherparty.Loancovenantstypicallyrequirethattheobligorbeinformedofthesale.The
drawbackofasaleinthecaseofcorporateloansisthepotentialimpairmentoftheoriginatingfinancial
institutions relationshipwiththeobligorofthe loansold. Syndicatedloansovercomethedrawbackofan
outrightsalebecausebanksinthesyndicatemayselltheirloansharesinthesecondarymarket. Thesale
maybethroughanassignmentorthroughparticipation.Whiletheformermechanismforasyndicatedloan
requirestheapprovaloftheobligor,thelatterdoesnotsincethepaymentsaremerelypassedthroughtothe
purchaserandthereforetheobligorneednotknowaboutthesale.
Anotherformofcreditrisktransfer(CRT)vehicle developedinthe1980sissecuritization[Fabozziand
Kothari(2007)]. Inasecuritization,afinancialinstitutionthatoriginatesloanspoolsthemandsells them to
aspecialpurposeentity(SPE).TheSPEobtainsfundstoacquirethepoolofloansbyissuingsecurities.
PaymentofinterestandprincipalonthesecuritiesissuedbytheSPEis obtainedfromthecashflowofthe
poolofloans.Whilethefinancialinstitutionemployingsecuritizationretainssomeofthecreditrisk
associatedwiththepoolofloans,themajorityofthecreditriskistransferredtotheholdersofthesecurities
issuedbytheSPE.
Tworecentdevelopmentsfortransferringcreditriskare creditderivativesandcollateralizeddebt
obligations(CDOs). Forfinancialinstitutions,creditderivativesallowthetransferofcreditrisk toanother
partywithoutthe saleof the loan. ACDOisanapplicationofthesecuritizationtechnology.Withthe
developmentofthecreditderivativesmarket,CDOscanbecreatedwithouttheactualsaleofapoolof
loanstoanSPE usingcreditderivatives.CDOscreatedusingcreditderivativesarereferredtoas synthetic
CDOs.
Inthisarticle,wediscussCDOs.WebeginwiththebasicsofCDOsandthendiscusssyntheticCDOs.The
issuesforregulatorsandsupervisorsofcapitalmarketswithrespecttoCDOs,aswellascreditderivatives,
arealsodiscussed.
FundamentalsofCDOs
ACDOissuesdebtandequityandusesthemoneyitraisestoinvestinaportfoliooffinancialassets, such
ascorporate debtobligationsorstructureddebtobligations.Itdistributesthecashflowsfromitsasset
portfoliototheholdersofitsvariousliabilitiesinprescribedwaysthattakeintoaccounttherelative
seniorityofthoseliabilities.
FourattributesofaCDO
AnyCDO canbe welldescribedby focusingonitsfourimportantattributes:assets,liabilities,purposes,
andcreditstructures.Likeanycompany,aCDOhasassets.WithaCDO,thesearefinancialassets,suchas
corporateloansormortgagebackedsecurities.Andlikeanycompany,aCDOhasliabilities.WithaCDO,
theserunthegamutofpreferredsharestoAAAratedseniordebt.Beyondtheseniorityandsubordination
ofCDOliabilities,CDOshaveadditionalstructuralcreditprotections,whichfallintothecategoryofeither
cashflowormarketvalueprotections.Finally,everyCDOhasapurposethatitwascreatedtofulfill,and
thesefallintothecategoriesof arbitrage,balancesheet,ororigination.
Assets
CDOs own financial assets such as corporate loans or mortgagebacked securities. A CDO is primarily
identifiedbyitsunderlyingassets.

The first CDOs, created in 1987, owned highyield bond portfolios. In fact, before the term CDO was
invented to encompass an everbroadening array of assets, the term in use was collateralized bond
obligationorCBO.In1989,corporateloansandrealestateloanswereusedinCDOsforthefirsttime,
causingthetermcollateralizedloanobligationorCLOtobecoined.Generally,CLOsarecomprisedof
performing highyield loans, but a few CLOs, even as far back as 1988, targeted distressed and
nonperformingloans.SomeCLOscomprisedofinvestmentgradeloanshavealsobeenissued.
Loans and bonds issued by emerging market corporationsand sovereign governments were first used as
CDO collateral in 1994, thus emerging market CDO or EM CDO. In 1995, CDOs comprised of
residential mortgagebacked securities (RMBS) were first issued. CDOs comprised of commercial
mortgagebacked securities (CMBS) and assetbacked securities (ABS), or combinations of RMBS,
CMBS,andABSfollowed.Theterm structuredfinanceCDOorSFCDOisthetermweprefertouseto
describethistypeofCDO.However,Moodyschampionsthetermresecuritizationsandmanyothersuse
ABSCDO,eventorefertoCDOswithCMBSandRMBSintheircollateralportfolios.
Liabilities
Anycompanythathasassetsalsohasliabilities.InthecaseofaCDO,theseliabilitieshaveadetailedand
strictrankingofseniority,goinguptheCDOscapitalstructureasequityorpreferredshares,subordinated
debt, mezzanine debt, Figure 1 Simple,typicalCDOTrancheStructure
and senior debt. These Tranche
Percentofcapitalstructure Rating
Coupon
tranches of notes and ClassA
77.50
AAA
LIBOR+26
equity are commonly ClassB
9.00
A
LIBOR+75
labeled Class A, Class ClassC
2.75
BBB
LIBOR+180
B,ClassC,andsoforth ClassD
2.75
BB
LIBOR+475
going from top to Preferredshares 8.00
NR
Residualcashflow
bottom of the capital
structure.TheyrangefromthemostsecuredAAAratedtranchewiththegreatestamountofsubordination
beneathit,tothemostlevered,unratedequitytranche.Figure1showsasimplifiedtranchestructurefora
CDO.
SpecialpurposesentitieslikeCDOsaresaidtobebankruptremote.Oneaspectofthetermisthattheyare
newentitieswithoutpreviousbusinessactivities.They,therefore,cannothaveanylegalliabilityforsinsof
thepast.AnotheraspectoftheirremotenessfrombankruptcyisthattheCDOwillnotbecaughtupinthe
bankruptcy of any other entity, such as themanager of the CDOs assets, a party that sold assets to the
CDO,orthebankerthatstructuredtheCDO.
Another, very important aspect of a CDOs bankruptcy remoteness is the absolute seniority and
subordinationoftheCDOsdebttranchestooneanother.Evenifitisacertaintythatsomeholdersofthe
CDOs debt will not receive their full principal and interest, cash flows from the CDOs assets are still
distributedaccordingtotheoriginalgameplandictatedbyseniority.TheCDOcannotgointobankruptcy,
eithervoluntarilyorthroughtheactionofanaggrievedcreditor.Infact, theneedforbankruptcyisobviated
because the distribution of the CDOs cash flows, even if the CDO is insolvent, has already been
determinedindetailattheoriginationoftheCDO.
Within the stipulation of strict seniority, thereis great variety in the features of CDO debt tranches. The
drivingforceforCDO structures istoraisefundsatthelowestpossiblecost.ThisisdonesothattheCDOs
equityholder,whoisatthebottomofthechainofseniority,cangetthemostresidualcashflow.
MostCDOdebtisfloatingrateoffLIBOR,butsometimesafixedratetrancheisstructured.Avoidingan
assetliability mismatch is one reason why floatingratehighyield loansare more popularin CDOs than
fixedratehighyieldbonds.SometimesaCDOemploysshorttermdebtinitscapitalstructure.Whensuch
debtisemployed,theCDOmusthaveastandbyliquidityproviderreadytopurchasetheCDOsshortterm
debtshoulditfailtoberesoldorrollinthemarket.ACDOwillonlyissueshorttermdebtifitscost,plus
thatoftheliquidityprovidersfee,islessthanthecostoflongtermdebt.

SometimesafinancialguarantyinsurerwillwrapaCDOtranche.UsuallythisinvolvesaAAArated
insurerandthemostseniorCDOtranche.Again,aCDOwouldemployinsuranceifthecostofthe
tranchesinsured couponplusthecostoftheinsurancepremiumislessthanthecouponthetranchewould
havetopayintheabsenceofinsurance.Tomeettheneedsofparticularinvestors,sometimestheAAA
trancheisdividedinto seniorandjuniorAAAtranches.
Purposes
CDOsarecreatedforoneofthreepurposes:

BalanceSheet AholderofCDOableassetsdesiresto(1)shrinkitsbalancesheet,(2)reduce
requiredregulatory andeconomiccapital,or(3)achievecheaperfundingcosts.Theholderofthese
assetssellsthemtotheCDO.Theclassicexampleofthisisabankthathasoriginatedloansover
monthsoryearsandnowwantstoremovethemfromitsbalancesheet.Unlessthebankisverypoorly
rated,CDOdebtwouldnotbecheaperthanthebanksownsourceoffunds.Butsellingtheloanstoa
CDOremovesthemfromthebanksbalancesheetandthereforelowersthebanksregulatorycapital
requirements.Thisistrueevenifmarketpracticerequiresthebanktobuysomeoftheequityofthe
newlycreatedCDO.
Arbitrage Anassetmanagerwishestogainassetsundermanagementandmanagementfees.
Investorswishtohavetheexpertiseofanassetmanager.Assetsarepurchasedinthemarketplacefrom
manydifferentsellersandputintotheCDO.CDOsareanothermeans,alongwithmutualfundsand
hedgefunds,foranassetmanagementfirmtoprovideitsservicestoinvestors.Thedifferenceisthat
insteadofalltheinvestorssharingthefundsreturninproportiontotheirinvestment,investorreturns
arealsodeterminedbytheseniorityoftheCDOtranchestheypurchase.
OriginationBanks,insurancecompanies,andREITswishtoincreaseequitycapital.Here,the
exampleisalargenumberofsmallersizebanksissuing trustpreferredsecurities1 directlytotheCDO
simultaneouswiththeCDOsissuanceofitsownliabilities.Thebankcapitalnoteswouldnotbe
issuedbutforthecreationoftheCDOtopurchasethem.

ThreepurposesdifferentiateCDOsonthebasisofhowtheyacquiretheirassetsandfocusonthe
motivationsofassetsellers,assetmanagers,andtrustpreferredsecuritiesissuers.Fromthepointofviewof
CDOinvestors,however,allCDOshaveanumberofcommonpurposes,whichexplainwhymany
investorsfindCDOdebtandequityattractive.Onepurposeisthedivisionanddistributionoftheriskofthe
CDOsassetstopartiesthathavedifferentriskappetites.Thus,aAAAinvestorcaninvestinspeculative
gradeassetsonalossprotectedbasis.OraBBinvestorcaninvestinAAAassetsonaleveredbasis.
ForCDOequityinvestors,theCDOstructureprovidesaleveragedreturnwithoutsomeofthesevere
adverseconsequencesofborrowingviarepurchaseagreementsfromabank.CDOequityholdersownstock
inacompanyandarenotliableforthelossesofthatcompany.EquitysexposuretotheCDOasset
portfoliois, therefore,cappedatthecostofequityminuspreviousequitydistributions.Insteadofshort
termbankfinancing,financingviatheCDOis lockedinforthe long termatfixedspreadstotheLondon
interbankofferedrate(LIBOR).
Creditstructures
BeyondtheseniorityandsubordinationofCDOliabilities,CDOshaveadditionalstructuralcredit
protections,whichfallintothecategoryofeithercashflow ormarketvalue protections. Thecreditquality
ofamarketvalueCDOderivesfromtheabilityoftheCDOtoliquidateitsassetsandrepaydebttranches.
Becausethe marketvaluecreditstructure islessoftenused,itwillnotbereviewedhere [Foradiscussion
ofthemarketvaluecreditstructure,seeLucasetal.(2006)].
The cashflowcreditstructure isthemostcommontypeofCDOstructureusedtoday.Itdoesnot relyupon
thesaleofassetstosatisfyinterestandprincipalpayments.Instead,subordinationissizedsothatthe after
defaultcashflow ofassetsisexpectedtocoverdebttrancheprincipalandinterestwithsomedegreeof
1

Trustpreferredsecuritiesareunsecuredobligationsthataregenerallyrankedlowestintheorderof
repayment.

certainty.Obviously,thecertaintythataAAACDOtranche,with23%subordinationbeneathit,will
receiveallitsprincipalandinterestisgreaterthanthecertaintyaBBCDOtranche,withonly8%
subordinationbeneathit,will. MostcashflowCDOshaveovercollateralizationandinterestcoveragetests.
Thesetestsdeterminewhethercollateralcashflowisdistributedtoequityandsubordinatedebttranches,
divertedtopaydownseniordebttrancheprincipal,orusedtopurchaseadditionalcollateralassets.Wewill
discussthesetestsindetaillaterinthisarticle,buttheirpurposeistoprovide additionalcreditenhancement
toseniorCDOdebttranches.
ACDOstructuralmatrix
Figure 2showsthefourCDObuildingblocksandavarietyofoptionsbeneatheachone.AnyCDOcanbe
welldescribedbyaskingandansweringthefourquestionsimpliedbythe Figure: whatareitsassets? What
aretheattributesofitsliabilities?Whatisitspurpose?Whatisitscreditstructure?
ThiswayoflookingatCDOsencompassesallthedifferentkindsofCDOsthathaveexistedinthepastand
allthekindsofCDOsthat
Figure2 CDOstructuralmatrix
arecurrentlybeing
Assets
Liabilities
Purpose
Credit
produced.Byadding
structure
syntheticassetoption
Highyieldloans
Fixed/floatingrate
Arbitrage
Cashflow
andunfundedsuper
Highgradestructured PIK/nonPIK
Balance
Marketvalue
senior to thematrix,the
finance
sheet
matrixalsoencompasses
Guaranteed/unenhanced
Origination
syntheticCDOs,atypeof Mezzaninestructured
finance
CDOwewilldiscussin
Capitalnotes
Shortterm/longterm
detaillaterinthis article.
Highyieldbonds
Delayeddraw/revolving
Emergingmarketdebt
PartiestoaCDO
Syntheticassets
Unfundedsupersenior
ACDOisadistinctlegal
entity,usuallyincorporatedintheCaymanIslands.ItsliabilitiesarecalledCDOs,soone mighthearthe
seeminglycircularphrasetheCDOissuesCDOs.OffshoreincorporationenablestheCDOtomoreeasily
sellitsobligationstoUnitedStatesandinternationalinvestorsandescapetaxationatthecorporateentity
level.WhenaCDOislocatedoutsidetheU.S.,itwilltypicallyalsohaveaDelawarecoissuer.Thisentity
hasapassiverole,butitsexistenceinthestructureallowsCDOobligationstobemoreeasilysoldtoU.S.
insurancecompanies.
Assetmanagers(orcollateralmanagers)selecttheinitialportfolioofanarbitrageCDOandmanageit
accordingtoprescribedguidelinescontainedintheCDOsindenture.Sometimesanassetmanagerisused
inabalancesheetCDOofdistressedassetstohandletheirworkoutorsale.AvarietyoffirmsofferCDO
assetmanagementservicesincludinghedgefundmanagers,mutualfundmanagers,andfirmsthat
specializeexclusivelyinCDOmanagement.
AssetsellerssupplytheportfolioforabalancesheetCDOandtypicallyretainitsequity.IncashCDOs,the
assetsinvolvedareusuallysmallersized loansextendedtosmallersizedborrowers.IntheU.S.,theseare
calledmiddlemarket loansandinEuropetheyarecalledsmallandmediumenterprise (SME)loans.
Investmentbankers and structurers workwiththeassetmanagerorassetsellertobringtheCDOtofruition.
Theysetupcorporateentities,shepherdtheCDOthroughthedebtratingprocess,placetheCDOsdebt
andequitywithinvestors,andhandleotherorganizationaldetails.Abigpartofthisjobinvolvesstructuring
theCDOsliabilities:theirsizeandratings,thecashdiversionfeaturesofthestructure,and,ofcourse,debt
tranchecoupons.ToobtainthecheapestfundingcostfortheCDO,thestructurermustknowwhentouse
shortterm debtorinsureddebtorsenior/juniorAAAnotes,tonamejustafewstructuraloptions.Another
partofthestructurersjobistonegotiateanacceptablesetofeligibleassetsfortheCDO.Thesetasksobvi
ouslyinvolveworkingwithandbalancingthedesiresoftheassetmanagerorseller,differentdebtand
equityinvestors,andratingagencies.
Monolinebondinsurers orfinancialguarantorstypicallyonlyguaranteetheseniormosttrancheinaCDO.
Often,insuranceisusedwhenaCDOinvestsinnewerassettypesorismanagedbyanewCDOmanager.

RatingagenciesapprovethelegalandcreditstructureoftheCDO,performduediligenceontheasset
managerandthetrustee,andratethevarioussenioritiesofdebtissuedbytheCDO.Usuallytwoorthree of
themajorratingagencies(Moodys,S&P,andFitch)ratetheCDOsdebt.DBRSisarecententrantin
CDOratingsandA.M.BesthasratedCDOsbackedbyinsurancecompanytrustpreferredsecurities.
TrusteesholdtheCDOsassetsforthebenefitofdebtandequityholders,enforcethetermsoftheCDO
indenture,monitorandreportuponcollateralperformance,anddisbursecashtodebtandequityinvestors
accordingtosetrules.Assuch,theirrolealsoencompassesthatofcollateralcustodianandCDOpaying
agent.
CashflowCDOs
Asexplainedearlier,arbitrageCDOsarecategorizedaseithercashflowormarketvaluetransactions.The
objectiveoftheassetmanagerinacashflowtransactionistogeneratecashflowforCDOtrancheswithout
theactivetradingof
Figure3 Interestcashflow andprincipalwaterfall
collateral.Becausethe
(1)
(2)
cashflowsfromthe
Interestwaterfall
Principalwaterfall
structurearedesigned
Unpaidseniorfees&
toaccomplishthe
Trusteefees&seniorexpenses
expenses
objectiveforeach
tranche,restrictionsare
Seniormanagementfee
ClassAuntilpaidinfull
imposedontheasset
manager.Theasset
managerislimitedin
ClassAinterest
ClassBuntilpaidinfull
hisorherauthorityto
buyandsellbonds.The
ClassAOCtest Iffailing,amortize
ClassCuntilpaidinfull
conditionsfor
classAuntiltestismet
disposingofissuesheld
ClassBinterest
ClassDuntilpaidinfull
arespecifiedandare
usuallydrivenbycredit
ClassBOCTest Iffailing,amortize
riskmanagement.Also,
UnpaidSubordinatedfees
ClassAandthenclassBuntiltestis
inassemblingthe
&expenses
met
portfolio,theasset
managermustmeet
Class Cinterest
Equitytranche
certainrequirementsset
forthbytherating
ClassCOCtest Iffailing,amortize
agencyoragenciesthat
classA,thenclassB,thenclassC
ratethedeal. Belowwe
untiltestismet
reviewcashflow
ClassDinterest
transactions.
Specifically,welookat
ClassDOCtest Iffailing,amortize
thedistributionofthe
classA,thenclassB,thenclassC,
cashflows,restrictions
thenclassDuntiltestismet
imposedontheasset
managertoprotectthe
Subordinatedexpenses
noteholders,andthe
keyfactorsconsidered
Subordinatedmanagementfee
byratingagenciesin
ratingtranchesofa
cashflowtransaction.
Equitytranche
Distributionofcashflows
Inacashflowtransaction,thecashflowsfromincomeandprincipalaredistributedaccordingtorulesset
forthintheprospectus.Thedistributionofthecashflowsisreferredtoasthewaterfall. Wedescribethese
rulesbelowandwillusearepresentativeCDOtoillustratethem2.

Foradiscussionofdealsbasedbyothertypesofcollateral,seeChapters39inLucasetal.(2006).

TherepresentativeCDOdealwewilluseisaU.S.$300millioncashflowCDOwitha typicalcashflow
structure.Thedealconsistsofthefollowing: U.S.$260million(87%ofthedeal)Aaa/AAA
(Moodys/S&P)floatingratetrancheU.S.$27million(U.S.$7millionfixedrate plusU.S.$20million
floatingrate)Class Bnotes,ratedA3byMoodysU.S.$5million(fixedrate)ClassCnotes,ratedBa2by
MoodysandU.S.$8millioninequity(calledpreferencesharesinthisdeal).
Thecollateralforthisdealconsistsprimarilyofinvestmentgrade,CMBS,ABS,REIT,and RMBS90%of
whichmustberatedatleastBaa3byMoodysorBBBbyS&P.3 Theassetmanagerisawellrespected
moneymanagementfirm. Column(1)ofFigure3 illustratesthepriorityofinterestdistributionsamong
differentclassesforoursampledeal.Interestpaymentsareallocatedfirsttohighprioritydealexpenses
suchasfees,taxes,andregistration,aswellasmoniesowedtotheassetmanagerandhedgecounterparties.
Afterthesearesatisfied,investorsarepaidinafairlystraightforward manner,withthemoreseniorbonds
paidofffirst,followedbythesubordinatebonds,andthentheequityclasses.
Notetheimportantroleinthewaterfallplayedbywhatisreferredtoasthe coveragetests.Wewillexplain
theseshortly.TheyareimportantbecausebeforeanypaymentsaremadeonclassBorclassCbonds,
coveragetestsarerunto ensure that thedealisperformingwithinguidelines.Ifthatisnotthecase,
consequencestotheequityholdersaresevere.Notefromcolumn(1)thatiftheclassAcoveragetestsare
violated,thenexcessinterestontheportfoliogoestopaydownprincipalonthe classAnotes,andcash
flowswillbedivertedfromallotherclassestodoso.IftheportfolioviolatestheclassBcoveragetests,
theninterestwillbedivertedfromclassCandtheequitytranche topaydownfirstprincipalonclassA,or,
ifclassAisretired,classBprincipal.
Column(2)showsthesimpleprincipalcashflowsforthisdeal.Principalispaiddownpurelyinclass
order.Anyremainingcollateralprincipalfromovercollateralizationgetspassedontotheequitypiece.
Restrictionsonmanagement:safetynets
Note holdershavetwomajorprotectionsprovidedintheformoftests,namely coverage andquality.
Coveragetestsaredesignedtoprotectnoteholdersagainstadeteriorationoftheexistingportfolio.There
areactuallytwocategoriesoftestsovercollateralizationand interestcoverage. Theovercollateralization,
orO/C, ratioforatrancheisfoundbycomputingtheratioofthe principalbalanceofthecollateralportfolio
overthe principal balanceofthattrancheandalltranchesseniortoit.Thatis,
O/C ratiofora tranche = [Principal(par)valueofcollateralportfolio][Principal oftranche+principalof
alltranchesseniortoit]
Thehighertheratio,the greaterprotectionthereisforthenote holders.Notethatthe O/C ratioisbasedon
theprincipalorparvalueof theassets. (Hence,anO/Ctestisalsoreferredtoasa parvaluetest.)AnO/C
ratioiscomputedforspecifiedtranchessubjecttotheO/Ctest.The O/C testforatrancheinvolves
comparingthetranchesO/C ratiotothetranchesrequiredminimumratioasspecifiedintheCDOs
guidelines.Therequiredminimum ratioisreferredtoastheovercollateralizationtrigger.The O/C testfora
trancheispassedifthe O/C ratioisgreaterthanorequaltoitsrespective O/C trigger.Inourrepresentative
CDO,therearetworatedtranchessubjecttothe O/C test classesAandB.Thereforetwo O/C ratiosare
computedforthisdeal.
TheinterestcoverageorI/Cratioforatrancheistheratioofscheduledinterestdueontheunderlying
collateralportfoliotoscheduledinteresttobepaidtothattrancheandalltranchesseniortoit.Thatis,
I/Cratioforatranche= [Scheduledinterestdueonunderlyingcollateralportfolio][Scheduledinterestto
thattranche+Scheduledinteresttoalltranchessenior]
ThehighertheI/Cratio,thegreatertheprotection.AnI/Cratioiscomputedforspecifiedtranchessubject
totheinterestcoveragetest.TheI/CtestforatrancheinvolvescomparingthetranchesI/Cratiotothe
tranchesinterestcoveragetrigger(i.e.,therequiredminimumratioasspecifiedintheguidelines).TheI/C
3

Atthetimeofpurchase,thecollateralcorresponded,onaverage,toaBaa2rating.

testforatrancheispassedifthecomputedI/CratioisgreaterthanorequaltoitsrespectiveI/Ctrigger.For
ourrepresentativedeal,classesAandBaresubjecttotheI/C test.
WeshowedinFigure3thatiftheclassAcoveragetestsareviolated,theexcessinterestontheportfolio
goestopaydownprincipalontheclassAnotes,andcashflowswillbedivertedfromtheotherclassesto
doso.Inthiscase,whathappenstotheclassBnotes?Theyhave apayinkindorPIKfeature.Thisisa
clearlydisclosedstructural featureinmostCDOswhere,insteadofpayingacurrentcoupon,theparvalue
ofthebondisincreasedbytheappropriateamount.SoifaU.S.$5couponismissed,theparvalue
increases, sayfromU.S.$100to U.S.$105.ThenextcouponiscalculatedbasedonthelargerU.S.$105par
amount.ThePIKconceptoriginatedinthehighyieldmarket,andwasemployedforcompanieswhose
futurecashflowswereuncertain.Theoptiontopayinkindwasdesignedtohelptheseissuersconserve
scarcecashorevenavoiddefault.ItwasimportedtotheCDOmarketasastructuralfeaturetoenhancethe
moreseniorclasses.
AfterthetranchesofaCDOdealarerated,theratingagenciesareconcernedthat thecompositionofthe
collateralportfoliomaybeadverselyalteredbytheassetmanagerovertime.Testsareimposedtoprevent
theassetmanagerfromtradingassetssoastoresultinadeteriorationofthequalityoftheportfolioandare
referredtoas qualitytests.Thesetestsdealwithmaturityrestrictions,thedegreeofdiversification,and
creditratingsoftheassetsinthecollateralportfolio.
Creditratings
TherearethreekeyinputstocashflowCDOratings:collateraldiversification, likelihoodofdefault,and
recoveryrates.Whileeachratingagencyusesaslightlydifferentmethodology,theyreachsimilar
conclusions.Forexample,Moodysusesthesameobjectiveprocessfordevelopingliabilitystructures
regardlessofthetypeofcollateral.Moodysdetermineslossesoneachtrancheunderdifferentdefault
scenarios,andprobabilityweightsthoseresults.Adiscussionofthemethodology usedbytherating
agenciesisbeyondthescopeofthisarticle.Theinterestedreaderisreferredto Lucasetal. (2006)andthe
referencesthereinformoreinformationabouttheratingprocess.
Synthetic CDOs
Thedevelopmentofthe creditderivativesmarket,particularlythe creditdefaultswap(CDS) market,
fosteredthedevelopmentofthesyntheticCDO.AsyntheticCDOdoesnotactuallyowntheportfolioof
assetsonwhichitbearscreditrisk.Instead,itgainscreditexposurebysellingprotectionvia CDSs.Inturn,
thesyntheticCDObuysprotectionfrominvestorsviathetranchesitissues.Thesetranchesareresponsible
forcreditlossesinthereferenceportfoliothatriseaboveaparticularattachmentpointeachtranches
liabilityendsataparticulardetachmentorexhaustionpoint.
ThefirstsyntheticCDOswereinitiatedbyU.S.andEuropeanbanksin1997forbalancesheetpurposes.
Themotivationwastoachieveregulatorycapitalreliefwithoutforcingthebankstosellloanstheyhad
originated.Instead,syntheticbalancesheetCDOsallowedsponsoringbankstopurchasecreditprotection
onloanstheycontinuedtoown,whichreducedtheircreditriskandrequiredcapital.AsyntheticCDOs
abilitytodelinkthecreditriskofanassetfrom itsownershipaffordsbankssubstantialflexibilityin
balancesheetmanagement.
Asexplainedearlier, therearebalancesheetCDOsandarbitrageCDOs.Thesameistrueforthesynthetic
variety.WhilethefirstsyntheticCDOswere ofthe balancesheet type,syntheticarbitrageCDOsgotunder
wayinearnestin2000,butexplodedthenextyeartoabout U.S.$60billion,includingbothfundedand
unfundedtranches.By2005,syntheticarbitrageissuancewasinexcessofU.S.$500billion,ifone includes
thestandardtranchesof CDSindices.SyntheticarbitrageCDOscomeinthefollowingforms:

FullcapitalstructureCDOs,whicharetheoldest, includeafullcomplementoftranchesfromsuper
seniortoequity.TheseCDOshaveeitherstaticreferenceportfoliosoramanagerwhoactivelytrades
theunderlyingportfolioofCDSs.
SingletrancheCDOs arenewer,andaremadepossiblebydealersfaithintheirabilitytohedgethe
riskofaCDOtranchethroughsinglenameCDS.SingletrancheCDOsoftenallowCDOinvestorsto
substitutecreditsandamendothertermsoverthecourseoftheCDOslife.

Belowweoutlinethefeaturesof thefirst typesofsyntheticarbitrageCDOssincetheyaremoretypicalof

CDOs[Lucasetal.(2006)]. Asurvey of the marketbytheEuropeanCentralBank(2004)in2003found
thatthegrowthintradingofCDSsandsyntheticCDOtranches,as wellastheemergenceofsingle
trancheCDOsandCDOsofCDOs,wereseentobethemostdynamicaspectsofthemarketin2003.
However,singlenameCDSscontinuedtobethemostimportantinstrumentsforhedgingindividual
exposures.
FullcapitalstructuresyntheticCDOs
FullcapitalstructuresyntheticarbitrageCDOscomeinmanyforms.Thebestwaytoexplainthe
differencesis
Figure4 SyntheticCDOspectrum
tofocuson
CDO#1
CDO#2
twoCDO
Referencepoolamount
U.S.$1billion
U.S.$1billion
typesthat
Numberofreferenceentities
100
100
represent the
Management
Static
Managed
rangeof
structural
Capital
Amount
Spread Amount
Spread
variations. The
Class
structure
(U.S.$ million)
(bps)
(U.S.$million)
(bps)
firsthasa
Supersenior
870
6
890 6
static
reference
ClassA AAA
50
50
30 48
portfolioof
ClassB AA
30
90
30 85
100
ClassC A
5
175
14 125
investment
ClassD BBB
15
400
20 275
gradenames
ClassE Equity
30
16
whichwewill
[Cashcollateral] [Class
refertoas
Coveragetest
none
A+B+C+D]>111%
CDO#1.The
Finalmaturity
5years
5years
second,which
Writedown
werefertoas
provisions
Immediatelyupondefault
Atendoflifeofdeal
CDO#2,is
Swapsettlement
Cash
Physical
managedwith
roughlythesameunderlying creditqualityasCDO#1.SalientfeaturesofeachofthetwoCDOs,including
capitalstructuresandspreads,areshowninFigure4.
SyntheticarbitrageCDOscanbedoneasstaticpoolsorasmanagedtransactions.Theadvantagetostatic
CDOsisthatthe investorcanexaminetheproposedportfoliobeforeclosingandknowthattheportfolio
willnotchange.Theinvestorscanaskthatcertaincreditsberemovedfromtheportfolioorcandecidenot
toinvestintheCDOatall.Therearealsonoongoingmanagementfees.Thedisadvantagetoastaticdeal
becomesapparentifanunderlyingcreditbeginstodeteriorate,becausenomechanismexistsfortheCDO
toriditselfoftheproblemcredit,whichremainsintheportfolioandmaycontinuetoerode.
First, let uslookatthecapitalstructure.ObservefromFigure4 thatstaticsyntheticCDO#1hasmuch
higherequity(3%versus1.6%)andnocoveragetests.Thehigherequitypercentageisareflectionofthe
absenceofcoveragetests.ThekeytounderstandingthesmallersizeoftheequitytrancheinCDO#2isthe
structureofitsinterestwaterfall.Initially,thetrustee,theseniordefaultswap,andthesenioradvisoryfees
areallpaidoutoftheavailablecollateralinterestandCDSpremiumreceipts.Next, interestispaidto the
variousnoteholders,fromclassAtoclassD,inorderoftheirseniority.Then,acoveragetestisconducted.
Ifthecoveragetestispassed,remainingfundsareusedtopaythesubordinateadvisoryfee,andtheresidual
cashflowgoestoequityholders.But, ifthecoveragetestisfailed,cashflowistrappedinareserve
account.CashintheCDOsreserveaccountisfactoredintothecoveragetest,helpingtheCDOtomeetits
requiredratio.Ifthecoveragetestcomesbackinto compliance,futureexcesscashflowscanbereleasedto
thesubordinateadvisoryfeeandtoequityholders.AttheCDOsmaturity,cashinthereserveaccount
becomespartoftheprincipalwaterfallandhelpstopayofftranchesinorderoftheirseniority.

DespitethedifferentproportionsofequityinthetwoCDOs,thecreditprotectionenjoyedbyratedtranches
ineachCDOisaboutequal.Thisissobecausecreditprotectionismeasurednotonlybytheamountof
subordinationbelowatranche,butalsobyhowhighcreditlossescanbeontheunderlyingportfoliobefore
thetranchescashflowsareaffected.Inthiscase,theratedtranchesfrombothCDOscansurvive
approximatelythesamelevelofdefaultlossestheloweramountofequityinCDO#2iscompensatedfor
byitscoveragetestandcashtrapmechanism.
Now,letuscomparetheequitycashflowsandthetimingofwritedowns.InCDO#1,equityispaidafixed
coupon,andthushasnoclaimontheresidualcashflowsoftheCDO.Equityholders receiveinterestonly
ontheoutstandingequitybalance.InCDO#2,theequityholdershaveaclaimonallresidualcashflowsof
theCDO.ThetimingofwritedownsisverydifferentforthetwoCDOs.InCDO#1,thereisacash
settlementwheneveracredit eventoccurs.Thus,whenacrediteventoccurs, (1)thatcreditisremoved
fromthepool,(2)theCDOpaysdefaultlosses,and(3)thelowesttrancheintheCDOiswrittendownby
theamountofdefaultlosses.Ifequityiswrittendowntozerofurtherlossesarewrittendownagainstthe
nextmostjuniortrancheandsoon,movinguptheCDOscapitalstructure.Bycontrast,whenacredit
eventoccursinCDO#2physicalsettlementoccurs.Thesecuritycanbesold,butthereisnowritedown
untiltheendof thedeal.Atthattime,theprincipalcashflowsgothroughtheprincipalwaterfall,payingoff
firsttheclassA noteholdersandthenthoseinclassB,C,andD.Afternoteholdersarepaid,remaining
fundsgototheequityholders.
Becauseofthesestructuraldifferencesandinvestortaste,theBBBandlowerclassesinCDO#1generally
sellatawiderspreadthantheydoinCDO#2.InFigure4,theBBBtrancheisshownatLIBOR+400in
CDO#1itisonlyLIBOR+275inCDO#2.InCDO#1,thewritedownsareimmediate,andthereisno
waytorecouplossesbybetterperformancelaterinthedealslife.Moreover,ifanyoftheclasses
(includingtheequity)incurlosses,theirinterestisreducedaccordingly.
SingletrancheCDOs
SingletrancheCDOsare notableforwhattheyarenot:theplacementofacompletecapitalstructure
complementoftranches,fromequitytosupersenior.Instead,aprotectionsellerentersintoonespecific
CDOtranchewithaCDSdealerinisolation.Protectionsellerscanchoosetheportfoliotheywishto
reference,aswellastheattachmentanddetachmentpointsofthetranchetheywishtosellprotectionon.
Thesefactorswillimplyapriceforthatprotection.Alternatively,theprotectionsellercanstartwitha
premiuminmindandthennegotiateothertermstocreateatransactionfurnishingthatpremium.Because
thereareonlytwopartiestothetransaction,executioncanbequickerthanitwouldbewithafullcapital
structureCDOencompassingmanyconstituencies.
ThesingletranchesyntheticCDOcanalsoprovideflexibilityoveritslife.Asreferencecreditsinthe
underlyingportfolioeithererodeorimproveincreditquality,thevalueoftheCDOchanges.If,for
example,referencecreditshaveallbeenseverelydowngradedthevalueofcreditprotectionincreases
becauseitismorelikely that therewillbedefaultlosses.AprotectionsellerofsuchasingletrancheCDO
mightbewillingtopayafeetoterminatetheCDOearlyratherthanbeexposedtodefaultlosseslater.
SingletrancheCDOinvestorscangobacktotheoriginaldealertoreverseoutofatrade,ortheycan
reversethetradewithanotherdealer.IfinvestorshavesoldprotectiontodealerA,forexample,theycan
buyprotectionontheexacttermsfromdealerB.Thiswouldleavethemwithoffsettingtrades.Inmany
cases,dealerswillallowtheinvestortostepoutofthetradescompletely,andthetwodealerswillfaceeach
otherdirectly.
ManysingletranchesyntheticCDOshaveafeaturewheretermsoftheCDOareadjustableoveritslife.
Recalltheexamplewhereunderlyingcreditshaveseverelydeteriorated.Protectionsellersmightbe
allowedtoreplaceasouredcreditwithabetteroneforafee. Alternatively,insteadofpayingafee,the
termsoftheCDOtranchemightchange.Inexchangeforgettingridofatroubledunderlyingcredit,the
attachmentpointmightbedecreased, thedetachmentpointmightbeincreased,orthepremiummight
decrease.
ConcernswithnewCRTvehicles

Aswithanynewcomplexfinancialproductintroducedbybanks,thereareregulatoryandsupervisory
concerns.Theintroductionofnew CRTvehicles,suchascashCDOsandcreditderivativesthatare
employedtocreatesyntheticCDOs, haselicitedthesame cautious responsefromoverseersoftheglobal
bankingsystem.Asexplainedbelow,agoodnumberoftheseconcernsarethesameasthoseidentifiedfor
derivatives,suchasinterestrateandequityderivatives,andsecuritizedproducts,suchascollateralized
mortgageobligations.
Fivestudieshaveidentifiedregulatory andsupervisoryconcernswithCRTvehicles,suchascredit
derivativesandCDOs.ThefirstisastudybytheFinancialStabilityForumoftheJointForum[JointForum
(2003)]. TheJointForumconsistsof theBaselCommitteeonBankingSupervision,theInternational
OrganizationofSecuritiesCommissions,andtheInternationalAssociationofInsuranceSupervisors.The
secondstudy wasconductedby theEuropeanCentralBank [ECB(2004)],whichwasa marketsurvey
basedoninterviewswithmorethan100banksfrom15EuropeanUnionbanks,fivelargeinternationally
activenonEUbanks,andsecuritieshousesoperatinginLondon.Thelastthreestudiesarebyrating
agencies,twobyFitchRatings(2003,2004)andtheonebyStandard&Poors(2005).Fromthefive
studies,fourgeneralissueswereidentified.Wediscusseachofthembelow.
Issue1 Cleanrisktransfer
AsnewvehiclesforCRThavedeveloped,increasingthemarketliquidityforcorporatedebtsuchasbonds
andbankloans,thenatureoftherisksfacedbymarketparticipantshaschangedinseveralways.Atone
time,thefocusofaninvestorinacorporatedebtwasontheabilityofthecorporationtomeetits
obligations.Theissuewith newCRTsiswhetherthereisaclean transferofcreditrisk.
Theconcernswithcreditderivativesand, therefore,syntheticCDOsbeingusedasCRTvehiclesare
threefold.Firstly,thereisaconcernwithcounterpartyrisk thefailureofthecounterpartysellingcredit
protectionwouldresultinthebuyerofcreditprotectionmaintainingthecreditexposurethatitthoughtit
hadeliminated.Withrespecttothisconcern,studieshavenotedthattherearestandardproceduresavailable
inriskmanagementthatcanbeemployedtoreducecounterpartyrisk.Theseriskmanagementtoolsare
equallyapplicabletooverthecounterderivativesusedtomanageinterestrateandcurrencyriskby
regulatedfinancialentities.
Secondly,whilethedevelopmentofstandarddocumentationforcreditderivative tradesbytheInternational
SwapsandDerivativesAssociation(ISDA)fosteredthegrowthofthatmarket,thereremainsaconcern
withlegalrisksthatmayarisefromatransaction. Legalriskistheriskthatacreditderivativecontractwill
notbeenforceableorlegallybindingonthecounterpartytothetradeormaycontainambiguousprovisions
thatresultinafailureofthecontracttofulfillitsintent.Themostprominentexampleiswhatthecredit
derivativesmarketfacedearlyinitslifedealingwiththeissue of whetheracrediteventhasoccurredand,
inparticular,controversialcrediteventssuchasrestructuring. The2004surveyoffinancialinstitutionsby
Fitchinvestigated thefrequencyofdisputedcreditevents andfoundthatabout14%ofthecreditevents
capturedinthesurveywerereportedtoinvolvesomeformofdispute.Asfortheresolutionofthose
disputes,Fitchfoundthatatthetimethevastmajorityhadbeenorwerebeingresolvedwithoutthe
involvementofthecourtsystem.Anotherexampleoflegalriskisthatofwhetherthecounterpartyhasthe
authoritytoenterintoacreditderivativetransaction.Thisisnotuniquetocreditderivatives,buthasbeen
thesubjectoflitigationinotherderivativemarkets. Forexample,interestratesswapsbetweenvarious
dealersandlocalU.K. authoritieswerevoidin1991 becauseitwasruledthelaterdidnothavethe legal
authoritytoenterintothecontractsinthefirstplace.
Issue2 Riskoffailure ofmarketparticipantstounderstandassociatedrisk
Withthedevelopmentofanymarketvehiclethereistheconcernthatmarketparticipantswillnot
understandtheassociatedrisks.Forexample,thereisevidenceintheinterestrateswapmarketofcorporate
entitiesallegedlyfailingtounderstandtheserisks,probablythetwomostwellknownlegalcasesbeingthat
ofGibsonGreetingsandProctor&Gamble. Thesameistrueforcollateralizedmortgageobligations.Both
oftheseinstrumentshavebeenimportantfinancialinnovations,buttherewereusers/investorswho
experiencedfinancialdifficulties/fiascosbecauseproductinnovationmayhaverunfaraheadofproduct
education.

Inthecaseofafinancialinstitutionthatseekstomakeamarketinthenew CRTvehicles,thereisaconcern
thatinsellingmorecomplexproducts, suchassyntheticCDOs,theymaynotbeproperlyhedgingtheir
positionandthereforeincreasingtheinstitutionsrisk.(Whilewehavenotdiscussedthe pricingof
syntheticCDOs,it fairtosaythattheseinstrumentsarenotsimpletoprice.) Thereismodelingrisk. For
example,inthecaseofasingletrancheCDOs,thedealerwillhaveanimbalancedpositiononCDSs and
willtrytohedgethatpositionbydeltahedging [Lucas(2007)].Therisk,ofcourse,isthatthedealerhasnot
hedgedproperly.
Withrespecttothisissue,therecommendationsofthereportoftheJointForumconcentratedontheneed
formarketparticipantstocontinueimprovingriskmanagementcapabilitiesandforsupervisorsand
regulatorstocontinueimprovingtheirunderstandingoftheassociatedissues.Giventhisfocus,thereport
setsforthrecommendationsformarketparticipantsandsupervisorsinthreeareas: riskmanagement,
disclosure,andsupervisory approaches,withparticularemphasisonreportinganddisclosure.
Issue3 Potentiallyhighconcentrationofrisk
ACRTvehicle canresultineitherthetransferofthecreditriskfromonebanktoanotherorfromabank to
anonbankentity.Withinthe bankingsystem,theconcerniswhethertherehasbecometoomuch
concentrationofcreditrisk.Forcreditrisktransferredoutofthebankingsystem,thereistheconcernwith
theextenttowhichcreditriskisbeingtransferredtononbanks,suchasmonoline ormultilineinsurance
companiesandhedgefunds.Theoverallconcernistheimpactonthefinancialsystemresultingfroma
failureofoneorafewmajorparticipantsintheCRTmarket.
ThetwostudiesbyFitchRating(2003,2004)reportedthenumberof banks(NorthAmericanand
European)andinsurancecompaniesactiveintheCRTmarketandtherelativesizeofeach.Inits2003
marketsurvey,Fitchsurveyedabout200financialinstitutions(banks,securitiesfirms,andinsurance
companies),focusingonthoseitclassifiedasprotectionsellers.Fitchfoundthatthroughcreditderivatives
theglobalbankingsystemtransferred U.S.$229billionofcreditriskoutside of thebankingsystem.Mostof
thiswastotheinsuranceindustry(monolineinsurancecompanies/financialguarantors,reinsurance,and
insurancecompanies). The insurance industry itself isthelargestsellerofcreditprotection.Fitchestimated
thattheinsuranceindustry soldU.S.$381billionofnetcreditprotection(i.e.,creditprotectionsoldless
creditprotectionpurchased). Ofthatamount,insurancecompaniesprovidedU.S.$303increditprotection
viathecreditderivativesmarketandthebalance,U.S.$78billionincreditprotectionbytheirparticipation
inthecashCDOmarket. Withintheinsuranceindustry,thelargestsellerofcreditprotectionisfinancial
guarantors,insuringtheseniortranchesinsyntheticCDOdeals. IntheopinionofFitch,theexpansionof
thesectorincreditderivativesmarkethasgenerallybeenwellmanagedandconsistentwiththeindustrys
rating. Fitchconcludesthatbankbuyingofcreditprotectionviacreditderivativeshassignificantly
increasedliquidityinthesecondarycreditmarketandallowedtheefficienttransferofrisktoothersectors
thatlacktheabilitytooriginatecredit.Therewasarelativelyhighconcentrationofcreditprotection
buyingbylarge,moresophisticatedbanks.Smallerandregionalbankswerenetsellersofcreditprotection
despitebanksbeing netbuyersofcreditprotectionintheaggregate.
Withrespecttocounterpartyconcentration,Fitchreportedthatthemarketisconcentratedamongthe top10
globalbanksandbrokerdealers. Whilehavinginvestmentgraderatings,theriskisthatthewithdrawalof
oneormoreofthesefirmsfromthemarketforfinancialorstrategicreasonscouldunderminethe
confidenceinthe CRT market.
Inits2003survey,Fitchattempted tocollectinformationonhedgefund activitiesbywritingtothe50
largesthedgefundsintheworld.Noneresponded.Inits2004survey,Fitchincludedquestionsforthe
majorintermediariesastotheirdealingswithhedgefunds.Fitchfoundthathedgefundsrepresented
between20%to30%oftheiroverall CDSindextrading.Ultimately,counterpartyriskexposuretohedge
fundsdependsontheextentofthecollateralizationofthetrades.Whilemostoftheintermediariesinthe
surveyrespondedthattheirpositionswithhedgefundswerefullycollateralized,somestatedthatitwasless
than100%collateralized.
Fitchalsofoundthatthereishighconcentrationinthecorporationsthatarethereferenceobligationsina
CDS.Settlementproblemscouldoccurifthereisacrediteventforoneofthesereferences,leadingtoa

majormarketdisruption.Moreover,becauseofthehighercorrelationofdefaultthatexistsfor
counterpartiesandcorporate referencesintheCRTmarket, incomparisontootherderivativemarkets,there
isaconcernwiththemarketfacing multiple defaults.TheECBreportconcluded that thepotentialfor
disruptionofthenew CRTvehicleswasgenerallysmall.
Issue4 Adverseselection
Theability of originatorstotransfercreditriskvia creditderivatives,CDOs,orsecuritizationhasraised
concernsthat alendingculturebasedonoriginationvolumeratherthanprudentlendingpracticesmaybe
inadvertentlyadoptedbybanks.ThisisaconcernaboutsecuritizationingeneralasnotedinFabozziand
Kothari(2007).
Conclusion
ThetwomostrecentintroductionsintotheCRTmarket, whichhavemadeitpossibletotransferlarge
amountsofcorporate creditriskexposure among banksaswellasfromthefinancialsectortothenon
financialsector, arecreditderivatives,inparticularCDS,andCDOs. OnevarietyoftheCDOisthe
syntheticCDO, inwhichcreditriskexposureistransferredviaCDSratherthanthetransferof ownershipof
corporatedebtobligations. ThereareconcernsraisedbyregulatorsregardingCDOsandCDSs,someof
thesebeingtheusualconcernswiththeintroductionofanynewfinancialinnovation. Thereportby the
EuropeanCentralBank(ECB(2004)] concludedthefollowingregardingthesenewCRTvehicles:The
reportsoverallassessmentoftrendsinthismarketispositive.Improvementsintheabilityofbanksand
otherfinancialinstitutionstodiversifyandhedgetheircreditrisksarehelpingthefinancialsystemto
becomemoreefficientandstable.
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ECB,2004,CreditrisktransferbyEUbanks:activities,riskandRiskmanagement, EuropeanCentral
Bank,May
Fabozzi,F.J.andV.Kothari,2007,Securitization:thetooloffinancialtransformation, Journalof
FinancialTransformation,thisissue
FitchRatings, 2003, Globalcreditderivatives:aqualifiedsuccess,September24
FitchRatings, 2004, Globalcreditderivativessurvey:singlenameCDSfuelgrowth,September7
JointForum, 2005,Creditrisktransfer.BankforInternationalSettlements
Lucas,D. J.,L. S.Goodman,andF.J.Fabozzi,2006, Collateralizeddebtobligations:structuresand
analysis(Secondedition), JohnWiley&Sons,NewJersey
Lucas,D. J.,L. S.Goodman,F. J.Fabozzi,andR.Manning,2007, Developmentsinthecollateralizeddebt
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