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Collateralized Debt Obligation (CDO)

Collateralized Debt Obligation (CDO)

di Anna Maria Romano, CGIL Toscana, Vice-Presidente di UNI-Europa Finance, esperta di problemi finanziari

With the 2008 crisis we had to learn about subprimes, the meaning of the word, the content and consequences of this financial object. I think it necessary to get familiar with another category of financial objects: CDOs.

What is a Collateralized Debt Obligation (CDO)?

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.

Wall Street Journal

To create a CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.

These tranches of securities become the final investment products: bonds, whose names can reflect their specific underlying assets. For examplemortgage-backed securities (MBS) are comprised of mortgage loans, and asset-backed securities (ABS) contain corporate debt, auto loans, or credit card debt. CDOs are called “collateralized” because the promised repayments of the underlying assets are the collateral that gives the CDOs their value.

Just an example

Senior Debt = Higher credit rating, but lower interest rates. Junior Debt = Lower credit rating, but higher interest rates.

The higher the credit rating, the lower the coupon rate (rate of interest the bond pays annually). If the loan defaults, the senior bondholders get paid first from the collateralized pool of assets, followed by bondholders in the other tranches according to their credit ratings; the lowest-rated credit is paid last.

To go behind the financial narrative and make it simple, we can use the example of “dishonest greengrocer”, that put the most beautiful and red strawberries on top of the basket, hiding under them the rotten ones.

So those who packs and sells CLOs prioritizes in the securitization process the tranches of loans with a higher rating, placing them higher and more evident and then offering a scheme to scale in terms of security and consequent greater return. In short, first the AAA tranches, then AA and then down to the lowest level of the junk.

Besides, collateralized debt obligations are complicated, and numerous professionals have a hand in creating them: a huge opacity!

  • Securities firms, who approve the selection of collateral, structure the notes into tranches and sell them to investors
  • CDO managers, who select the collateral and often manage the CDO portfolios
  • Rating agencies, who assess the CDOs and assign them credit ratings (ring a bell?)
  • Financial guarantors, who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments
  • Investors such as pension funds and hedge funds

“CDOs and the Global Financial Crisis” Collateralized debt obligations exploded in popularity, with CDO sales rising almost tenfold from $30 billion in 2003 to $225 billion in 2006. But their subsequent implosion, triggered by the U.S. housing correction, saw CDOs become one of the worst-performing instruments in the subprime meltdown, which began in 2007 and peaked in 2009. The bursting of the CDO bubble inflicted losses running into hundreds of billions of dollars for some of the largest financial services institutions. These losses resulted in the investment banks either going bankrupt or being bailed out via government intervention and helped to escalate the global financial crisis, the Great Recession, during this period.
Despite their role in the financial crisis, collateralized debt obligations are still an active area of structured-finance investing. CDOs and the even more infamous synthetic CDOs are still in use, as ultimately they are a tool for shifting risk and freeing up capital—two of the very outcomes that investors depend on Wall Street to accomplish, and for which Wall Street has always had an appetite.” Investopedia

Investopedia

2) Why do we have to be concerned?

This kind of securities play the lion’s share in both hedge funds’ and pension funds’ portfolios, guaranteeing very interesting returns. IN COVID out break the problem begins to arise when the most at-risk components packaged in those products go under stress, at the point toh ave a red warning flag: “The CLOs have been downgraded at such a hectic pace that they come to threaten the same safeguards that are put in place to ensure the financial strength of those securities, overcoming them,” Bloomberg reported. In mid-April a US hedge fund was so desperate to get rid of 100 million dollars of countervalue of European CLOs that it agreed to liquidate them at one-fifth of their face value.
That is, even today, in the general silence on the phenomenon, some tranches of those products travel on prices of 20 cents on the dollar. Hence, the ECB’s haste to set up a Fed-style program designated for the purchase of junk debt.

The so called Big Alchemy is able to transform a product substantially composed of 90% junk loans into an investmnent grade bond portfolio, de facto, by hiding the risks. Which remains low in a period of calm on the markets but when a destabilizing and unexpected element such as the Covid-19 crisis comes to act as an accelerator or a reagent of the damage, they can multiply exponentially and wildly. Above all, at the speed of light.

Subprimes have been mostly an USA issue and the contagion in Europe has been quiet perimetrical. CLOs have, on the contrary, a strong european barycentre: suffice it to say how involved BNP Paribas, AXA and Deutsche Bank are.

The chart is an example to show the increase in BNP Paribas.

Risky Finance

Please, don’t consider me a new Cassandra: I’m just using a bit of knowledge to rise an alert in our common job. I’ll be using it in ECB SD, but it could be a matter to discuss with commission or in ESAs, mostly.

References

Mauro Bottarelli – Business insider
Investopedia
Risky Finance
Wall street Journal

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