Collateralised Debt Obligations
Domenico Picone 1 City University Business School, London Royal Bank of Scotland
This chapter explores the market of CDOs and synthetic CDOs and their use in bank balance sheet management. We first review different types of CDOs used in capital markets and their economic rationals and then discuss the growth in synthetic CDOs under structural and balance sheet management perspectives. Following this we analyse the CDO equity piece and how it can be used in portfolio management, and then, we offer a structuring example: using with the Moody’s Binomial Expansion and Double Binomial Expansion Techniques we arrive at the best debt structure for a synthetic CDO. We conclude with a short introduction on the S&P CDO evaluator.
The CDO structure
A CDO is a special purpose company or vehicle (SPV), complete with assets, liabilities and a manager. Typically, the CDO’s assets consist of a diversified portfolio of illiquid and credit-risky assets such as high yield bonds (CBO) or bank leverage loans (CLO) 2 .
Figure 1: CDO Diagram
We have set up a typical CDO structure in Figure 1. The assets are transferred to the SPV that funds these assets, from cash proceeds of the notes it has issued. The CDO structure allocates interest income and principal repayment from a pool of different debt instruments to a prioritised collection of securities notes called tranches. Senior notes are paid before mezzanine and lower rated notes. Any residual cash flow is paid to the equity piece. This makes the senior CDO liabilities significantly less risky than the collateral.
The content of this paper reflects personal view of the author and not the opinion of Royal Bank of Scotland. Most recently, CDO technology has been extended to emerging market debts, structured finance securities, commercial real estate-linked debt, distressed assets, and last to arrive, private equity funds.
Domenico Picone, City University Business...