Collateralized Debt Obligations

Abstract

A collateralized debt obligation (CDO) is an asset-backed security backed by a diversified pool of one or more classes of debt (corporate loans, corporate bonds, emerging market bonds, asset-backed securities, residential mortgage-backed securities, commercial mortgage-backed, securities, and real estate investment trusts). The list of asset types included in a CDO portfolio is continually expanding. CDOs are categorized based on the motivation of the sponsor of the transaction: balance sheet, arbitrage, or origination. A synthetic CDO is so named because the CDO does not actually own the pool of assets on which it has the risk. Stated differently, a synthetic CDO absorbs the economic risks, but not the legal ownership, of its reference credit exposures. The nonsynthetic CDO is referred to as a “cash” structure. The building block for synthetic CDOs is a credit default swap, which allows the transfer of the economic risk of a pool of assets, but not the legal ownership, of underlying assets. Keywords: collateralized debt obligations (CDOs); synthetic CDOs; arbitrage CDOs; balance sheet CDOs; origination CDOs; market value credit structures; cash flow credit structure; cash flow waterfall, coverage tests; overcollateralization tests; Interest coverage tests; par value test; overcollateralization trigger; pay-in-kind (PIK) feature; quality tests; diversity score; weighted average rating factor (WARF) recovery rates; diversification; loss distribution tests; full capital structure CDOs; single-tranche CDOs; standard tranches of credit default swap indices

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