Yale ICF Working Paper No. 0706
Collateralized Debt Obligations and Credit Risk
Douglas J. Lucas, Executive Director, CDO Research, UBS
Laurie S. Goodman, CoHead, Global Fixed Income Research, UBS
Frank J. Fabozzi, Professor in the Practice of Finance, Yale University,
School of Management and International Center for Finance
This paper can be downloaded without charge from the
Social Science Research Network Electronic Paper Collection:
Collateralized debt obligations and credit risk transfer
Douglas J. Lucas, Executive director and head of CDO Research, UBS
Laurie S. Goodman, Managing director and CoHead of Global Fixed Income Research, UBS
Frank J. Fabozzi, Professor in the Practice of Finance, School of Management, Yale University
Several studies have reported how new credit risk transfer vehicles have made it easier to reallocate large
amounts of credit risk from the financial sector to the nonfinancial sector of the capital markets. In this
article, we describe one of these new credit risk transfer vehicles, the collateralized debt obligation.
Synthetic credit debt obligations utilize credit default swaps, another relatively new credit risk transfer
Financial institutions face five major risks: credit, interest rate, price, currency, and liquidity. The
development of the derivatives markets prior to 1990 provided financial institutions with efficient vehicles
for the transfer of interest rate, price, and currency risks, as well as enhancing the liquidity of the
underlying assets. However, it is only in recent years that the market for the efficient transfer of credit risk
has developed. Credit risk is the risk that a debt instrument will decline in value as a result of the
borrower’s inability (real or perceived) to satisfy the contractual terms of its borrowing arrangement. In the
case of corporate debt obligations, credit risk encompasses default, credit spread, and rating downgrade
The most obvious way for a financial institution to transfer the credit risk of a loan it has originated is to
sell it to another party. Loan covenants typically require that the obligor be informed of the sale. The
drawback of a sale in the case of corporate loans is the potential impairment of the originating financial
institution’s relationship with the obligor of the loan sold. Syndicated loans overcome the drawback of an
outright sale because banks in the syndicate may sell their loan shares in the secondary market. The sale
may be through an assignment or through participation. While the former mechanism for a syndicated loan
requires the approval of the obligor, the latter does not since the payments are merely passed through to the
purchaser and therefore the obligor need not know about the sale.
Another form of credit risk transfer (CRT) vehicle developed in the 1980s is securitization [Fabozzi and
Kothari (2007)]. In a securitization, a financial institution that originates loans pools them and sells them to
a special purpose entity (SPE). The SPE obtains funds to acquire the pool of loans by issuing securities.
Payment of interest and principal on the securities issued by the SPE is obtained from the cash flow of the
pool of loans. While the financial institution employing securitization retains some of the credit risk
associated with the pool of loans, the majority of the credit risk is transferred to the holders of the securities
issued by the SPE.
Two recent developments for transferring credit risk are credit derivatives and collateralized debt
obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another
party without the sale of the loan. A CDO is an application of the securitization technology. With the
development of the credit derivatives market, CDOs can be created without the actual sale of a pool of
loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic
In this article, we discuss CDOs. We begin with the basics of CDOs and then discuss synthetic CDOs. The
issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives,
are also discussed.
Fundamentals of CDOs
A CDO issues debt and equity and uses the money it raises to invest in a portfolio of financial assets, such
as corporate debt obligations or structured debt obligations. It distributes the cash flows from its asset
portfolio to the holders of its various liabilities in prescribed ways that take into account the relative
seniority of those liabilities.
Four attributes of a CDO
Any CDO can be well described by focusing on its four important attributes: assets, liabilities, purposes,
and credit structures. Like any company, a CDO has assets. With a CDO, these are financial assets, such as
corporate loans or mortgagebacked securities. And like any company, a CDO has liabilities. With a CDO,
these run the gamut of preferred shares to AAA rated senior debt. Beyond the seniority and subordination
of CDO liabilities, CDOs have additional structural credit protections, which fall into the category of either
cash flow or market value protections. Finally, every CDO has a purpose that it was created to fulfill, and
these fall into the categories of arbitrage, balance sheet, or origination.
CDOs own financial assets such as corporate loans or mortgagebacked securities. A CDO is primarily
identified by its underlying assets.
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
obligation’ or ‘CBO.’ In 1989, corporate loans and real estate loans were used in CDOs for the first time,
causing the term ‘collateralized loan obligation’ or ‘CLO’ to be coined. Generally, CLOs are comprised of
performing highyield loans, but a few CLOs, even as far back as 1988, targeted distressed and
nonperforming loans. Some CLOs comprised of investmentgrade loans have also been issued.
Loans and bonds issued by emerging market corporations and 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, and ABS followed. The term ‘structured finance CDO’ or ‘SF CDO’ is the term we prefer to use to
describe this type of CDO. However, Moody’s champions the term ‘resecuritizations’ and many others use
‘ABS CDO,’ even to refer to CDOs with CMBS and RMBS in their collateral portfolios.
Any company that has assets also has liabilities. In the case of a CDO, these liabilities have a detailed and
strict ranking of seniority, going up the CDO’s capital structure as equity or preferred shares, subordinated
debt, mezzanine debt, Figure 1 Simple, typical CDO Tranche Structure
and senior debt. These Tranche
Percent of capital structure Rating
tranches of notes and Class A
LIBOR + 26
equity are commonly Class B
LIBOR + 75
labeled Class A, Class Class C
LIBOR + 180
B, Class C, and so forth Class D
LIBOR + 475
going from top to Preferred shares 8.00
Residual cash flow
bottom of the capital
structure. They range from the most secured AAA rated tranche with the greatest amount of subordination
beneath it, to the most levered, unrated equity tranche. Figure 1 shows a simplified tranche structure for a
Special purposes entities like CDOs are said to be ‘bankrupt remote.’ One aspect of the term is that they are
new entities without previous business activities. They, therefore, cannot have any legal liability for sins of
the past. Another aspect of their ‘remoteness from bankruptcy’ is that the CDO will not be caught up in the
bankruptcy of any other entity, such as the manager of the CDO’s assets, a party that sold assets to the
CDO, or the banker that structured the CDO.
Another, very important aspect of a CDO’s bankruptcy remoteness is the absolute seniority and
subordination of the CDO’s debt tranches to one another. Even if it is a certainty that some holders of the
CDO’s debt will not receive their full principal and interest, cash flows from the CDO’s assets are still
distributed according to the original game plan dictated by seniority. The CDO cannot go into bankruptcy,
either voluntarily or through the action of an aggrieved creditor. In fact, the need for bankruptcy is obviated
because the distribution of the CDO’s cash flows, even if the CDO is insolvent, has already been
determined in detail at the origination of the CDO.
Within the stipulation of strict seniority, there is great variety in the features of CDO debt tranches. The
driving force for CDO structures is to raise funds at the lowest possible cost. This is done so that the CDO’s
equity holder, who is at the bottom of the chain of seniority, can get the most residual cash flow.
Most CDO debt is floating rate off LIBOR, but sometimes a fixed rate tranche is structured. Avoiding an
assetliability mismatch is one reason why floatingrate highyield loans are more popular in CDOs than
fixedrate highyield bonds. Sometimes a CDO employs shortterm debt in its capital structure. When such
debt is employed, the CDO must have a standby liquidity provider ready to purchase the CDO’s shortterm
debt should it fail to be resold or roll in the market. A CDO will only issue shortterm debt if its cost, plus
that of the liquidity provider’s fee, is less than the cost of longterm debt.
Sometimes a financial guaranty insurer will wrap a CDO tranche. Usually this involves a AAA rated
insurer and the most senior CDO tranche. Again, a CDO would employ insurance if the cost of the
tranche’s insured coupon plus the cost of the insurance premium is less than the coupon the tranche would
have to pay in the absence of insurance. To meet the needs of particular investors, sometimes the AAA
tranche is divided into senior and junior AAA tranches.
CDOs are created for one of three purposes:
Balance Sheet A holder of CDOable assets desires to (1) shrink its balance sheet, (2) reduce
required regulatory and economic capital, or (3) achieve cheaper funding costs. The holder of these
assets sells them to the CDO. The classic example of this is a bank that has originated loans over
months or years and now wants to remove them from its balance sheet. Unless the bank is very poorly
rated, CDO debt would not be cheaper than the bank’s own source of funds. But selling the loans to a
CDO removes them from the bank’s balance sheet and therefore lowers the bank’s regulatory capital
requirements. This is true even if market practice requires the bank to buy some of the equity of the
newly created CDO.
Arbitrage An asset manager wishes to gain assets under management and management fees.
Investors wish to have the expertise of an asset manager. Assets are purchased in the marketplace from
many different sellers and put into the CDO. CDOs are another means, along with mutual funds and
hedge funds, for an asset management firm to provide its services to investors. The difference is that
instead of all the investors sharing the fund’s return in proportion to their investment, investor returns
are also determined by the seniority of the CDO tranches they purchase.
Origination Banks, insurance companies, and REITs wish to increase equity capital. Here, the
example is a large number of smallersize banks issuing trust preferred securities 1 directly to the CDO
simultaneous with the CDO’s issuance of its own liabilities. The bank capital notes would not be
issued but for the creation of the CDO to purchase them.
Three purposes differentiate CDOs on the basis of how they acquire their assets and focus on the
motivations of asset sellers, asset managers, and trust preferred securities issuers. From the point of view of
CDO investors, however, all CDOs have a number of common purposes, which explain why many
investors find CDO debt and equity attractive. One purpose is the division and distribution of the risk of the
CDO’s assets to parties that have different risk appetites. Thus, a AAA investor can invest in speculative
grade assets on a lossprotected basis. Or a BB investor can invest in AAA assets on a levered basis.
For CDO equity investors, the CDO structure provides a leveraged return without some of the severe
adverse consequences of borrowing via repurchase agreements from a bank. CDO equity holders own stock
in a company and are not liable for the losses of that company. Equity’s exposure to the CDO asset
portfolio is, therefore, capped at the cost of equity minus previous equity distributions. Instead of short
term bank financing, financing via the CDO is locked in for the long term at fixed spreads to the London
interbank offered rate (LIBOR).
Beyond the seniority and subordination of CDO liabilities, CDOs have additional structural credit
protections, which fall into the category of either cash flow or market value protections. The credit quality
of a market value CDO derives from the ability of the CDO to liquidate its assets and repay debt tranches.
Because the market value credit structure is less often used, it will not be reviewed here [For a discussion
of the market value credit structure, see Lucas et al. (2006)].
The cash flow credit structure is the most common type of CDO structure used today. It does not rely upon
the sale of assets to satisfy interest and principal payments. Instead, subordination is sized so that the after
default cash flow of assets is expected to cover debt tranche principal and interest with some degree of
Trust preferred securities are unsecured obligations that are generally ranked lowest in the order of
certainty. Obviously, the certainty that a AAA CDO tranche, with 23% subordination beneath it, will
receive all its principal and interest is greater than the certainty a BB CDO tranche, with only 8%
subordination beneath it, will. Most cash flow CDOs have overcollateralization and interest coverage tests.
These tests determine whether collateral cash flow is distributed to equity and subordinate debt tranches,
diverted to pay down senior debt tranche principal, or used to purchase additional collateral assets. We will
discuss these tests in detail later in this article, but their purpose is to provide additional credit enhancement
to senior CDO debt tranches.
A CDO structural matrix
Figure 2 shows the four CDO building blocks and a variety of options beneath each one. Any CDO can be
well described by asking and answering the four questions implied by the Figure: what are its assets? What
are the attributes of its liabilities? What is its purpose? What is its credit structure?
This way of looking at CDOs encompasses all the different kinds of CDOs that have existed in the past and
all the kinds of CDOs that
Figure 2 CDO structural matrix
are currently being
produced. By adding
‘synthetic asset option’
and ‘unfunded super
Highgrade structured PIK/nonPIK
senior’ to the matrix, the
matrix also encompasses
synthetic CDOs, a type of Mezzanine structured
CDO we will discuss in
Short term/long term
detail later in this article.
Emerging market debt
Parties to a CDO
Unfunded super senior
A CDO is a distinct legal
entity, usually incorporated in the Cayman Islands. Its liabilities are called CDOs, so one might hear the
seemingly circular phrase ‘the CDO issues CDOs.’ Offshore incorporation enables the CDO to more easily
sell its obligations to United States and international investors and escape taxation at the corporate entity
level. When a CDO is located outside the U.S., it will typically also have a Delaware coissuer. This entity
has a passive role, but its existence in the structure allows CDO obligations to be more easily sold to U.S.
Asset managers (or collateral managers) select the initial portfolio of an arbitrage CDO and manage it
according to prescribed guidelines contained in the CDO’s indenture. Sometimes an asset manager is used
in a balance sheet CDO of distressed assets to handle their workout or sale. A variety of firms offer CDO
asset management services including hedge fund managers, mutual fund managers, and firms that
specialize exclusively in CDO management.
Asset sellers supply the portfolio for a balance sheet CDO and typically retain its equity. In cash CDOs, the
assets involved are usually smallersized loans extended to smallersized borrowers. In the U.S., these are
called ‘middle market’ loans and in Europe they are called ‘small and medium enterprise’ (SME) loans.
Investment bankers and structurers work with the asset manager or asset seller to bring the CDO to fruition.
They set up corporate entities, shepherd the CDO through the debt rating process, place the CDO’s debt
and equity with investors, and handle other organizational details. A big part of this job involves structuring
the CDO’s liabilities: their size and ratings, the cash diversion features of the structure, and, of course, debt
tranche coupons. To obtain the cheapest funding cost for the CDO, the structurer must know when to use
shortterm debt or insured debt or senior/junior AAA notes, to name just a few structural options. Another
part of the structurer’s job is to negotiate an acceptable set of eligible assets for the CDO. These tasks obvi
ously involve working with and balancing the desires of the asset manager or seller, different debt and
equity investors, and rating agencies.
Monoline bond insurers or financial guarantors typically only guarantee the seniormost tranche in a CDO.
Often, insurance is used when a CDO invests in newer asset types or is managed by a new CDO manager.
Rating agencies approve the legal and credit structure of the CDO, perform due diligence on the asset
manager and the trustee, and rate the various seniorities of debt issued by the CDO. Usually two or three of
the major rating agencies (Moody’s, S&P, and Fitch) rate the CDO’s debt. DBRS is a recent entrant in
CDO ratings and A. M. Best has rated CDOs backed by insurance company trust preferred securities.
Trustees hold the CDO’s assets for the benefit of debt and equity holders, enforce the terms of the CDO
indenture, monitor and report upon collateral performance, and disburse cash to debt and equity investors
according to set rules. As such, their role also encompasses that of collateral custodian and CDO paying
Cash flow CDOs
As explained earlier, arbitrage CDOs are categorized as either cash flow or market value transactions. The
objective of the asset manager in a cash flow transaction is to generate cash flow for CDO tranches without
the active trading of
Figure 3 Interest cash flow and principal waterfall
collateral. Because the
cash flows from the
structure are designed
Unpaid senior fees &
to accomplish the
Trustee fees & senior expenses
objective for each
tranche, restrictions are
Senior management fee
Class A until paid in full
imposed on the asset
manager. The asset
manager is limited in
Class A interest
Class B until paid in full
his or her authority to
buy and sell bonds. The
Class A OC test If failing, amortize
Class C until paid in full
class A until test is met
disposing of issues held
Class B interest
Class D until paid in full
are specified and are
usually driven by credit
Class B OC Test If failing, amortize
risk management. Also,
Unpaid Subordinated fees
Class A and then class B until test is
in assembling the
portfolio, the asset
manager must meet
Class C interest
certain requirements set
forth by the rating
Class C OC test If failing, amortize
agency or agencies that
class A, then class B, then class C
rate the deal. Below we
until test is met
review cash flow
Class D interest
Specifically, we look at
Class D OC test If failing, amortize
the distribution of the
class A, then class B, then class C,
cash flows, restrictions
then class D until test is met
imposed on the asset
manager to protect the
noteholders, and the
key factors considered
Subordinated management fee
by rating agencies in
rating tranches of a
cash flow transaction.
Distribution of cash flows
In a cash flow transaction, the cash flows from income and principal are distributed according to rules set
forth in the prospectus. The distribution of the cash flows is referred to as the ‘waterfall.’ We describe these
rules below and will use a representative CDO to illustrate them 2 .
For a discussion of deals based by other types of collateral, see Chapters 3–9 in Lucas et al. (2006).
The representative CDO deal we will use is a U.S.$300 million cash flow CDO with a typical cash flow
structure. The deal consists of the following: U.S.$260 million (87% of the deal) Aaa/AAA
(Moody’s/S&P) floating rate tranche; U.S.$27 million (U.S.$7 million fixed rate plus U.S.$20 million
floating rate) Class B notes, rated A3 by Moody’s; U.S.$5 million (fixed rate) Class C notes, rated Ba2 by
Moody’s; and U.S.$8 million in equity (called preference shares in this deal).
The collateral for this deal consists primarily of investmentgrade, CMBS, ABS, REIT, and RMBS; 90% of
which must be rated at least “Baa3” by Moody’s or BBB– by S&P. 3 The asset manager is a well respected
money management firm. Column (1) of Figure 3 illustrates the priority of interest distributions among
different classes for our sample deal. Interest payments are allocated first to high priority deal expenses
such as fees, taxes, and registration, as well as monies owed to the asset manager and hedge counterparties.
After these are satisfied, investors are paid in a fairly straightforward manner, with the more senior bonds
paid off first, followed by the subordinate bonds, and then the equity classes.
Note the important role in the waterfall played by what is referred to as the coverage tests. We will explain
these shortly. They are important because before any payments are made on class B or class C bonds,
coverage tests are run to ensure that the deal is performing within guidelines. If that is not the case,
consequences to the equity holders are severe. Note from column (1) that if the class A coverage tests are
violated, then excess interest on the portfolio goes to pay down principal on the class A notes, and cash
flows will be diverted from all other classes to do so. If the portfolio violates the class B coverage tests,
then interest will be diverted from class C and the equity tranche to pay down first principal on class A, or,
if class A is retired, class B principal.
Column (2) shows the simple principal cash flows for this deal. Principal is paid down purely in class
order. Any remaining collateral principal from overcollateralization gets passed on to the equity piece.
Restrictions on management: safety nets
Note holders have two major protections provided in the form of tests, namely coverage and quality.
Coverage tests are designed to protect noteholders against a deterioration of the existing portfolio. There
are actually two categories of tests overcollateralization and interest coverage. The overcollateralization,
or O/C, ratio for a tranche is found by computing the ratio of the principal balance of the collateral portfolio
over the principal balance of that tranche and all tranches senior to it. That is,
O/C ratio for a tranche = [Principal (par) value of collateral portfolio] ÷ [Principal of tranche + principal of
all tranches senior to it]
The higher the ratio, the greater protection there is for the note holders. Note that the O/C ratio is based on
the principal or par value of the assets. (Hence, an O/C test is also referred to as a par value test.) An O/C
ratio is computed for specified tranches subject to the O/C test. The O/C test for a tranche involves
comparing the tranche’s O/C ratio to the tranche’s required minimum ratio as specified in the CDO’s
guidelines. The required minimum ratio is referred to as the overcollateralization trigger. The O/C test for a
tranche is passed if the O/C ratio is greater than or equal to its respective O/C trigger. In our representative
CDO, there are two rated tranches subject to the O/C test classes A and B. Therefore two O/C ratios are
computed for this deal.
The interest coverage or I/C ratio for a tranche is the ratio of scheduled interest due on the underlying
collateral portfolio to scheduled interest to be paid to that tranche and all tranches senior to it. That is,
I/C ratio for a tranche = [Scheduled interest due on underlying collateral portfolio] ÷ [Scheduled interest to
that tranche + Scheduled interest to all tranches senior]
The higher the I/C ratio, the greater the protection. An I/C ratio is computed for specified tranches subject
to the interest coverage test. The I/C test for a tranche involves comparing the tranche’s I/C ratio to the
tranche’s interest coverage trigger (i.e., the required minimum ratio as specified in the guidelines). The I/C
At the time of purchase, the collateral corresponded, on average, to a Baa2 rating.
test for a tranche is passed if the computed I/C ratio is greater than or equal to its respective I/C trigger. For
our representative deal, classes A and B are subject to the I/C test.
We showed in Figure 3 that if the class A coverage tests are violated, the excess interest on the portfolio
goes to pay down principal on the class A notes, and cash flows will be diverted from the other classes to
do so. In this case, what happens to the class B notes? They have a payinkind or PIK feature. This is a
clearly disclosed structural feature in most CDOs where, instead of paying a current coupon, the par value
of the bond is increased by the appropriate amount. So if a U.S.$5 coupon is missed, the par value
increases, say from U.S.$100 to U.S.$105. The next coupon is calculated based on the larger U.S.$105 par
amount. The PIK concept originated in the highyield market, and was employed for companies whose
future cash flows were uncertain. The option to payinkind was designed to help these issuers conserve
scarce cash or even avoid default. It was imported to the CDO market as a structural feature to enhance the
more senior classes.
After the tranches of a CDO deal are rated, the rating agencies are concerned that the composition of the
collateral portfolio may be adversely altered by the asset manager over time. Tests are imposed to prevent
the asset manager from trading assets so as to result in a deterioration of the quality of the portfolio and are
referred to as quality tests. These tests deal with maturity restrictions, the degree of diversification, and
credit ratings of the assets in the collateral portfolio.
There are three key inputs to cash flow CDO ratings: collateral diversification, likelihood of default, and
recovery rates. While each rating agency uses a slightly different methodology, they reach similar
conclusions. For example, Moody’s uses the same objective process for developing liability structures
regardless of the type of collateral. Moody’s determines losses on each tranche under different default
scenarios, and probabilityweights those results. A discussion of the methodology used by the rating
agencies is beyond the scope of this article. The interested reader is referred to Lucas et al. (2006) and the
references therein for more information about the rating process.
The development of the credit derivatives market, particularly the credit default swap (CDS) market,
fostered the development of the synthetic CDO. A synthetic CDO does not actually own the portfolio of
assets on which it bears credit risk. Instead, it gains credit exposure by selling protection via CDSs. In turn,
the synthetic CDO buys protection from investors via the tranches it issues. These tranches are responsible
for credit losses in the reference portfolio that rise above a particular attachment point; each tranche’s
liability ends at a particular detachment or exhaustion point.
The first synthetic CDOs were initiated by U.S. and European banks in 1997 for balance sheet purposes.
The motivation was to achieve regulatory capital relief without forcing the banks to sell loans they had
originated. Instead, synthetic balance sheet CDOs allowed sponsoring banks to purchase credit protection
on loans they continued to own, which reduced their credit risk and required capital. A synthetic CDO’s
ability to delink the credit risk of an asset from its ownership affords banks substantial flexibility in
balance sheet management.
As explained earlier, there are balance sheet CDOs and arbitrage CDOs. The same is true for the synthetic
variety. While the first synthetic CDOs were of the balance sheet type, synthetic arbitrage CDOs got under
way in earnest in 2000, but exploded the next year to about U.S.$60 billion, including both funded and
unfunded tranches. By 2005, synthetic arbitrage issuance was in excess of U.S.$500 billion, if one includes
the standard tranches of CDS indices. Synthetic arbitrage CDOs come in the following forms:
Fullcapital structure CDOs, which are the oldest, include a full complement of tranches from super
senior to equity. These CDOs have either static reference portfolios or a manager who actively trades
the underlying portfolio of CDSs.
Singletranche CDOs are newer, and are made possible by dealers’ faith in their ability to hedge the
risk of a CDO tranche through singlename CDS. Single tranche CDOs often allow CDO investors to
substitute credits and amend other terms over the course of the CDOs’ life.
Below we outline the features of the first types of synthetic arbitrage CDOs since they are more typical of
CDOs [Lucas et al. (2006)]. A survey of the market by the European Central Bank (2004) in 2003 found
that the “growth in trading of CDSs and synthetic CDO tranches, as well as the emergence of single
tranche CDOs and CDOs of CDOs, were seen to be the most dynamic aspects of the market in 2003.
However, singlename CDSs continued to be the most important instruments for hedging individual
Full capital structure synthetic CDOs
Full capital structure synthetic arbitrage CDOs come in many forms. The best way to explain the
Figure 4 Synthetic CDO spectrum
to focus on
Reference pool amount
Number of reference entities
first has a
Class A AAA
Class B AA
Class C A
Class D BBB
Class E Equity
which we will
[Cash collateral] ÷ [Class
refer to as
CDO #1. The
we refer to as
Immediately upon default
At end of life of deal
CDO #2, is
roughly the same underlying credit quality as CDO #1. Salient features of each of the two CDOs, including
capital structures and spreads, are shown in Figure 4.
Synthetic arbitrage CDOs can be done as static pools or as managed transactions. The advantage to static
CDOs is that the investor can examine the proposed portfolio before closing and know that the portfolio
will not change. The investors can ask that certain credits be removed from the portfolio or can decide not
to invest in the CDO at all. There are also no ongoing management fees. The disadvantage to a static deal
becomes apparent if an underlying credit begins to deteriorate, because no mechanism exists for the CDO
to rid itself of the problem credit, which remains in the portfolio and may continue to erode.
First, let us look at the capital structure. Observe from Figure 4 that static synthetic CDO #1 has much
higher equity (3% versus 1.6%) and no coverage tests. The higher equity percentage is a reflection of the
absence of coverage tests. The key to understanding the smaller size of the equity tranche in CDO #2 is the
structure of its interest waterfall. Initially, the trustee, the senior default swap, and the senior advisory fees
are all paid out of the available collateral interest and CDS premium receipts. Next, interest is paid to the
various note holders, from class A to class D, in order of their seniority. Then, a coverage test is conducted.
If the coverage test is passed, remaining funds are used to pay the subordinate advisory fee, and the residual
cash flow goes to equity holders. But, if the coverage test is failed, cash flow is trapped in a reserve
account. Cash in the CDO’s reserve account is factored into the coverage test, helping the CDO to meet its
required ratio. If the coverage test comes back into compliance, future excess cash flows can be released to
the subordinate advisory fee and to equity holders. At the CDO’s maturity, cash in the reserve account
becomes part of the principal waterfall and helps to pay off tranches in order of their seniority.
Despite the different proportions of equity in the two CDOs, the credit protection enjoyed by rated tranches
in each CDO is about equal. This is so because credit protection is measured not only by the amount of
subordination below a tranche, but also by how high credit losses can be on the underlying portfolio before
the tranche’s cash flows are affected. In this case, the rated tranches from both CDOs can survive
approximately the same level of default losses; the lower amount of equity in CDO #2 is compensated for
by its coverage test and cash trap mechanism.
Now, let us compare the equity cash flows and the timing of write downs. In CDO #1, equity is paid a fixed
coupon, and thus has no claim on the residual cash flows of the CDO. Equity holders receive interest only
on the outstanding equity balance. In CDO #2, the equity holders have a claim on all residual cash flows of
the CDO. The timing of writedowns is very different for the two CDOs. In CDO #1, there is a cash
settlement whenever a credit event occurs. Thus, when a credit event occurs, (1) that credit is removed
from the pool, (2) the CDO pays default losses, and (3) the lowest tranche in the CDO is written down by
the amount of default losses. If equity is written down to zero further losses are written down against the
next most junior tranche and so on, moving up the CDO’s capital structure. By contrast, when a credit
event occurs in CDO #2 physical settlement occurs. The security can be sold, but there is no writedown
until the end of the deal. At that time, the principal cash flows go through the principal waterfall, paying off
first the class A note holders and then those in class B, C, and D. After note holders are paid, remaining
funds go to the equity holders.
Because of these structural differences and investor taste, the BBB and lower classes in CDO #1 generally
sell at a wider spread than they do in CDO #2. In Figure 4, the BBB tranche is shown at LIBOR + 400 in
CDO #1; it is only LIBOR + 275 in CDO #2. In CDO #1, the writedowns are immediate, and there is no
way to recoup losses by better performance later in the deal’s life. Moreover, if any of the classes
(including the equity) incur losses, their interest is reduced accordingly.
Singletranche CDOs are notable for what they are not: the placement of a complete capital structure
complement of tranches, from equity to super senior. Instead, a protection seller enters into one specific
CDO tranche with a CDS dealer in isolation. Protection sellers can choose the portfolio they wish to
reference, as well as the attachment and detachment points of the tranche they wish to sell protection on.
These factors will imply a price for that protection. Alternatively, the protection seller can start with a
premium in mind and then negotiate other terms to create a transaction furnishing that premium. Because
there are only two parties to the transaction, execution can be quicker than it would be with a fullcapital
structure CDO encompassing many constituencies.
The singletranche synthetic CDO can also provide flexibility over its life. As reference credits in the
underlying portfolio either erode or improve in credit quality, the value of the CDO changes. If, for
example, reference credits have all been severely downgraded the value of credit protection increases
because it is more likely that there will be default losses. A protection seller of such a singletranche CDO
might be willing to pay a fee to terminate the CDO early rather than be exposed to default losses later.
Singletranche CDO investors can go back to the original dealer to reverse out of a trade, or they can
reverse the trade with another dealer. If investors have sold protection to dealer A, for example, they can
buy protection on the exact terms from dealer B. This would leave them with offsetting trades. In many
cases, dealers will allow the investor to step out of the trades completely, and the two dealers will face each
Many singletranche synthetic CDOs have a feature where terms of the CDO are adjustable over its life.
Recall the example where underlying credits have severely deteriorated. Protection sellers might be
allowed to replace a soured credit with a better one for a fee. Alternatively, instead of paying a fee, the
terms of the CDO tranche might change. In exchange for getting rid of a troubled underlying credit, the
attachment point might be decreased, the detachment point might be increased, or the premium might
Concerns with new CRT vehicles
As with any new complex financial product introduced by banks, there are regulatory and supervisory
concerns. The introduction of new CRT vehicles, such as cash CDOs and credit derivatives that are
employed to create synthetic CDOs, has elicited the same cautious response from overseers of the global
banking system. As explained below, a good number of these concerns are the same as those identified for
derivatives, such as interest rate and equity derivatives, and securitized products, such as collateralized
Five studies have identified regulatory and supervisory concerns with CRT vehicles, such as credit
derivatives and CDOs. The first is a study by the Financial Stability Forum of the Joint Forum [Joint Forum
(2003)]. The Joint Forum consists of the Basel Committee on Banking Supervision, the International
Organization of Securities Commissions, and the International Association of Insurance Supervisors. The
second study was conducted by the European Central Bank [ECB (2004)], which was a market survey
based on interviews with more than 100 banks from 15 European Union banks, five large internationally
active nonEU banks, and securities houses operating in London. The last three studies are by rating
agencies, two by Fitch Ratings (2003, 2004) and the one by Standard & Poor’s (2005). From the five
studies, four general issues were identified. We discuss each of them below.
Issue 1 – ‘Clean’ risk transfer
As new vehicles for CRT have developed, increasing the market liquidity for corporate debt such as bonds
and bank loans, the nature of the risks faced by market participants has changed in several ways. At one
time, the focus of an investor in a corporate debt was on the ability of the corporation to meet its
obligations. The issue with new CRTs is whether there is a ‘clean’ transfer of credit risk.
The concerns with credit derivatives and, therefore, synthetic CDOs being used as CRT vehicles are
threefold. Firstly, there is a concern with counterparty risk the failure of the counterparty selling credit
protection would result in the buyer of credit protection maintaining the credit exposure that it thought it
had eliminated. With respect to this concern, studies have noted that there are standard procedures available
in risk management that can be employed to reduce counterparty risk. These risk management tools are
equally applicable to overthecounter derivatives used to manage interest rate and currency risk by
regulated financial entities.
Secondly, while the development of standard documentation for credit derivative trades by the International
Swaps and Derivatives Association (ISDA) fostered the growth of that market, there remains a concern
with legal risks that may arise from a transaction. Legal risk is the risk that a credit derivative contract will
not be enforceable or legally binding on the counterparty to the trade or may contain ambiguous provisions
that result in a failure of the contract to fulfill its intent. The most prominent example is what the credit
derivatives market faced early in its life dealing with the issue of whether a credit event has occurred and,
in particular, controversial credit events such as restructuring. The 2004 survey of financial institutions by
Fitch investigated the frequency of disputed credit events and found that about 14% of the credit events
captured in the survey were reported to involve some form of dispute. As for the resolution of those
disputes, Fitch found that at the time the vast majority had been or were being resolved without the
involvement of the court system. Another example of legal risk is that of whether the counterparty has the
authority to enter into a credit derivative transaction. This is not unique to credit derivatives, but has been
the subject of litigation in other derivative markets. For example, interest rates swaps between various
dealers and local U.K. authorities were void in 1991 because it was ruled the later did not have the legal
authority to enter into the contracts in the first place.
Issue 2 Risk of failure of market participants to understand associated risk
With the development of any market vehicle there is the concern that market participants will not
understand the associated risks. For example, there is evidence in the interest rate swap market of corporate
entities allegedly failing to understand these risks, probably the two most wellknown legal cases being that
of Gibson Greetings and Proctor & Gamble. The same is true for collateralized mortgage obligations. Both
of these instruments have been important financial innovations, but there were users/investors who
experienced financial difficulties/fiascos because product innovation may have run far ahead of product
In the case of a financial institution that seeks to make a market in the new CRT vehicles, there is a concern
that in selling more complex products, such as synthetic CDOs, they may not be properly hedging their
position and therefore increasing the institution’s risk. (While we have not discussed the pricing of
synthetic CDOs, it fair to say that these instruments are not simple to price.) There is modeling risk. For
example, in the case of a singletranche CDOs, the dealer will have an imbalanced position on CDSs and
will try to hedge that position by delta hedging [Lucas (2007)]. The risk, of course, is that the dealer has not
With respect to this issue, the recommendations of the report of the Joint Forum concentrated on the need
for market participants to continue “improving risk management capabilities and for supervisors and
regulators to continue improving their understanding of the associated issues.” Given this focus, the report
sets forth recommendations for market participants and supervisors in three areas: risk management,
disclosure, and supervisory approaches, with particular emphasis on reporting and disclosure.
Issue 3 Potentially high concentration of risk
A CRT vehicle can result in either the transfer of the credit risk from one bank to another or from a bank to
a nonbank entity. Within the banking system, the concern is whether there has become too much
concentration of credit risk. For credit risk transferred out of the banking system, there is the concern with
the extent to which credit risk is being transferred to nonbanks, such as monoline or multiline insurance
companies and hedge funds. The overall concern is the impact on the financial system resulting from a
failure of one or a few major participants in the CRT market.
The two studies by Fitch Rating (2003, 2004) reported the number of banks (North American and
European) and insurance companies active in the CRT market and the relative size of each. In its 2003
market survey, Fitch surveyed about 200 financial institutions (banks, securities firms, and insurance
companies), focusing on those it classified as protection sellers. Fitch found that through credit derivatives
the global banking system transferred U.S.$229 billion of credit risk outside of the banking system. Most of
this was to the insurance industry (monoline insurance companies/financial guarantors, reinsurance, and
insurance companies). The insurance industry itself is the largest seller of credit protection. Fitch estimated
that the insurance industry sold U.S.$381 billion of net credit protection (i.e., credit protection sold less
credit protection purchased). Of that amount, insurance companies provided U.S.$303 in credit protection
via the credit derivatives market and the balance, U.S.$78 billion in credit protection by their participation
in the cash CDO market. Within the insurance industry, the largest seller of credit protection is financial
guarantors, insuring the senior tranches in synthetic CDO deals. In the opinion of Fitch, “the expansion of
the sector in credit derivatives market has generally been well managed and consistent with the industry’s
rating.” Fitch concludes that bank buying of credit protection via credit derivatives “has significantly
increased liquidity in the secondary credit market and allowed the efficient transfer of risk to other sectors
that lack the ability to originate credit.” There was a relatively high concentration of credit protection
buying by large, more sophisticated banks. Smaller and regional banks were net sellers of credit protection
despite banks being net buyers of credit protection in the aggregate.
With respect to counterparty concentration, Fitch reported that the market is concentrated among the top 10
global banks and brokerdealers. While having investmentgrade ratings, the risk is that the withdrawal of
one or more of these firms from the market for financial or strategic reasons could undermine the
confidence in the CRT market.
In its 2003 survey, Fitch attempted to collect information on hedge fund activities by writing to the 50
largest hedge funds in the world. None responded. In its 2004 survey, Fitch included questions for the
major intermediaries as to their dealings with hedge funds. Fitch found that hedge funds represented
between 20% to 30% of their overall CDS index trading. Ultimately, counterparty risk exposure to hedge
funds depends on the extent of the collateralization of the trades. While most of the intermediaries in the
survey responded that their positions with hedge funds were fully collateralized, some stated that it was less
than 100% collateralized.
Fitch also found that there is high concentration in the corporations that are the reference obligations in a
CDS. Settlement problems could occur if there is a credit event for one of these references, leading to a
major market disruption. Moreover, because of the higher correlation of default that exists for
counterparties and corporate references in the CRT market, in comparison to other derivative markets, there
is a concern with the market facing multiple defaults. The ECB report concluded that the potential for
disruption of the new CRT vehicles was generally small.
Issue 4 Adverse selection
The ability of originators to transfer credit risk via credit derivatives, CDOs, or securitization has raised
concerns that a lending culture based on origination volume rather than prudent lending practices may be
inadvertently adopted by banks. This is a concern about securitization in general as noted in Fabozzi and
The two most recent introductions into the CRT market, which have made it possible to transfer large
amounts of corporate credit risk exposure among banks as well as from the financial sector to the non
financial sector, are credit derivatives, in particular CDS, and CDOs. One variety of the CDO is the
synthetic CDO, in which credit risk exposure is transferred via CDS rather than the transfer of ownership of
corporate debt obligations. There are concerns raised by regulators regarding CDOs and CDSs, some of
these being the usual concerns with the introduction of any new financial innovation. The report by the
European Central Bank (ECB (2004)] concluded the following regarding these new CRT vehicles: “The
report’s overall assessment of trends in this market is positive. Improvements in the ability of banks and
other financial institutions to diversify and hedge their credit risks are helping the financial system to
become more efficient and stable.”
ECB, 2004, “Credit risk transfer by EU banks: activities, risk and Risk management,” European Central
Fabozzi, F. J. and V. Kothari, 2007, “Securitization: the tool of financial transformation,” Journal of
Financial Transformation, this issue
Fitch Ratings, 2003, “Global credit derivatives: a qualified success,” September 24
Fitch Ratings, 2004, “Global credit derivatives survey: singlename CDS fuel growth,” September 7
Joint Forum, 2005, “Credit risk transfer.” Bank for International Settlements
Lucas, D. J., L. S. Goodman, and F. J. Fabozzi, 2006, Collateralized debt obligations: structures and
analysis (Second edition), John Wiley & Sons, New Jersey
Lucas, D. J., L. S. Goodman, F. J. Fabozzi, and R. Manning, 2007, Developments in the collateralized debt
obligations markets: new products and insights, John Wiley & Sons, New Jersey
Standard & Poor’s, 2003, “Demystifying banks’ use of credit derivatives,” December.