Collateralized Debt Obligations: Structures and Analysis, Second Edition

CHAPTER 21

The CDO Arbitrage

Both the pattern of CDO issuance—such as heavy or light volume, or which type of collateral dominates—as well as the configuration of completed deals—Are there AA or A rated tranches, or simply a larger AAA and BBB class?—are dictated to a large degree by CDO arbitrage. In this chapter, we first look at the CDO arbitrage and examine a “quick and dirty” analysis for benchmarking activity levels. We then focus on how the arbitrage dictates deal structure. Spread configurations and the exact collateral used are important in determining optimal deal structure.

BUILDING BLOCKS

In a CDO, asset purchases are financed by a combination of liabilities plus equity. The “arb” exists when those assets can be purchased and the liabilities sold with enough left over to provide a competitive return to equity holders. Mortgage market participants recognize this exercise for what it is: a kissing cousin to the collateralized mortgage obligations (CMO) arbitrage.

Like the CMO arbitrage, in any intended CDO arbitrage sample structures are always run to determine when this arb is “close.” Dealers then act on those results to optimize deal structure so as to increase the likelihood that the deal can actually be executed. Let us look at some simplified examples of “arb” runs for bond and loan deals and then at how these deals can be fine-tuned to improve the arb's attractiveness.

Crude Run

The basis for the arb is the “crude run.” In this run, we look for is whether return-on-equity ...