Collateralized Debt Obligations: Structures and Analysis, Second Edition

CHAPTER 22

How to Evaluate a CDO and Manage a CDO Portfolio

In this chapter, we look at evaluating CDOs individually and as part of a portfolio. We make two points about buying CDO deals individually. First, we make the case that one of the most important points to look for in a CDO purchase is the structural protections inherent in a CDO. There is a natural tension between the interest of debtholders and equity holders that the CDO structure tries to address. Buyers of CDO debt will want to look at both the incentive structures in a CDO, as well as how the manager has done on outstanding CDOs. Second, in picking managers, track record cannot be taken at face value. Common sense goes a long way.

We then move on to managing a CDO portfolio. Some portfolio managers have quite an extensive collection of CDOs, owning 100 to 200 different CDOs. Yet they often tend to look at buying each additional CDO as if they were buying their first. They do not place the CDOs within a general portfolio framework. In the second half of the chapter, we make the case that investors should buy CDOs backed by different types of collateral. Asset class is a far more important determinant of returns than is choice of specific managers. Finally, we look at diversity on a portfolio basis. A low diversity CDO may add more diversity to a portfolio because it is backed by a different type of collateral than a high diversity CDO.

INCENTIVE CLASHES IN CDO STRUCTURES

When a deal is going well, the interests of ...