Handbook of Finance: Financial Markets and Instruments

Chapter 38. Collateralized Debt Obligations

DOUGLAS J. LUCAS

Executive Director and Head of CDO Research, UBS

LAURIE S. GOODMAN, PhD

Co-head of Global Fixed Income Research Manager of U.S. Securitized Products Research, UBS

FRANK J. FABOZZ1, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

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, ...