Introduction to Securitization

WHY STUDY CDOs?

CDOs have three distinctive features that warrant an independent study of this structured product. We describe these features in this section.

Arbitrage Motive

As explained in Chapter 2, ABS are created to lower funding costs and for risk management purposes. The first CDO transactions were primarily motivated by transferring assets off the balance sheet of a bank and are referred to as balance sheet CDOs. Today, the dominant motivation for the creation of a CDO is arbitrage opportunities. The term arbitrage here is used in a very loose way because there is, in fact, risk to the sponsor of a CDO and, therefore, investors. What the sponsor of a CDO does is create of pool of assets and funds those assets by selling securities (the CDOs). So far, this is not different from a typical ABS transaction. However, the purpose is to earn a return on the pool of assets that exceeds the funding costs to acquire those assets. The difference between the return earned on the assets and the funding costs is shared by the CDO sponsor, CDO manager, and CDO equity investor. Just how it is shared by these three entities is a part of the CDO waterfall, which we describe in more detail in this and the next two chapters.

Pool of Corporate Exposures

While a residential mortgage-backed security (RMBS) or auto-loan securitization transaction is backed by a pool of retail loans, a CDO is a pool of wholesale or corporate loans or exposures. This, by itself, has a significant impact ...