BASIC ECONOMIC DRIVERS OF CDOs
Why do CDOs exist? Why might it be possible for the manager of a CDO to provide higher returns to its noteholders than a mutual fund manager investing in debt instruments? Why would a CDO be able to attain higher leverage and still have some securities rated AAA, as compared to a mutual fund? Were CDOs simply the product of a benign credit market cycle, or have they become a permanent part of the financial landscape?
These are hard questions, and it might be too early to answer at least some of these questions, as CDOs have only recently been tempered with a downturn in the credit cycle—the subprime crisis in the summer of 2007 is the first major jolt to the CDO business. However, the apparent economic fundamentals of CDOs appear like this. CDO managers select a pool of relatively risky assets on their asset side. The asset risk is accentuated by a high leverage on the liability side with a junior class of 4% to 5% bearing the first-loss risk of the entire asset pool. The risk of assets, thus magnified, is mitigated by the diversification of the assets. Asset diversity and financial leverage are the two economic drivers of CDOs—leverage creates risk and returns, and diversity is what makes the leverage tolerable.
The leverage and diversity also explain some of the key questions that we just raised—the relatively higher returns of CDOs are explained by the leverage, and the leverage, in turn, is explained by the diversity.
Thus, the diversity ...