Introduction to Securitization

INVESTING IN CDOs

In this and the following section, we look at CDOs from the investor’s perspective.

Investor Motivations

The CDO business has grown rapidly, as revealed by data in Chapter 11. Apart from sheer growth in the numbers of CDOs, the variety of investors who have invested in CDOs has also grown. Investors in senior, mezzanine, and equity classes come with different motivations.

Senior investors in CDOs are obviously driven by the diversification motive. The spreads at CDO AAA level are relatively higher than corporate AAAs, but the difference is not substantial. The IMF’s Global Financial Stability Report of September 2007 gave some data about CDO (specifically, structured finance CDOs) investors. It appears that at senior level, hedge funds are major investors, followed by asset managers, banks, and insurance companies. At the equity level, banks, insurance companies, hedge funds, and asset managers, in that order, are the prime investors.

The following factors explain investor preference for CDOs:

1. Strength and stability. Compared to corporate debt, CDOs have had a historically lower default rate. However, being a highly leveraged instrument, CDOs are prone to cyclical changes. Once in a while, as the corporate debt scenario worsens, the CDO market gets some jitters. The subprime meltdown has caused substantial pains to the CDO sector, with several severe downgrades and some early amortizations.

2. Diversification. CDOs enable investors already active in traditional ...