Early CDO Technology
A collateralized debt obligation (CDO) is backed by portfolios of assets that may include a combination of bonds, loans, securitized receivables, asset-backed securities, tranches of other CDOs, or credit derivatives referencing any of the former. Some market practitioners define a CDO as being backed by a portfolio including only bonds and/or loans, but most market practitioners use the former definition. I’ll use CDO as an umbrella term for asset securitizations.
Up to the end of the 1990s, CDOs all used special purpose entities (SPEs), also known as special purpose vehicles (SPVs), that purchased the portfolio of assets and issued tranches of debt and equity. The SPE purchased the assets from a bank’s balance sheet and/or trading books. These are known as true sale structures.
Special purpose entities are usually bankruptcy-remote, meaning they are delinked from the credit risk of the bank arranger, also known as the originator. The bank arranger can earn servicing fees, administration fees, and hedging fees from the SPV, but otherwise has no claim on the cash flows of the assets in the SPV.
Formerly, banks and investment banks underwrote the CDO tranches to provide the funds—often along with bridge financing—for the purchase of the portfolio assets, which backed the tranches. This is no longer always the case. Synthetic securitizations eliminate the need for a special purpose entity, albeit they may also use an SPE to issue limited recourse notes ...