At their best, CDO managers can add value by monitoring CDO collateral and making sure that the trustee understands the cash flow structure of the deal so that mistakes are not made. For example, in some CDOs, reinvestments have occurred long after the reinvestment period has ended. In other deals, payments were made between special purpose entities that should not have been made. A diligent CDO manager can catch and correct these errors and can head off portfolio credit deterioration. Unfortunately, this seems to have been a utopian goal, and most collateralized debt obligation managers collected fees for little more than producing reports.
As mentioned before, if a deal manager has a claim on the equity cash flows, there is a conflict of interest between the manager and more senior noteholders. If CDO managers are affiliated with the capital markets group of an investment bank or with related hedge funds, there may be a conflict of interest with the various roles of the manager. The CDO manager may be tempted to trade deteriorating assets from the capital markets group into the CDO warehouse. There may be a temptation to trade hedge fund assets with the CDO, creating artificial mark-to-market prices for the underlying collateral.
One would think that the best way to avoid these negative consequences is to use an independent CDO manager. Independence is somewhat of a myth, however, since CDO managers rely on investment banks to award them the right to ...