CHAPTER 21Collateralized Debt Obligations (CDOs)

Daniel I. Castro, Jr.

INTRODUCTION TO CDOs

This chapter, in general, describes how typical collateralized debt obligations (CDOs) are structured and how they operate. It should be kept in mind, however, that every CDO is unique and there can be significant variation in the specifics of each deal.

A CDO is an entity—and typically a bankruptcy‐remote special‐purpose vehicle (SPV), also referred to as a special‐purpose entity (SPE)—that purchases a pool of assets (collateral assets) financed by the issuance of debt and equity securities (CDO securities). The collateral assets can be any of a variety of debt instruments that generate cash flow from which the CDO can make payments to the holders of its CDO securities. Collateral assets can include RMBSs, CMBSs, leveraged business loans, trust preferred securities, and other cash‐generating debt obligations. CDO securities in turn are issued in tranches, with each tranche assigned a different priority to the payment of principal and interest by the terms of the CDO's governing documents.

CDOs are structured finance products designed to securitize diversified pools of debt securities. ABS CDOs are typically backed primarily by RMBSs, with small amounts of other ABS. The purpose of a securitization is to repackage and redistribute risk, and the act of securitization is the process of converting assets into securities backed by those assets. CDOs finance the purchase of their asset portfolios ...

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