CDO Structures

CDO structures may be either conventional or synthetic. The conventional structures were the first to be widely used, but synthetic ones have become increasingly common since the late 1990s. The difference between the two structures lies in how they transfer credit risk from the originator to the SPV in conventional CDO structures, this is achieved by transferring assets in synthetic structures, credit derivative instruments are used. 

CDOs of both types are also categorized by the motivation behind their creation. The two main categories are issuer- or balance sheet—Anw n transactions and investor-driven or market value arbitrage transactions. 

Because the SPV now owns the assets, it has an asset-and-liability profile that must be managed during the term of the CDO. The typical liability structure includes a senior tranche rated Aaa/Aa, a junior tranche rated Ba, and an unrated equity tranche. The equity tranche is the riskiest, since it is the first to absorb any losses in the underlying portfolio. For this reason, it is often referred to as t t first-loss tranche. 

In the case of a CLO, the originating bank commonly continues to service the underlying loan portfolio and retains the equity tranche. 

Structuring a conventional CDO may give rise to significant issues. For instance, the transfer of assets into the SPV may have adverse tax. 

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In snmmary, a CDO is a very powerfnl tool that facilitates the needs of many market constituents. Like all tools, however, they have to be used properly. A CDO structured where the unique particulars of the collateral, the asset manager, and investor are considered, and most importantly balanced, begins to define the minimum standard of excellence that all good structnred financiers shonld respect. 

In this section we will attempt to complement the theory and approaches discussed so far with actual transaction examples. Specifically, we will highlight Euro Zing I CDO as a further example of the flexibilities a CDO s liability structure can adopt. Equally, we will explore the use of indexation in CDO structures with the Rosetta CBO I transaction. And finally, Robeco CSO III will be examined as the first fully managed, standalone CDO backed by credit derivatives. 

The cumulative benefits to synthetic CDO structures versus cash structures, if they are all in play, amount to dramatically improved economics. For instance, if all of the asset side (flexibility, ramp-up, basis) benefits sum to only 10 bps, and the liability benefit is 40 bps on 70% of the capital structure, the savings would amount to 38 bps (= 40 x 0.7 + 10) on a 1 billion transaction. For a 5-year synthetic CDO, the PV of those 38 bps amounts to over 17 million. In a leveraged structure, of course, these benefits will primarily accrue to the equity and their impact will be magnified as shown in Exhibit 22.8. Clearly, the synthetic CDO may be an efficient vehicle for investors to use in accessing diversified tranches of risk. 

Having examined a snapshot of the no-loss potential return to investors as well as the potential execution benefits of synthetic CDO structures, the next question becomes the potential for loss. The allocation of gains and losses, and their order of priority (the waterfall ), is negotiated and governed by the language of the synthetic CDO. In a typical syn-... 

For the balance of the discussion we will assume a traditional type of structure, but it is worth noting that, in lengthy bilateral contracts, issues far removed from attachment points and spread can have large impacts on pricing. The very flexibility available to investors in synthetic CDO structures means that additional attention is required to evaluate transactions. 

RiskMetrics Group CDOManager is designed to analyze cash and synthetic CDO structures. It helps assess the risk associated with a CDO and calculate prices. CDOManager produces expected cash flow from the assets and feeds them into a waterfall to determine the cash flow to the notes. Exhibit 22.16 provides a screenshot from CDOManager. 

In an ABS or CDO structure the issuer will usually issue different tranches of notes with different levels of seniority. As losses occur in the portfolio, the most junior investors will start losing their investment. The mezzanine investors will only face a loss on their investment after the junior tranche has been lost, that is, the losses on the portfolio are greater than the junior tranche. The senior tranche investors will only face a loss on their investments when the losses on the portfolio are greater than the sum of the junior tranche and the mezzanine tranche together. 

A typical CDO structure is described in several legal agreements that formalize the roles played by the various counterparties to the deal. In addition to the offering circular, which presents the transaction details to investors, these documents include the following ... 

The high-silica ferrierite, designated as ZJM-2, has been synthesized by induction of CDO-structure zeolite building units in the absence of organic templates [llZl]. The resulting zeolite was ciystalline, had a high surface area, similar crystal shapes, and oidy tetrahedral aluminum and abundant acidic sites. 

The leverage factor in some of the products reached very high levels. After CDOs, more leverage was sought with CD0 2, which were CDO structures investing in other CDOs. 

Zhang H, Guo Q, Ren L, Yang C, Zhu L, Meng X, et al. Organotemplate-free synthesis of high-sUica ferrierite zeolite induced by CDO-structure zeolite building units. J Mater Chem 2011 21 9494-7. 

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