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| Risk & Reward: Products: Risky Business? |
A Guide to CDO Structures
John Ferry
11/01/2005
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The common feature of all CDO structures is the transference of a portfolio
of securities to a special-purpose vehicle (SPV)—a company set up as an
independent legal entity. This SPV then issues different classes of
securities—tranches—to investors in the capital markets. As with any
business, the investors who buy these notes effectively have claims on the
assets and cash flow of the SPV in the event of a bankruptcy.
However,
investors are subject to a ranking in terms of seniority when it comes to these
claims. At the top there are the senior creditors, who are the first to get
paid—and the last to lose money—in the event of insolvency. As they take on the
least amount of risk, they also get paid the smallest amount of interest on
their paper. Further down the CDO food chain, risk increases, but so does the
potential return.
Credit rating agencies such as Standard & Poor’s and
Moody’s Investors Service assign ratings to each tranche. Investments linked to
the most senior tranche are rated AAA. Below this is the mezzanine tranche,
which is generally rated from high BBB to low B. At the bottom is the equity
tranche, which has nothing to do with shares but is named as such because it is
considered to have the risk characteristics of equity. The equity tranche is
also known as the first-loss piece and is generally unrated. There may also be
other tranches slotted in between these main groups.
This structure is known
in the trade as a waterfall, because if the CDO were liquidated, money made from
selling its assets would be used primarily to repay investors in the senior
tranche. Money left from this initial payment would then flow to the mezzanine
tranches, and then continue on down the investor food chain. Conversely, most of
the money generated by the debt in the collateral pool pays out to the equity
investors, hence the high returns to that group. The mezzanine investors get a
smaller return, and the senior tranche investors get an even smaller return.
What is left over goes to compensate the arranging bank and, if there is one,
the collateral pool asset manager. Back to Main Article: Products: Risky Business?
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