Collateralized Debt Obligations (CDOs) are structured fixed-income and equity securities backed by a variety of assets including corporate loans, bonds, residential and commercial mortgage and other asset-backed securities- and can include synthetic exposure to these assets through credit default swaps. CDOs are generally securitized and issued out of a special investment vehicle or trust structure, with a variety of tranches issued that vary in seniority, coupon rate and credit quality. A typical CDO structure may have 5-6 tranches, with ratings varying from AAA to BB or B and equity (generally unrated).

First developed in 1987 by bankers at Drexel Burnham Lambert, the CDO market grew to over $500 billion in issuance in 2006, the peak issuance year for CDOs. According to SIFMA, over $1.4 trillion in CDO securities have been issued in the past 5 years, with a few hundred billion in additional issuances not accounted for in statistics. Excluding CDOs that have been liquidated, it is estimated that there are approximately $1 trillion in face value of current outstanding securities. The CDOs themselves are very complex; in addition to having different collateral types, CDOs can be structured in various ways depending upon their purpose (such as risk management or arbitrage) including cash-flow deals, pure synthetic transactions, hybrids of the two and market value.

CDO Liquidity
Largely intended to be “buy and hold” securities, investment banks placed CDO securities on a 144A or Reg S basis, with limited information available for a buyer to accurately price. Accordingly, there has historically not been a very active secondary market for CDOs. In addition, due to the 144A nature of the securities, as well as the counterparty agreements with some of the tranches, some CDOs have transfer restrictions. When they have traded, CDOs have traditionally traded over-the-counter (OTC) among a scattered array of dealers around the globe – usually only with the dealer who originally underwrote the CDO. Due to the insolvency and financial instability of the traditional large dealers, the secondary trading market virtually no longer exists. Currently, investors have nowhere to turn to for price discovery for their CDO securities. SecondMarket has leveraged its technology and deep buyer base, adding CDO data and analytical tools to centralize trading through its online trading platform, to help correct this imbalance.

Major CDO Structures and Classifications
As mentioned above, there are myriad collateral types underlying the CDO structures. CDOs can be described and classified by the major asset types, which include:
• Asset backed Securities including RMBS, CMBS and other consumer ABS;
• Corporate bonds (these structures are also known as Collateralized Bond Obligations or CBOs);
• Banks loans (the structures are also known as Collateralized Loan Obligations or CLOs);
• Emerging market debt;
• Credit derivatives;
• Other CDOs (these structures are also known as CDO-squared);
• Other specialized debt types.

Additionally, CDOs can be classified by the motivation for CDO formation. CDOs serve two general functions- balance sheet reduction and arbitrage. The motivation of the issuing institution for balance sheet transactions, often large financial institutions such as banks, is often to remove assets from their balance sheets to free up capital and/or lower their risk profile. Arbitrage CDOs attempt to capture a spread between relatively higher yielding assets in the collateral pool and lower yielding CDO issued liabilities. The following four structures achieve these objectives:

Cash CDOs
The exposure to underlying assets or transference of risk from assets can either be done by purchasing the asset outright or synthetically. Cash CDOs actually own the underlying MBS, bonds, loans or other collateral. The asset portfolios are typically managed in one of two ways:

Cash-flow
With cash-flow CDOs, the portfolio is structured such that asset managers pay principal and interest to holders of the senior and mezzanine CDO tranches with proceeds generated from interest payments and principal payments from maturing securities of the pool collateral. Certain restrictions are placed upon the manager, with any purchase or disposition of assets usually tied to credit (and not market) considerations.
Market Value
Market value structures are unique in that their asset pool can increase and decrease over time based upon changes in the value of the portfolio over time. Underlying collateral is bought and sold to manage liability payments to investors. With this type of structure, a close monitoring of collateral market trading activity is undertaken, and the collateral is marked to market. The manager has much more purchase and disposition freedom than with a cash flow CDO.

Synthetic CDOs
Synthetic CDOs attempt to diversify risk of certain collateral for the seller and give the buyer exposure to the same asset on the other side of the transaction. The underlying collateral is not owned, but diversification and exposure are achieved through the writing of a variety of credit default swaps which are tied to the desired asset exposure, also known as “reference entities.”

Hybrid CDOs
With hybrid CDOs, the collateral is usually a pre-determined mix of both funded securities and credit derivatives. This structure usually results in a deal with a super-senior tranche and the remainder of the structure similar to any other cash-flow transaction as described above. The super-senior performs two functions: first to fund for any cash-flows required to cover losses on the credit derivatives, and second, to provide for “super-catastrophic losses” – usually losses far in excess of normal AAA assumptions.
 

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