Benefits of Collateralized Debt Obligation (CDO’s)

In the previous article, we studied about the beginning of the collateralized debt obligations (CDO’s) and how they were born out of the mortgage backed securities. We also saw that collateralized debt obligations (CDO’s) were not a way to magically get rid of risks. Instead, these securities would ensure that everyone is not forced to take the risks. They would just reassign the risks to whoever is willing to take them for a price. A lot of negative information about the collateralized debt obligations (CDO’s) has been heard in the media. However, there are some positives to the story as well. We will look at the benefits in this article.

Catering To Different Investor Groups

The financial markets are full of investors with different kinds of needs. There are young single people and then there are grandpas. There are people who can afford to lose money and then there are people who wouldn’t want to afford a single penny. Most asset classes can only cater to one or few of these investor groups. For instance equity is for the high risk investor whereas debt is for the low risk investor. However, that was not the case with mortgages after collateralized debt obligations (CDO’s) were introduced. Collateralized debt obligations (CDO’s) were the miracle of structured finance which allowed the same product to be sold to multiple sellers who had very different risk reward needs. This created a huge demand for these securities which was desirable because selling a large number of these securities would help society pursue the American dream of owning a house.

Flexible Tenures

Mortgage loans were known for being highly illiquid as well as for having very large tenures. A typical mortgage loan would last for three decades. Most investors were not willing to buy securities with such a long maturity even if there was an active secondary mortgage market for them to cash out and leave. This is because the cash flows that will arise from these mortgages three decades hence are impossible to predict even for the most sophisticated of investors. It is for this reason that collateralized debt obligations (CDO’s) became more popular. Through the use of the tranching technique it was possible to create multiple securities with shorter or longer tenures as required by the buyers. This also led to the proliferation of collateralized debt obligations (CDO’s) since these securities could literally be custom made to meet the needs of the clients.

Overcollateralization

One of the biggest risks facing the buyers of any kinds of bonds is the risk of prepayment. In case there is a prepayment there are left with the principal and no way to invest it at the same rate of return. This was even more common in the mortgage markets since many mortgages were being taken out for purely speculative purposes. Hence, at least a portion of them were to repaid within the first few years. To counter this problem, the investment bankers started using a process called overcollateralization while creating the collateralized debt obligations (CDO’s). Hence, if they had mortgages worth $200, they would sell bonds only for $150. The balance $50 would act as a buffer to absorb prepayments and hence the name overcollateralization. However, once prepayments crossed the $50 mark, they would have to be absorbed by the bondholders depending upon which tranche they belong to. However, under normal circumstances the likelihood of that happening was minimal. Once again the collateralized debt obligations (CDO’s) were made more marketable by the use of this practice.

Principal Only Bonds

There was a class of investors that was still wary that the homeowners would decide to refinance and prepay their debts at the exact moment when the interest rates were low. This would leave the bondholders with a pile of cash and no way to invest it at a high interest rate. To cater to the needs of such people, the makers of collateralized debt obligations (CDO’s) created a different class of security called the principal only bond. This was very similar to the zero coupon bond in the fact that it sold at a discount and then it would be retired for its full value on maturity. Hence, the holders of these bonds would receive their money at an earlier time ensuring that the time weighted return on their investment would be higher than it would otherwise have been. Principal only bonds were preferred by the more senior and the more conservative investors.

Interest Only Bonds

The opposite of principle only bonds were interest only bonds. These bonds were meant for the risky investors since their value could dramatically change virtually overnight. In case of a prepayment, the borrower need not make any more interest payments. Hence, the holders of interest only bonds will get paid drastically less if the interest rates fall and a lot of borrowers decide to refinance their homes or pay the amount upfront. The converse of this was also true, in case of no prepayments the holders of these bonds would get paid a lot and for a long time and would end up making a killing! Hence, the collateralized debt obligations (CDO’s) were structured in such a way that the high risk investors could also get a piece of the pie.

These benefits of the collateralized debt obligations (CDO’s) were well known at the time. This is why these instruments were considered to be the creation of brilliant innovative minds. However, lesser known was the fact that mortgage payments and interest rates were highly sensitive and difficult to predict. Therefore, no matter how sophisticated an investor is they simply did not have the means to find out what these securities were worth.


❮   Previous  Article Next  Article   ❯

Authorship/Referencing - About the Author(s)

MSG team comprises experienced faculty and professionals who develop the content for the portal. We collectively refer to our team as - “MSG Experts”. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.