These original CDOs were called ‘cashflow’ CDOs because the interest payments and principal payments of the notes issued to investors came from the interest and principal redemptions in the underlying bond portfolio. Almost all CDOs today are cashflow in this sense. But there are also a handful of ‘market value’ CDOs – so called because their performance depends on the market value of the underlying asset portfolio as well as the cashflows the assets generate.
Source: B&B Structured Finance Ltd |
While the earliest CDOs were static, meaning that the asset portfolio would not change during the life of the deal, most deals now employ a manager. The manager can help to avoid losses in the portfolio by trading out of deteriorating credits, and can take a profit when assets appreciate.
The biggest cash CDO managers are generally US-based firms such as TCW, Ellington Capital Management, Highland Capital Management and Babson Capital. However, European banks such as Credit Suisse and WestLB also have big CDO management arms.
Rating agencies are central to the CDO market. The economics of a CDO are heavily dependent on achieving a top rating (such as triple A) for a large proportion of the deal’s liabilities. This ensures that the cost of funding the CDO tranches (that is, paying their coupons) is lower than the income from the assets in the portfolio. This generates an ‘arbitrage’ between the assets and liabilities, which is why most CDOs are also refered to as arbitrage CDOs.
In contrast, some CDOs are not arranged to take advantage of this arbitrage. They are carried out by banks that wish to remove assets from their balance sheets – often for regulatory reasons. Such deals are often referred to as balance sheet CDOs. However, the distinction between arbitrage and balance sheet CDOs is often a hazy one in practice.