In a cash (as opposed to a synthetic) CDO, an investment bank sets up a vehicle to acquire a diverse portfolio of fixed income assets. The vehicle issues several classes of bonds (called tranches) which rank in sequential order of priority. This is called the capital structure of the transaction. If there are losses in the portfolio, the most junior investors (called equity investors) are the first to experience a loss. When the losses exceed the size of the equity tranche, the investors in the tranche above the equity tranche start to experience losses. When that tranche is used up, losses pass to the tranche above it. And so on.
The different classes of bonds are usually rated by one or several of the major rating agencies, with the most senior liabilities enjoying a triple A rating and the second most risky bonds rated double or triple B. The equity or first loss tranche is usually unrated.
Each tranche achieves its rating based on the rating agency’s estimate of loss probability for that tranche, based on the expected losses in the portfolio and the level of subordination provided by the tranches beneath that tranche in the capital structure.
Most cash CDOs employ features designed to divert income away from the junior liabilities and towards the senior debt if the portfolio experiences a certain level of defaults or a certain drop in income. The most important test is the overcollateralisation (OC) test, which states that the value of the assets needs to exceed the value of the outstanding liabilities by a certain ratio.
In a cashflow (as opposed to a market value) CDO, the OC test is based on the par or face value of the assets, and does not take account of the market value of the portfolio.