different debt obligations and/or a package of bank loans into a financial security that is divided up into various tranches with each tranche having different risk and return characteristics. The best way to illustrate a CDO is via a simple example:
subprime borrowers and some of which are medium to lower risk such as Alt-A
and prime borrowers). If fully serviced the interest payable on the loans
is equivalent to 10% resulting in an interest rate cash flow of $50 million plus principal repayments each year.
The original set of bank loans with a zero default rate would yield $50 million per annum of interest income. The bank that made the loans may try to offload a large part of the risk on the loans by bundling the various loans and packaging
them into a CDO. The first tranche (Tranche 1) is known as the equity tranche and is the riskiest part since if there is a default on the first $25 million of principal and interest then the holders of the equity tranche would be wiped out. Since this is the riskiest part of the CDO it attracts the highest rate of interest, in this example 30% - typically the equity tranche is not assigned a rating as it is understood to be high risk. If the default rate goes above $25 million then Tranche 2 - the junior tranche is next at risk. The value of the junior tranche in the example is $100 million, so if losses/defaults on interest and principal increase to $125 million this tranche would be wiped out in addition to the equity tranche. Since the junior tranche is the next in line after the equity tranche, it will have a relatively low credit rating for example BBB and attracts a lower yield of say 15%, lower than the equity tranche but a higher yield than the next tranche at risk which is Tranche 3 - the Mezzanine tranche. Holders of the Mezzanine Tranche will only incur losses if defaults rise above $125 million and they will be wiped out if they hit $250 million. The safest Tranche which was frequently given a AAA rating is Tranche 4 known as the Senior Tranche. It is only once losses exceed the $250 million then losses will be suffered by owners of this tranche. Since it is
the safest tranche it attracts the lowest rate of return, in the example, this is set at 6% per annum.
Since the various tranches of a CDO have different risk return characteristics the credit rating agencies such as Moody’s and Standard and Poor’s play a pivotal role in assigning credit ratings to the various tranches. Moody’s for instance
applies a methodology that looks at the default correlations between
the various securities in the pool, the average credit quality of the pool of securities, the structure of the CDO and expected losses to each tranche when assigning its credit ratings. The fact that the CDO was sliced up into various tranches made it an attractive security for different types of investors – for example, pension funds would be attracted the AAA tranche and Hedge funds to the junior tranche and other banks to the mezzanine tranche.
Although the above example gives a good idea of what a CDO is, there are a number of additional important points that need to be made. The first is that each CDO is a rather unique package, the quality of the CDO and the credit rating
attached to each of its tranches will depend upon the quality of the original bank loans and how these have been packaged in the CDO.
Another point is that even of some of the borrowers default on their bank
loans there will likely be some recovery against the assets owned by the defaulting borrower. For example, if one of the loans in the CDO is for $500,000 against a house purchase then even if the borrower defaults the bank will still be able to foreclose on the home and this will have some value say $300,000 after recovery expenses that can be used to repay the CDO holders. There are likely to be some covenants in the CDO that may make it hard for the originating bank to reschedule and renegotiate loans with the original borrowers if they are having difficulty making payments.