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Much has been written about the structure of a collateralized debt obligation (or "CDO") offering.1 In short, a CDO is an arbitrage vehicle that invests in a portfolio of financial assets-commercial loans, corporate or emerging market bonds, asset-backed securities, and trust preferred securities have been the predominant portfolios-that the CDO finances by issuing multiple tranches of senior and subordinated notes under an indenture and (often) issuing a "first loss" class of preference shares or income notes. A CDO is usually formed as a "bankruptcy remote" special-purpose vehicle in a tax-free jurisdiction (e.g., the Cayman Islands) or in a nominal tax jurisdiction (e.g., Ireland). In most cases a CDO will obtain ratings on the securities that it issues from Fitch, Moody s, and/or Standard & Poor's. Frequently, the CDO will retain an investment advisor, known as the collateral manager, to select and manage its portfolio. In some cases, it will enter into interest-rate hedges (usually under an ISDA master agreement) to mitigate the interest-rate mismatches between its assets and its liabilities.
CDOs can be categorized in several different ways based on their fundamental characteristics:
* Does the CDO invest primarily in cash markets (a "cash CDO") or through the derivatives markets (a "synthetic CDO")?
* Is the CDO structure based on the par amount and cash flows of its assets and liabilities (a "cash flow CDO") or is it based on the value of its assets (a "market value CDO")?
* Does the CDO have a fixed portfolio (a "static CDO") or is its portfolio traded (a "managed CDO")?
Perhaps the most common way of categorizing a CDO is based on the type of assets in which the CDO primarily invests: a CLO (which invest in loans), an ABS CDO (which invests in asset-backed securities), an emerging markets CDO (which invests in emerging markets bonds), a CBO (which invests in corporate bonds), a TRUP CDO (which invests in trust preferred securities), or a CFO (which invests in hedge funds or private equity funds). Under this last method, a CDO2 is simply a CDO which invests in other CDOs.
From this simple definition, a wide range of products have developed. As a result, a CDO^sup 2^ can be one of four very different types of transactions:
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