Definition
of Collateralized Debt Obligation (CDO)
Collateralized
debt obligation is a generic term for a subset of securitizations. The
term
collateralized debt obligation encompasses collateralized bond obligations
(CBOs), collateralized mortgage obligations (CMOs), collateralized fund
obligations (CFOs) and more. Collateralized debt obligations can be backed
by any type or combination of types of debt: tranches of other collateralized
debt obligations, asset backed bonds, notes issued by a special purchase
entity that purchases other underlying assets, which are used as collateral
to back the notes, hedge fund obligations, bonds, loans, future receivables
or any other type of debt.
Definition
of CDO Arbitrage
A
collateralized debt obligation may consist of tranches of varying degrees
of risk. For example, a collateralized debt
obligation backed by a portfolio of bonds might be tranched into four classes
of risk with the following ratings: a senior (“AAA”) tranche, mezzanine
tranches rated anywhere from AA to B, and unrated first loss risk. First loss
risk is also called “equity,” or “preferred shares,” or
by other names, but it is not to be confused with common equity or preferred
shares issued by corporations with ongoing businesses. The difference between
the income from the portfolio and its value and the cash owed to the investors,
the liabilities, less the deal expenses (legal, rating agencies, structuring
fees, and more) is known as the CDO “arbitrage”. In particular,
the investment bank arranger will normally pre-sell the first-loss tranche,
the riskiest tranche. The implied internal rate of return at which this first-loss
risk can be sold to an outside investor is a key determinant of what is known
as the collateralized debt obligation arbitrage (CDO arbitrage).
Source:
Tavakoli, J. Collateralized Debt Obligations & Structured Finance, John
Wiley & Sons, 2003.
   
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