Collateralized Debt Obligations (CDOs) are the liabilities of specialized investment companies that operate with pre-defined, strict investment guidelines. These investment companies, or Special Purpose Vehicles (SPVs), are designed to transfer cash flows from a diversified set of assets, the collateral, to a tiered series of liabilities, the debt obligations. The effect of diversification and tiering is a better average risk weighting for the liabilities than for the assets, resulting in a cost of funding for the vehicle that is lower than the cash flows expected from the assets, which is a financial arbitrage. This credit improvement is the source of value in CDOs, fueling the growth of this market segment. ABS-backed CDOs alone account for $40-45 billion per year of issuance.
Collateral (Assets).
The collateral backing a CDO represents the asset side of the SPV's balance sheet. These assets provide the expected cash flows required to pay the costs of management and administration of the SPV, fulfill the liability payments, and provide an attractive return (15-20%) to the equity investor. The assets are typically asset-backed securities such as commercial and residential mortgages, auto loans and credit card receivables, as well as corporate debt, both investment-grade and high-yield. Structured notes are sometimes included. As an alternative to cash instruments, derivatives such as credit default swaps also have been used to back CDOs. The benefit of the derivative approach is that the liability structure of the CDO can be notional, or "synthetic", thus eliminating the need for a balance sheet.
Asset selection is the first source of credit improvement in CDOs. A large number of assets, usually more than 50, are chosen based on contribution to overall portfolio return and risk. Through the portfolio effect, the cash flows of a diversified, or uncorrelated, set of assets becomes much more certain than the cash flows of individual assets.
