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Bundling debt into a CDO changes the riskiness of investing in debt in two
ways:
Reduction of Statistical Outliers
First, CDOs reduce the effect of statistical outliers : CDOs turn individual
loans into a portfolio in which a default by any single lender is unlikely to
have an enormous impact on the portfolio as a whole. By aggregating
many different mortgages together into a CDO, investors can own a small
percentage of many different mortgages, and therefore the CDO's losses
as a result of borrowers defaulting on their obligations usually represent
the statistical averages in the market as a whole.
Tranches
Second, CDOs are created in tranches - portions of the underlying debt
that vary in their riskiness, despite being backed by a generic pool of
bonds or loans.
Typically, a pool of debt is divided into three tranches, each of which is a
separate CDO. Each tranche will have different maturity, interest rates and
default risk. This allows the CDO creator to sell to multiple investors with
different degrees of risk preference.
The bottom tranche will pay the highest interest rate, but will be the first
to lose money if some of the loans in the pool aren't repaid. The top
tranche will have the lowest interest rate, but will always be the first to be
repaid - the bottom two tranches have to be wiped out before the top
tranche is affected. This allows bankers to create investments with risk /
reward profiles that are very different from the underlying debt in the
pool. So, one pool of mortgages can be divided into three CDOs, one with
an "AAA" debt rating that pays low interest, one with an intermediate debt
rating with moderate interest, and one with a low debt rating with high
interest. This is important because some asset manager are only allowed
to invest in "AAA" rated debt - dividing a pool of debt that is not AAA rated
into three different CDO tranches means at least some portion of that debt
is now AAA rated and can be purchased by institutions that can only invest
in AAA debt.
For example: A bond pool of $100 million is divided into three tranches
and is expected to earn 15%, or $15 million in interest per annum. The
pool is divided into 3 tranches, A ($25 million), B ($50 million) and C ($25
million), where A is senior to B, and B is senior to C. The associated
interest rate with each tranche is 10%, 15% and 20% respectively.
Therefore, if none of the bonds default, A receives $2.5 million, B receives
$ 7.5 million, and C receives $ 5 million. However, if there is a default and
the interest income is reduces to $11 million - in this case, since A and B
are senior to C, they will be settled before C is settled. As a result, tranche
A and B receives their full interest of $ 2.5 million and $7.5 million,
whereas tranche C only receives $ 1 million.
CDO Market
CDOs are structured by investment banks and are bought by all types of
asset managers, including hedge funds, insurance companies, banks and
pension funds. CDOs can also be purchased through most retail brokerage
accounts.
III.Criticisms of CDOs
CDOs have been criticized as being highly complex instruments that are
difficult to value. Warren Buffet is on record for calling CDOs financial
weapons of mass destruction -- since he believes, contrary to the
philosophy behind CDOs, that default risk is correlated and cannot be
diversified away.[5] CDOs and other such debt-related derivatives have
been blamed for making the 2007 credit crisis a lot more severe than it
should have been and have led to the failure of institutions such as
Lehman Brothers (LEH), MBIA (MBI) and AIG. [6]