Collateralized Debt Obligations: Advantages and Disadvantages

In the previous article, we studied about how collateralized debt obligations (CDOs) are derivative instruments that have been built on top of other derivative instruments. They are complicated to understand and risky to trade. However, despite the various negative accusations against collateralized debt obligations (CDOs), they continue to be very popular. This is because they have some distinct advantages. In this article, we will have a closer look at the advantages and disadvantages which can be attributed to collateralized debt obligations (CDOs).

Advantages of Collateralized Debt Obligations (CDOs)

At first glance, it might seem like the collateralized debt obligations might create very little value. This is because of the fact that they just take one form of asset and repackage it. The entire process seems unnecessary and it may appear like it is only meant to create transaction costs and management fees. However, there are several advantages to collateralized debt obligations (CDOs) which attract people towards this instrument. They have been mentioned below:

• Collateralized debt obligations (CDOs) provide an opportunity to release capital that might otherwise be held for regulatory reasons. Since the risky loans do not stay on the bank’s books, the banks do not have to set aside capital for them. This capital has a very high opportunity cost for banks. This is the reason why these instruments which require very little capital outlay and release capital are very useful for them.

• Collateralized debt obligations (CDOs) are also known for using pooling and tranching to create very different risk-return profiles from the same underlying asset. This helps a variety of investors to park their funds in the same asset. For instance, buying corporate debt may be considered too risky for a corporate fund. However, buying the seniormost tranche of a collateralized debt obligation based on corporate debt may be considered less risky since the topmost tranche has a very high credit rating

• Collateralized debt obligations (CDOs) pay different interest rates on different tranches. While breaking down the interest rates and recreating them, investment bankers add spreads to these rates. These spreads help pay for the management fee. However, they are not a burden on investors since they create new security with a different risk-return profile that matches their needs more closely

• Another major benefit of collateralized debt obligations (CDOs) is the fact that they allow investors to get more liquidity. Fixed income instruments as well as credit derivatives have limited liquidity in the market. On the other hand, the market for CDOs is incredibly liquid. It is not uncommon to find a CDO which has more liquidity as compared to its underlying asset. This high liquidity is the result of the value created by the CDO process. This is because once CDOs are created, more investors start investing their money in fixed income assets as compared to earlier

Disadvantages of Collateralized Debt Obligations (CDOs)

Collateralized debt obligations (CDOs) have several well-documented disadvantages as well. They have been listed below:

• The collateralized debt obligations (CDOs) structures tend to be very complicated. There are two types of checks which rating agencies perform. One check is about how the issuers of CDOs will be able to fulfill their obligations in the event of a default. However, a default may not be necessary for the lower tranches of CDOs to lose money.

  There is a complex credit protection structure that is commonly worded into these contracts. These complex structures have to be modeled in order to find out the probability of the lower tranches not being paid. This exercise is complex since it requires the use of empirical data and probability. This complication prevents the average retail investor from successfully investing and trading in CDOs

• The entire risk profile of collateralized debt obligations is based on assumptions. For instance, prior to 2008, if a CDO portfolio has less concentration and less correlation it was considered less risky. Hence, if an asset pool had mortgages from New Jersey as well as California it was considered to be less risky. The assumption was that all real estate markets cannot go down at the same time. However, this assumption proved to be false in 2008, when the entire market went down and colossal losses were faced by CDO holders since this situation had never been predicted in their models. This over-dependence on complex mathematical models makes CDOs extremely risky.

• Ironically, collateralized debt obligations end up creating more credit risk! This is because a lot of these instruments are issued by unregulated financial institutions. Hence, they do not set aside enough capital to make good catastrophic losses. In a way, CDOs are like having an unregulated insurance market. It exposes more parties to credit risk since they have a false assurance that they are protected against such risks.

Collateralized debt obligations have their own advantages and disadvantages. This is the reason why investors have a love-hate relationship with this financial instrument. However, there is no denying the fact that this instrument is very risky and that conservative investors should simply avoid using it.