First CDO was introduced in 1987 by Michael Milken by constructing a portfolio of junk bonds issued by various organizations. After that, various other financial firms started constructing CDO’s by forming portfolio of fixed income generating assets such as auto loans, home loans, student loans, credit card loans, etc.
First of all, commercial bank retail or commercial bank approves a loan like home loan, car loan, and credit card loan for individuals or business organizations. These loans might be approved by these banks on lenient terms. After approval, these loans are sold to the investment bank which pools a number of loans and repackages them in a financial product called CDO. These CDO’s are then sold to the investors. Payments received by the commercial banks in form of interest and principal are redirected by them to the investor. In this process, the commercial bank transfers the risk to the investors. In case there is default on payment of the said loan, a large portion of risk is transferred by banks to the investors which are generally large hedge funds or pension funds.
CDO’s is separated and categorized in rated tranches on the basis of level of risk of the underlying loan. There are two types of tranches i.e. senior tranches and junior tranches. Senior tranches are the safest as they have the first claim to the assets in case of default in payment of loans. Junior tranches are riskier hence they provide higher rate of return to compensate for higher level of risk.
Each CDO is provided with a debt rating by the credit rating agencies. There are majorly four kinds of credit rating for the CDO. CDO with lowest risk is given AAA rating; These CDOs are last to be effected by loan default risk and first to receive interest and principle payments. Middle tranches are assigned credit ratings ‘AA” and ‘BB’ whereas lowest rated tranches are called equity tranches.
Generally, it is very rare for an individual person to acquire a CDO. These are generally purchased by large investors such as banks, insurance companies, hedge funds, investment managers, retirement funds, pension funds etc. These intuitions invest in these CDO’s in lieu of higher returns in accordance with the accepted level of risks. These CDO’s are very beneficial in case of strong or consistent economy as the chances of loan default in such economy is very low.
There are majorly five parties in a CDO construction. These parties are as follows-
Investment banks and commercial banks- firstly, commercial bank approves a loan like home loan, car loan, credit card loan for individuals or business organizations and sell it to investment bank. Investment banks repackage them into CDO’s.
Rating agencies- these agencies are responsible for assessing a CDO on the basis of risk and assign a rating to them.
Investors- these are the parties who invest in CDO’s. Investors usually include banks, insurance companies, hedge funds, investment managers, retirement funds, pension funds, etc.
CDO manager- manager is responsible for selecting collateral and manage CDO’s.
Financial guarantor’s – These are the institutions which ensure repayment and reimburse for any loss incurred by the investor (Coval et al., 2009).
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