Moorad Choudhry

Originating Collateralized Debt Obligations for Balance Sheet Management

The collateralized debt obligation (CDO) is a structured finance product modeled along similar lines to earlier securitized products such as asset-backed securities and mortgage-backed securities, in which a distinct legal entity known as a special purpose vehicle (also referred to as a special-purpose entity) issues bonds or notes against an investment in the cash flows of an underlying pool of assets. These assets can be bonds, commercial bank loans, or a mixture of both bonds and loans. Banks developed CDOs as a tool for use in regulatory capital management and credit risk management. Further development of CDOs saw them integrated with credit derivatives and used for additional purposes such as credit trading and arbitrage. In this article, the authors consider the economic drivers behind the origination of CDOs and analyze their structure. They then illustrate their application to economic capital management using two actual transactions.