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Cash Flow Collateralized Debt Obligations

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Collateralized debt obligations (CDO) can be structured as cash-flow deals. With cash flow CDOs, an investment bank sets up a vehicle to acquire a diverse portfolio of fixed income assets. The vehicle issues several classes of bonds (called tranches) which rank in sequential order of priority. This is called the capital structure of the transaction.

The tranches are usually rated by one or several of the major rating agencies, with the most senior liabilities enjoying a triple A rating and the second most risky bonds rated double or triple B. The equity or first loss tranche is usually unrated.

Cash flows from collateral are used to pay principal and interest to investors. If such cash flows prove inadequate, principal and interest is paid to tranches according to seniority. At any point in time, all immediate obligations to a given tranch are met before any payments are made to less senior tranches.

If there are losses in the portfolio, the most junior investors (called equity investors) are the first to experience a loss. When the losses exceed the size of the equity tranche, the investors in the tranche above the equity tranche start to experience losses. When that tranche is used up, losses pass to the tranche above it.

To compensate for the risk associated with bearing the first-loss position, the equity investors are generally paid most of the residual interest and may achieve a high annual rate of return. The money invested by the noteholders is used by the special purpose vehicle to purchase the assets and cover the costs associated with executing the transaction. The par value of the securities at maturity is used to pay the notional amounts of the liabilities.

Ideally, cash flow CDOs offer investors access to a diversified and actively managed portfolio of credit risks in a single investment that provides enhanced returns that correspond to each investor’s appetite for risk. Investors in CDO senior and mezzanine bonds can earn high returns relative to similarly rated asset backed securities. CDO equity investors can earn leveraged returns.

Unfortunately, sub prime mortgage debt is often a significant part of the investments bundled together in a cash flow CDO. This became a problem when the subprime mortgage market collapsed in 2007. Some large investment banks, such as Bear Stearns and Lehman Bothers, had large amounts of money tied up in securities, like cash flow CDOs, that were based on subprime mortgage loans. To complicate matters, they were not forthcoming with their lenders and investors about the condition of their investments. This created a crisis in confidence and led to the demise of both banks.

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