ABS CDO

By: EconomyWatch Content   Date: 30 January 2010

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An Asset Backed Security or ABS refers to a financial security or bond backed by a loan, lease or receivables against any type of cash asset. An ABS is issued following the securitization of a pool of various small and illiquid assets that can not be easily sold off on an individual basis. Collateralized Debt Obligation or CDO is a structured type of ABS, the value of which is derived from a portfolio of fixed income assets.  

Process of Issuing an ABS CDO

The issuance of CDOs involves the pooling of various assets into financial instruments for sale to investors. The securitization of the various assets is done by a Special Purpose Vehicle or SPV which then issues the CDOs or the securities in tranches representing the level of risk associated with them. The senior most CDOs are the first ones to be paid from the cash flows from the underlying assets while the equity tranche or the junior most level of CDOs are the first ones to bear the losses. CDO securities are generally taxable as debt instruments except for the lowest tranche which is treated as equity. 

Benefits and Risks associated with an ABS CDO

The risks and returns associated with a CDO are directly dependant on the definition of the various tranches issued and indirectly on the underlying assets. The issuance of CDOs allows the originator of the assets to pass credit risk to other institutions or individual investors besides freeing up some of the funds for investment in other avenues.

 

The issuing company or the SPV earns a commission at the time of the issue of CDOs besides earning management fees during the lifetime of the security issued. And since there is no residual liability, the banks or the issuers tend to issue more and more loans or concentrate on volumes rather than focusing on the quality of the loan. This structural flaw in the debt securitization market is one of the major reasons for the credit and banking crisis of 2007-2009.

 

Apart from the traditional CDOs backed by a portfolio of cash assets, Synthetic CDOs are also being issued by banks and investment companies. The Synthetic CDOs gain exposure to a portfolio of cash assets through the use of Credit Default Swaps or CDSs.

 

 

 


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