Home Finance GuideHigh Finance CDO Credit

CDO Credit

By: EconomyWatch Content Date: 30 January 2010

About The Author

Follow The Money

Collateralized Debt Obligation (CDO) is a securities portfolio created with a pool of similar assets, typically corporate bonds or collateralized loans, aiding in the dispersion of risk. CDO credit is offered by different originators, from investment banks to commercial lenders, including banking giants Bank of America and Goldman Sachs.

CDO Credit Rating

CDO credit ratings, similar to the ratings of traditional debt instruments, are indicators of the instrument’s default risk. This default risk is based on the probabilities of default (PDs) or expected loss (EL) of the different securities in the CDO asset pool. CDO rating by all major rating agencies, including Fitch, Moody’s and Standard and Poor’s, is made after a comprehensive assessment of instrument-specific documentation. These agencies typically follow a two-step rating procedure for rating a CDO:

General analysis: At this stage, the rating agencies assess the CDO asset pool’s credit risk using several analytical models, depending on the nature of the underlying assets. These models may also vary from agency to agency.
Structural analysis: This stage entails evaluating and comparing future cash inflow from the securities in the asset pool. Default occurs when the cash inflow is not adequate to cover the payments for a CDO tranche. This stage also encompasses legal assessments of all third parties involved in the CDO deal, including asset managers and servicers.

The result of structural analysis is matched with that of general analysis, enabling to make adjustments to the model assumptions. Finally, the information accumulated is aggregated into alphanumeric ratings that are benchmarked to the complete historical performance of the securities in the CDO pool.

CDO Credit Crunch: The Bear Stearns Disaster

CDO credit has been identified as an important trigger of the 2007-2009 sub-prime mortgage crisis. The high amount of sub-prime mortgage or loans to high risk individuals in the market prompted banks to tie these collateralized sub-prime mortgage to CDOs for diluting their default risk. When the sub-prime borrowers failed to meet their mortgage payments, a vicious cycle got created in the financial market, leading to a significant economic collapse.

Bear Stearns is one of the many financial giants that constructed CDOs with sub-prime mortgages. In fact, it constructed special structured investment vehicles with these high-risk securities worth $400 billion. This contributed to the historic downfall of Bear Stearns.