June 28 (Reuters) - Collateralized debt obligations, or CDOs, are a rapidly growing class of securities created by bundling portions of other bonds into a new, more diversified structure that spreads the risk among investors around the world.
Demand for CDOs in the past few years has fueled demand for other debt such as subprime mortgage asset-backed securities.
While there are many kinds of debt used as collateral, the surge in subprime bonds as a percentage of total ABS has led to their domination in many CDOs. Investors watching the prolonged U.S. housing slump cause rising delinquencies and losses on the ABS expect CDO values and ratings will soon be affected.
Losses at two Bear Stearns Cos. BSC.N hedge funds after bad bets on subprime came to a head in June as bank creditors tried to extricate their investments in the fund. Most of the funds’ CDO assets put up for sale never found buyers at prices acceptable to the banks, fueling speculation that ABS CDOs would suffer widespread markdowns, sources said.
High-grade CDOs buy the top, “AAA” rated portions, while so-called mezzanine CDOs are comprised of the riskier parts of underlying bonds structured to take the first losses, if any.
U.S. CDO issuance surged in 2006 to $386 billion from about $201 billion in 2005, according to JPMorgan Chase & Co. Managers have packaged $182 billion so far in 2007. (CDO volume in Europe last year was $141.2 billion. In Asia, it was $21.9 billion.) PRIMARY TYPES OF CDOs:
STRUCTURED FINANCE CDO: Includes CDOs backed by asset-backed securities supported by residential mortgages (subprime, “Alt-A” and prime), student loans, manufactured housing loans, auto and credit card receivables.
High-grade structured finance CDO issuance increased to $128.5 billion last year from $59 billion in 2005. Volume of mezzanine structured finance CDOs was $55.6 billion in 2006 and $30.7 billion in 2005. (Home-equity loans, consisting mostly of subprime mortgages, are the fastest-growing segment of ABS, rising to 26 percent this year from 14 percent in 2000.)
Issuance of high-grade and mezzanine structured finance CDOs this year is on pace to exceed 2006’s record.
C0RPORATE BOND CDO: A CDO backed by debt issued by a corporation, both junk and investment grade.
Investment-grade debt CDO issuance rose to $34.9 billion in 2006 from nearly $18 billion in 2005. High-yield bond CDO issuance that pioneered the CDO market in the late 1980s was $1.2 billion last year and $1.6 billion in 2005. Volume is just above $1 billion for both categories this year.
COLLATERALIZED LOAN OBLIGATIONS, or CLOs: A type of CDO packaged with slices of high-yield bank loans. Issuance rose to $106 billion in 2006 from $59.7 billion in 2005. More than $53 billion has been sold since January this year.
OTHER TYPES OF CDOs:
COMMERCIAL MORTGAGE BOND CDO: A CDO backed by commercial mortgage-backed securities, or CMBS. Volume of $28.3 billion last year was more than double that of 2005. Issuance this year has topped $12.6 billion
EMERGING MARKET BOND CDO: A CDO backed by emerging market debt. Sales of $881 million in 2006 compare with $1.6 billion in 2005.
CDO OF CDO: A “CDO squared” is collateralized with pieces of existing cash flow or synthetic CDOs. Volume of $9.6 billion in 2007 has nearly matched full-year issuance of $9.9 billion in 2006 and more than double that of 2005.
CASH FLOW CDO: These CDOs pay investors directly from the interest and principal payments to the underlying debt. These make up the bulk of CDOs.
SYNTHETIC CDO: A structured or corporate bond CDO created with contracts referencing the value of a bond, instead of the bond itself. Synthetic CDOs sell insurance against default of the referenced collateral with credit default swaps.
MARKET VALUE CDO: A security designed to rise or fall with the value of the underlying collateral.