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Collateralized Debt Obligations and Credit Risk Transfer

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  • Douglas Lucas
  • Laurie Goodman
  • Frank Fabozzi

Abstract

Several studies have reported how new credit risk transfer vehicles have made it easier to reallocate large amounts of credit risk from the financial sector to the non-financial sector of the capital markets. In this article, we describe one of these new credit risk transfer vehicles, the collateralized debt obligation. Synthetic credit debt obligations utilize credit default swaps, another relatively new credit risk transfer vehicle. Financial institutions face five major risks: credit, interest rate, price, currency, and liquidity. The development of the derivatives markets prior to 1990 provided financial institutions with efficient vehicles for the transfer of interest rate, price, and currency risks, as well as enhancing the liquidity of the underlying assets. However, it is only in recent years that the market for the efficient transfer of credit risk has developed. Credit risk is the risk that a debt instrument will decline in value as a result of the borrower's inability (real or perceived) to satisfy the contractual terms of its borrowing arrangement. In the case of corporate debt obligations, credit risk encompasses default, credit spread, and rating downgrade risks. The most obvious way for a financial institution to transfer the credit risk of a loan it has originated is to sell it to another party. Loan covenants typically require that the obligor be informed of the sale. The drawback of a sale in the case of corporate loans is the potential impairment of the originating financial institution's relationship with the obligor of the loan sold. Syndicated loans overcome the drawback of an outright sale because banks in the syndicate may sell their loan shares in the secondary market. The sale may be through an assignment or through participation. While the former mechanism for a syndicated loan requires the approval of the obligor, the latter does not since the payments are merely passed through to the purchaser and therefore the obligor need not know about the sale. Another form of credit risk transfer (CRT) vehicle developed in the 1980s is securitization [Fabozzi and Kothari (2007)]. In a securitization, a financial institution that originates loans pools them and sells them to a special purpose entity (SPE). The SPE obtains funds to acquire the pool of loans by issuing securities. Payment of interest and principal on the securities issued by the SPE is obtained from the cash flow of the pool of loans. While the financial institution employing securitization retains some of the credit risk associated with the pool of loans, the majority of the credit risk is transferred to the holders of the securities issued by the SPE. Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs. In this article, we discuss CDOs. We begin with the basics of CDOs and then discuss synthetic CDOs. The issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives, are also discussed.

Suggested Citation

  • Douglas Lucas & Laurie Goodman & Frank Fabozzi, 2007. "Collateralized Debt Obligations and Credit Risk Transfer," Yale School of Management Working Papers amz2503, Yale School of Management.
  • Handle: RePEc:ysm:somwrk:amz2503
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    File URL: http://icfpub.som.yale.edu/publications/2503
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    Cited by:

    1. W. Scott Frame & Lawrence J. White, 2009. "Technological change, financial innovation, and diffusion in banking," FRB Atlanta Working Paper 2009-10, Federal Reserve Bank of Atlanta.
    2. Markose, Sheri & Giansante, Simone & Shaghaghi, Ali Rais, 2012. "‘Too interconnected to fail’ financial network of US CDS market: Topological fragility and systemic risk," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 627-646.
    3. Sarai Criado & Adrian van Rixtel, 2008. "Structured finance and the financial turmoil of 2007-2008: and introductory overview," Occasional Papers 0808, Banco de España;Occasional Papers Homepage.

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