Role of Collateralized Debt Obligations in the Growth of Asset-Backed Security

Asset-backed securities (also known as ABSs) offer a more reliable source of income than non-asset-backed securities. Understanding the inner workings of these security instruments is key to diversifying risks.

One of the main components of ABSs is the CDO or collateralized debt obligation. CDOs are responsible for a large portion of ABS growth. We will explore more the inner workings of ABSs and their growth relation with CDOs in this segment.

How Collateralized Debt Obligations Are Structured

CDOs are composed of various types of debt. This can range from corporate debt to a variety of bonds, mortgages, student loans and even credit card debt. Each level of debt has different risk, which includes the risk of default.

Collateralization comes from the slicing of debt into smaller pieces and layering them in what is called tranches. This slicing technique helps to diversify risk. Tranches explicitly divide risk into three main areas from the riskiest assets up to those with the least risk. Higher risk tranches pay more interest but also have a higher chance of default.

Rather than an investment bank creating CDOs, a separate entity called a special purpose vehicle (SPV) is created. The SPV then creates and manages CDOs. CDOs are created from illiquid debt. Once this debt is sliced into smaller amounts and repacked with various other forms of debt into a CDO, it can become more liquid, providing a more reliable value of the debt.

ABSs and CDOs have distinct differences. ABSs are often composed of CDOs and package their debt based on interest payment differences. Whereas CDOs will package debt based on the risk of default. Debt doesn't have to be the only investment within an ABS. A layer within an ABS may be composed of equities. In this case, more risk will be associated with the equity layer than the debt layer. There is still a risk of default within debt layers but that risk will be well known based on the quality of debt.

ABSs and CDOs aren't to be confused with MBSs or mortgage-backed securities. MBSs are specifically focused on slicing mortgages into smaller amounts and repackaging them into a new security called an MBS. This slicing and repackaging have the same effect as with ABSs and CDOs - it further reduces risk and helps to make debt more liquid and marketable.

Growth of CDOs

In the U.S., the consumer makes up ~70% of GDP (gross domestic product). This includes home mortgages, home equity lines of credit and second mortgages. All of which contribute to the growth of CDOs and thus ABSs.

Fintechs are also contributing to the growth of ABSs by offering more loans to consumers. Because fintechs make heavy use of technology, they are able to offer competitive loans to consumers without incurring the same overhead costs of banks. These loans can then be bundled up into CDOs, which can further be bundled into ABSs.

Another driver of ABS growth is interest rates. When interest rates are low, consumers tend to take out more loans, including mortgages and home equity loans. The opposite is also true - as interest rates rise and loans become more expensive, consumers slow down origination of new loans. Additionally, if the economy slows down while rates are high, it can lead to issues with consumers unable to pay back their loans. The lower tranche of a CDO can then begin to suffer defaults.

In addition to consumer growth, investors are seeking higher returns in the current low rate environment. pymnts.com noted that a Financial Times report found that Wall Street firms sold greater than $70 billion in auto ABSs in 2017, marking them the highest amount of ABSs since 2007.

Pymnts.com also reported that in 2016, Santander Consumer USA increased the number of sub-prime deals it issued by $2 billion to $8.76 billion.

Auto loans are another source of growth for ABSs. As consumers demand more vehicles, more loans are created. These loans can be collateralized and divided up into CDO tranches, which can be packaged into ABSs.

Custom CDOs

Depending on the CDOs that are available on the market, you may find that none offer the risk/reward ratio you are looking for or that many CDOs are too illiquid. In this case, creating a custom CDO may be the best route.

An SPV can help with the actual creation of a CDO but before reaching that point, it's important to do in-depth research about which debt should be included in the CDO, at what proportions, along with an estimate about potential liquidity.

The financial research professionals at Research Optimus (ROP) have many years of experience in analyzing debt and equity investments. Our analysts can create detailed reports that show how a potential custom CDO will perform, the risk involved and estimates for liquidity. Please contact us to learn more and plan the engagement right away.

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