CDOs are privately placed securities backed by pools of financial assets. CDO equity represents a residual claim on the cash flows from the assets collateralizing a CDO. Those assets could be leveraged loans, corporate bonds, residential mortgage loans, commercial mortgage loans, or something else (e.g., emerging market debt and trust-preferred securities).
A CDO redistributes cash flows from a set of assets to a series of notes. The cash flow structure is the most common type of CDO and will receive the bulk of this report’s attention. With this structure, cash flow coverage tests are based on asset par amounts. With the less common market value structure, coverage tests are based on asset market values. Synthetic structures, many of which forego coverage tests, are also quite common.
In funded synthetic CDOs, the collateral is a combination of credit default swaps (CDS) and high-quality assets. In cash flow structures, the mechanism that determines the allocation of cash flows is called a waterfall. Equity payments are last in priority, after liability payments, management fees and taxes. The residual cash flows available to pay equity can be diverted if interest and par coverage ratios fall below prescribed limits. Collateral losses due to default and trading losses will result in equity principal losses.
Because a CDO is collateralized by a pool of assets, a long equity position is similar in risk to a long position in the collateral and a short position in the senior notes. The senior note investors typically receive a fixed spread above LIBOR. Hence, equity is a matched funded position when the collateral is floating rate. The term funding structure implies that equity is also a nonrecourse, leveraged investment. Nonrecourse means the investment does not require additional funding other than what is originally tendered, regardless of how poorly the assets perform. Leveraged means the investor borrows money to purchase the security, presumably at a lower interest rate than the expected return on the investment. This allows investors to increase the potential return (but also the risk) of their investment.