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CDO (Collaterised Debt Obligations)


Priority of Payments

CDOs are leveraged investment vehicles used to pool different types of assets and allow investors with different risk/return appetites to participate in the performance of those assets. Investors in CDOs could benefit from the use of fixed-cost, long-term financing of senior tranches (cf. below). CDO equity (and, to a lesser extent, the junior debt classes of a CDO) is effectively a leveraged investment in the Underlying Assets included in the CDO portfolio. As investors move down a CDO tranche structure in priority and rating, the risks increase with respect to the CDO investment. Investors in CDO residual interests enjoy the benefits (and bear the additional risks) of leveraged exposure to a large, diversified pool of underlying assets, typically a portfolio of bonds (corporate or sovereign), bank loans leveraged loans, asset-backed securities and other bonds and debt instruments (“Underlying Assets”).

A CDO raises capital through issuance of notes and allocates interest and principal payments according to prioritised collection CDO securities (called tranches). The tranches are usually arranged according to priority of payment or subordination e.g. senior tranches are paid before mezzanine or equity tranches.

Diversity

CDO portfolios are generally designed to be highly diversified with respect to issuer, industry and sector concentrations.

Static and Dynamic Pool

A static CDO is one which the Underlying Assets are not subject to active adjustment by the manager of the CDO and the performance of the CDO is determined by the number and timing of defaults of the Underlying Assets. A dynamic CDO (or market-value CDO) is generally managed based on predetermined guidelines or constraints, similar to a mutual fund.

Portfolio Constitution and Guidelines

The portfolio guidelines specified in the CDO transaction may require the manager to: (1) construct portfolios so that the Underlying Assets are suitably diversified and have certain credit quality and (2) maintain specified levels of diversity and credit quality of the portfolio of any substitutes assets or to maintain or improve such diversity and credit quality if diversity or credit quality of the portfolio falls below the specified levels).

Overcollateralisation and Interest Cover

To increase credit quality of the CDO, the CDO may be overcollaterised (i.e. having portfolio assets greater than all or a portion of the CDO issuer&aops;s debt) and have interest coverage tests (i.e. having excess portfolio interest income after paying expense). If portfolio assets deteriorate, the interest cash flows paid to the junior or subordinated note or equity holders may be redirected to pay down senior debt first.

Reinvestment and Trading

The terms of the CDO may allow the manager to reinvest in other assets over a certain period (typically 3 to 5 years) to the extent that any Underlying Assets pay off early, amortize, terminate or are redeemed. Sometimes the manager is allow to trade out of defaulted Underlying Assets, credit risk securities and appreciated securities.

Rating

The debt securities issued by CDO issuers are generally rated by one or more national rating agencies and utilize statistical methodologies employed by such national rating agencies in order to create their capital structure. The aim of these methodologies is to realign the risk of portfolio assets to investors on a tiered basis.

derivativeslawyer.com

Last updated 14 February 2006

The above notes are intended to provide only general outlines and should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They should never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation in reliance thereof.

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