Collateralized Debt Obligations: Structures and Analysis, Second Edition

CHAPTER 10

Market Value CDOs

As explained in Chapter 1, there are cash flow and market value collateralized debt obligations. Many investors look suspiciously at the senior and mezzanine tranches of market value CDOs. Their concern is that this deal structure gives the manager the same latitude to manage a portfolio as a hedge fund manager. That view is wrong. It is based on a misconception about how market value CDOs are really structured and the protection they provide investors.

While market value deals are a distinct minority of CDOs, they are the structure of choice for certain types of collateral, where the cash flows are not predictable. It is very difficult to use unpredictable cash flows within the confines of a cash flow structure. Moreover, market value structures may also appeal to managers and equity buyers who like the greater trading flexibility inherent in these deals. Finally, market value transactions also facilitate the purchase of assets that mature beyond the life of the transaction, because the price volatility associated with the forced sale of these assets is explicitly considered.

This chapter provides an overview of the differences between cash flow and market value structures. It also examines the mechanics of market value CDOs, focusing on the advance rates (i.e., the percentage of a particular asset that may be issued as rated debt)—the key to protecting the debt holders. Then we look at some volatility numbers, which indicate how conservative the advance ...