Structured Credit

In a typical transaction, a bank will sell a pool of loans it has originated to a bankruptcy-remote special purpose vehicle (SPV). The SPV will pay for

the assets by issuing a set of tranches of liabilities with different seniorities. Investors buying part of a tranche assume some of the credit risk of

the underlying pool of collateral to the extent that losses on the loans may exceed the par value of more junior tranches.


Nth-to-default (e.g. first-to-default DCX, VW, TUI)
Single tranche CDO (e.g. 3-6% tranche of iTraxx Series 5 or a bespoke portfolio)
CDS index (e.g. iTraxx Series 5)
Fixed, floating, or zero coupon (e.g. zero coupon equity tranche)
Fixed or floating recovery (e.g. zero recovery CLNs or market recovery CLNs)
Whole or partial principal protection (e.g. 80% principal protected)
Leverage (e.g. €10m note linked to €50m iTraxx index, early termination on spread trigger, client carries MTM of €50m iTraxx)
Spread widening note (e.g. bearish note on a single credit, basket of credits or an index)
Combo notes (e.g. given a reference portfolio, the principal is at risk with the senior tranche, typically a 10-15% tranche, and the coupons are at risk

with the junior tranche, typically a 2-5% tranche.

CDO - Collaterised Debt Obligations

  • Unregulated type of asset backed security

  • They contain a portfolio of fixed income assets (bonds, loans)

  • These assets are divided into different tranches

  • (senior tranches, rated AAA, low coupon)

  • (mezzanine tranches, rated AA-BB)

  • (equity tranches [also known as first-loss tranche or toxic waste], un-rated, high coupon)

  • These are marked to market frequently

CDOs very in both structure and underlying asset
A CDO is a corporate entity constructed to hold assets as collateral and provide coupons for cashflow.
A CDO is constructed in the following way: A special purpose vehicle (SPV) acquires a portfolio of credit,
common assets include: mortgage backed securities, real estate debt, high yield corporate loans
The SPV then issues different classes of bonds and equity

A CDO investor takes a position in an entity that has no defined risk or reward (not directly in the underlying asset)

Therefore the investment is dependent on the quality of the metrics and assumptions used for defining the risk and reward of the different tranches

The issuer of the CDO typically an investment bank, earns a commission at the time of issue and earns management fees during its life

Mortgage backed securities (MBS) are different because an investor is investing in the actual underlying collateral.



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