Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs.”
One fairly long look-in:
“CDOs are created for one of three purposes:
* Balance Sheet A holder of CDO-able assets desires to (1) shrink its balance sheet, (2) reduce required regulatory and economic capital, or (3) achieve cheaper funding costs. The holder of these assets sells them to the CDO. The classic example of this is a bank that has originated loans over months or years and now wants to remove them from its balance sheet…..
* Arbitrage An asset manager wishes to gain assets under management and management fees. Investors wish to have the expertise of an asset manager. Assets are purchased in the marketplace from many different sellers and put into the CDO. CDOs are another means, along with mutual funds and hedge funds, for an asset management firm to provide its services to investors. The difference is that
instead of all the investors sharing the fund’s return in proportion to their investment, investor returns are also determined by the seniority of the CDO tranches they purchase.
* Origination Banks, insurance companies, and REITs wish to increase equity capital. Here, the example is a large number of smaller size banks issuing trust preferred securities directly to the CDO simultaneous with the CDO’s issuance of its own liabilities. The bank capital notes would not be issued but for the creation of the CDO to purchase them.”
Lucas, Douglas J., Goodman, Laurie and Fabozzi, Frank J., “Collateralized Debt Obligations and Credit Risk Transfer” (2007). Yale ICF Working Paper No. 07-06 Available at SSRN: http://ssrn.com/abstract=997276