CDOs of CDOs: art eating itself?

By Darren Smith

This article was first published as a chapter in Credit Derivatives, by Risk Books.

DEVELOPMENT OF THE MARKET

The collateralised debt obligation (CDO) market has grown from virtually nothing in the early 1990s to a market growing at an annual rate of over US$150 billion rated notes per annum. The CDO or collateralised bond obligation (CBO) market, as it was initially, grew out of the junk-bond market meltdown of the early 1990s. After that market recovered, there was no new issuance for a period of five years or so, from which there was an explosion of issuance. So, although the market has been technically in existence since the late 1980s, the real growth occurred from the middle 1990s (see Figure 1).

The CDO-of-CDO market, or CDO-squared market, was a natural extension of the market much the same way CMOs extended the mortgage market. The technology can be used for a number of different purposes, including arbitrage, repackaging risk and capital arbitrage. The CDO-of-CDO market did not develop until the late 1990s and was pioneered originally by the ZING transactions by the ZAIS Group.

CDOs, particularly the mezzanine tranches, proved to be ideally suited to being repackaged

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