The start of the market

Since the collateralisation of debt instruments was first developed and applied to mortgage bonds in the 1980s, the market has grown at an exponential rate and quickly been adopted to cover practically every type of debt

Clare Island, Galway Bay, Copernicus, Concerto, Thunderbird. The names are more likely to conjure up images of the racecard on Grand National Day than of a menu of financial products. These, and hundreds of other equally colourfully named instruments, are examples of collateralised debt obligations (CDOs), which in recent years have been among the fastest-developing investment vehicles in the financial services industry. As the rating agency Moody’s noted in its Review of activity in the structured finance arena in 2003: “The dramatic growth in the number of deals means that this market is now 100 times the size it was in 1998.”

The breakneck speed of the market’s development has brought with it an apparently bewildering amount of jargon, introducing new issuers, intermediaries and investors to a world of combo-notes and repacks, of CDOs squared and rating agency drill-downs.

The rapid emergence of much of this jargon, which this guide will aim to demystify, is in large measure a by-product of the dynamism, flexibility and adaptability of an instrument that has built upon a blindingly obvious concept. This is that the advancement of any form of credit should be based upon the ability of the borrower to repay – or on the collateral, security or compensation in the event of default that a borrower is able to provide.

That concept is pivotal to instruments that can be generically described as ‘collateralised obligations’ (COs), one of the most straightforward definitions of which is the one given by Dutch asset management company Robeco to its investors in a description of one of its CDOs. This is that the instrument is simply a “promissory note backed by collateral or security”.

In the market for COs, that security can be taken from a very wide spectrum of alternative financial instruments, such as bonds (collateralised bond obligations, or CBOs), loans (collateralised loan obligations, or CLOs), funds (collateralised fund obligations, or CFOs), mortgages (collateralised mortgage obligations, or CMOs) and others. They can (and frequently do) source their collateral from a combination of two or more of these asset classes.

Collectively, these instruments are popularly referred to as CDOs, which are bond-like instruments that use the cashflows from their assets to pass coupon payments on to their investors. In a technique known as tranching (slicing up), those payments are made on a sequential basis, depending on the seniority of investors within the capital structure of the CDO.

The history of collateralisation

The market for CDOs is generally believed to date back to the late 1980s and the repackaging and redistribution in the US by houses such as Drexel Burnham Lambert and Kidder Peabody of portfolios of high-yield bonds and loans. Prior to those transactions, however, a market for CMOs – the forerunner of modern CDOs – was taking shape in the US market by the early 1980s. In 1983, for example, the Federal Home Loan Mortgage Corporation pioneered structures that built on existing mortgage securitisation templates by creating so-called pay-through structures. These divided cashflows up into a number of tranches to suit investor preferences, and by the late 1980s these securities remained the only form of COs familiar to the market cognoscenti.

In their 1988 book Securitization, S G Warburg’s John Henderson and Jonathan Scott make no mention of COs other than CMOs, which are described at length. And COs of any kind are the subject of even less attention in Securitization of Credit, published in the same year under the auspices of the McKinsey Securitization Project. That book makes no more than a single, passing reference to CMOs.

Clearly, therefore, although portfolios of securities were being re-parcelled into COs by the late 1980s, the rapid evolution of CDOs is very much a story of the 1990s. In the US market, the degree to which that story was being backed by highly liquid, jumbo issuance was becoming self-evident by the middle of the 1990s, with volume breaking through the $10 billion mark for the first time in 1996. It was September 1997, however, that provided a key landmark for the US market when NationsBank launched a $4 billion CLO repackaging just over 1,000 commercial loans valued at about $6 billion. That made it the largest CLO the US market had ever seen, prompting an excited Barron’s, a US financial weekly newspaper, to describe the bond as “the type of transaction that bond geeks live for”.

Unusually, however, by 1997 the US market had already been eclipsed by Europe in terms of its capacity to structure and distribute jumbo COs. A year before the NationsBank deal, the UK’s NatWest had thrown down the gauntlet in the market with the launch of Rose Funding, a $5 billion CLO backed by more than 200 loans to corporates in 17 different countries.

By the late 1990s, the structure of the international market for COs of all kinds was becoming characterised by a number of conspicuous and interrelated trends. First, issuance volume was rising exponentially, as was understanding and acceptance of the CDO technique. That process led Duff & Phelps (now part of Fitch Ratings) to describe 1999 as a year that was marked by “considerable maturation and change in the CDO market”, and as the landmark period in which CDOs crossed what the agency described as “the line from ‘esoteric’ to ‘mainstream’ assets”.

Second, cross-border investment flows into CDOs were rising steeply. For example, in November 1998, when BankBoston launched a $2.18 billion CLO, more than 25% of the notes were sold to investors outside the US, which was viewed at the time as an unusually high proportion. Third, by now more and more asset classes were being used as security for COs. In February 1998, for example, Credit Suisse First Boston (CSFB) launched the first CLO backed entirely by project finance loans, with a $617 million transaction collateralised against 41 fully secured loans, the majority of which were accounted for by power projects.

Another trend that had become conspicuous by 1999 and, more strikingly, 2000 was the speed with which the concept of the CO was being popularised across continental Europe. As Europe’s largest economy, Germany was an important source of new deal flow in the CDO market. Elsewhere in Europe, in November 1999, Banca Commerciale Italiana (BCI) became the first Italian bank to issue a public CLO backed by its corporate loan book in an E170m transaction dubbed Scala 1 Ltd. The following summer, meanwhile, saw the first securitisation of European loans by a Belgian bank (KBC Bank), as well as the first CLO in Switzerland for UBS (named the Helvetic Asset Trust).

By the late 1990s, changes to legislation and regulation were emerging as important sources of support for new issuance in the CDO market in some pockets of Europe. In May 1999, Spain passed a law that specifically allowed for the provision of government guarantees for securitisations of loans originated by banks under a special line of credit for small and medium-sized enterprises (pequeñas y medianas empresas) from Instituto de Credito Oficial, the state funding agency. That allowed for the issuance of CLOs backed by tranches effectively offering investors quasi-government risk.

By 2000 and 2001, the most important determinant of increasing volumes in the CDO market globally, however, was the explosive growth in the market for credit derivatives in general, and for credit default swaps (CDS) in particular. That growth paved the way for an equally explosive expansion of the market for synthetic CDOs, which had made their first appearance in Europe at the end of 1997. In 2003, 92% of all European CDOs rated by Moody’s were accounted for by synthetic structures, up from 88% in 2002.

Following its explosive growth between 1997 and 2002, the expansion in the European market for CDOs paused for breath in 2003. Moody’s reported in January 2004 that the total market volume of rated CDO issuance in the Europe, Middle East and Africa region declined by 8% to $82 billion (E71 billion) in 2003.