The Impact of Collateralized Debt Obligation Arbitrage on Tranching and Financial Leverage of Structured Finance Securities

For several years leading up to the outbreak of the financial crisis, growth in the use of arbitrage collateralized debt obligations (CDOs) was explosive. In this paper, we discuss potential sources of such arbitrage opportunities, in particular, potential gains due to “bond-like pricing”. For this purpose, we examine the risk profiles of CDOs in some detail, which reveals significant differences between CDO tranches and corporate bonds, in particular concerning a considerably increased sensitivity to systematic risks. Treating the structured products as single name instruments allows us to quantify these differences. We then price CDO tranches approximately with the Merton model, similar to corporate bonds. Using a sample CDO portfolio, we describe some opportunities for “CDO arbitrage” when investors consider corporate and CDO bonds as substitute investments and use bond-like pricing. We then discuss how tranches with high systematic risk can be generated and how CDO arrangers can exploit this to their advantage. It comes as no surprise that precisely these types of structures featured in many of the CDOs issued prior to the outbreak of the financial crisis.