CDO VS CDS: What Are The Differences?

A Collateralized Debt Obligation (CDO) is an investment item created by pooling many loans or bonds together to generate tiered cash flows from debt obligations such as mortgages. Once the risk is pooled, it becomes diversified. On the other hand, credit-Default Swaps (CDS) are derivative products whose worth depends on the risk of the underlying asset.

Key Takeaways

• One purpose of a derivative is to mitigate the risk of economic loss emerging from changes in the worth of the underlying item
• As an investor, you can use CDO and CDS to increase your profit
• CDS is typically the domain of institutional investors such as hedge funds or banks
• A CDO is a complex structured finance product backed by a pool of loans and other assets
• There are many types of CDO, and each is based on the underlying asset such as loans, real estate fixed income securities, and reinsurance contracts

Why Do Investors Buy CDO And CDS?

The usual investors of CDOs are investment banks, pension funds, insurance companies, and hedge funds. 

The main reason for buying CDOs is to outperform treasury yields while minimizing the risk of exposure. When the economy is doing well, adding more risk can bring more returns.

CDS is typically the domain of institutional investors such as hedge funds or banks. However, retail investors can also invest in swaps through Exchange Traded Funds (ETFs) and mutual funds. As an individual, it is possible to trade in CDS but with a high principal. 

With CDS, you can view whether an entity’s credit is valuable or not, and depending on your perspective, you can decide to go long-term or short-term. 

The Difference Between CDO And CDS

Understanding the differences between CDO and CDS is important to know the best derivative to invest in. Here are the main differences:

Aim

As said earlier, a CDO is a complex structured finance product backed by a pool of loans and other assets. CDO will have a ramp-up period where the loan is held on the financial institution’s balance sheet as an investment. Once they have enough loans, the financial institution will form an SPE (special purpose entity) to remove the loans from its balance sheet. Afterward, the SPE issues the CDO then sells it to investors.

CDO’s will then proceed to payout the interest earned on the loans to the CDO holder.  SPE enables the issuer to advance reserves if debts don’t pay enough interest to pay off the CDO holder. CDO’s are found under securitization.

On the other hand, CDS is a derivative product whose worth depends on the underlying asset’s risk. The underlying asset is also known as the reference obligation. For you to be granted a CDS contract, the following requirements must be met: 

1. The CDS contract has to be based on a particular firm’s debt 

2. You must commit to making quarterly premium payments

Market

Selling CDOs, are one-way firms use to expand their liquidity. CDO bundles individual loans into a final product that a financial institution can be sold on the secondary market. The product is known as asset-backed security if loans incorporated are corporate debt and mortgage-backed security if the loans are mortgages.

The CDO market has been involved in the ongoing economic downturn, inclusive of the caving in of the housing market. For instance, Bear Sterns investing banking company in New York reportedly had unmatched losses in 2007 due to the decline in value of its CDO holdings sponsored by subprime mortgages. 

The CDS market has also been linked with the ongoing economic downturn. For instance, Lehman Brothers investing banking company and AIG insurance organization were parties in many CDS transactions. However, the Federal Reserve Board, treasury secretary and chairs of the Commodities Futures Trading Commission, and the Securities and Exchange Commission are implementing changes to make CDS transactions clearer and add oversight to the derivatives market.

A CDS buyer can be anyone who legally signs the contract and adds it to a financial portfolio. A person or entity may or may not be interested in the underlying financial instrument of being a buyer. However, a buyer can become part of a CDS to hedge financial risk or profit on speculation that the instrument may fail. Hedge funds Banks and other security firms are typical sellers of CDS. 

A CDS is a privately negotiated derivative where a buyer pays an agreed-upon amount to a seller and, in return, receives a payment if a certain event occurs, such as default in the underlying financial instrument. The buyer does not need to take ownership of the underlying security and does not have to suffer a loss from the event to receive payment from the seller. Therefore, CDS can be used for speculating.

Security/Insurance

There are many types of CDO, and each is based on the underlying asset such as loans, real estate fixed income securities, and reinsurance contracts. A structured finance CDO is primarily sponsored by structured products such as asset-backed and mortgage-backed securities. Credit derivatives like CDS primarily sponsor collateralized synthetic obligations (CSO).

There is a broad consensus that CDS is not insurance. As stated above, the buyer does not need to take ownership of the underlying security and does not have to suffer a loss in the event to receive payment from the seller. When the specified event occurs, the seller settles with the buyer in accordance to contract terms. The amount of loss the buyer suffers, if any, becomes irrelevant.

Do CDOs And CDS Have A Financial Crisis?

Yes, CDOs and CDS can contribute to a financial crisis. For instance, the extreme economic downtime period in December 2007 in the US turned into a global recession in 2009 known as the Great Recession. The collapse of the housing under financial markets can be traced to the unregulated and irresponsible use of these financial instruments. The following financial crisis was experienced between years 2008-2009:

1. An overwhelming load of mortgage and financed securities began with the housing market bubble. This bubble bundled high-risk loans

2. Reckless lending that resulted in unprecedented numbers of loans in default, bundled together, the losses led many financial institutions to fail and require a governmental bailout

Efforts to revive the economy were made through the American Recovery and Reinvestment Act of 2009. However, CDO and CDS didn’t cease practicing as long as they followed the laid rules.

The Impact Of CDO And CDS During The Global Financial Crisis Of 2008-2009

The aftermath of the extreme economic downturn period that began in December 2007 was;

1. The crisis deeply impacted the housing market. Evictions and closures began within months.

2. The stock market, in response, began to plummet, and major businesses worldwide began to fail, losing millions.

3. Declining credit availability and failing confidence in financial stability led to fewer and more cautious investments, and international trade slowed to a crawl.

The passed response act facilitated bank bailouts, expansionary monetary policy, and mergers to stimulate economic growth.

Best Regulation Practices About CDO And CDS

Financial Guarantee Insurance Companies (FGI’s) should follow practices outlined by the New York Insurance Department. The department held a public hearing to address the potential regulation of FGI’s concerning CDS on December 5, 2008. The practices listed below were effective from January 1, 2009:

1. Entities engaging in the CDS business have to be licensed;

2. FGI’s must maintain the increased amount of financial reserves to engage in certain CDS transactions;

3. FGI’s can only insure limited investment types 

4. Reporting standards and increasing accounting to allow the New York Insurance department greater oversight; and

5. Restricting aggregate investment portfolios to investment-grade securities or better

The practices apply for non-naked CDS. These are cases where buyers use CDS to protect against losses in instruments they own.

How Are CDS And CDOs Priced?

The notional value of CDS refers to the phase value of the underlined security. The premium that is laid by the CDS to the sellers is expressed as a proportion of the contract’s notional value

The pricing of synthetic CDOs involves the computation of aggregate loss distributions over different time horizons. In a bottom-up approach CDOs, tranche premiums depend on the individual credit risk of names in the underlined portfolio and the dependence structure between default times.

Final Thoughts

The premium of CDS will change as the market’s perception of a firm’s financial health changes.  CDS is a financial swap agreement that the seller compensates the buyer in the event of debt and CDO, a complex structured finance product backed by a pool of loans and other assets depending on credit availability. 

Both CDOs and CDS are powerful tools in the economy. CDS provides insurance-like protection against the possibility of a default, and CDOs act as a financial tool that bundles individual loans into a product that can be sold in a secondary market. As long as firms follow the laid rules, CDOs and CDSs will keep advancing and positively impacting the economy.

References:

1. https://www.cga.ct.gov/2008/rpt/2008-R-0668.htm
2. https://theawarenessnews.com/2020/05/04/crisis-makers-cds-and-cdo/
3. https://www.ask-rk.com/cdo-vs-cds.html

Last Updated on November 4, 2022 by Magalie D.