Skip to main content

CDO Cagematch

Back "in the day" you didn't really care what default rights investors in senior tranches of your CDO negotiated for. Hell, the whole damn thing is insured. And, on top of that, there is a ton of junior stuff under them to absorb it all. Why not just given them what they want and pump the price up a little bit? Most commonly, senior tranches get the reins on payments out of the trusts if certain covenants are violated.
Usually that sort of thing activates if certain of the underlying instruments are downgraded, if payments are missed, or if total assets fall below a certain level. (Good luck substantiating this last one in a mark-to-market environment).
Lately, downgrades have been hitting many CDO structures and giving the senior note holders control over the entire CDO structure's revenue. As you might imagine, junior note holders grow quickly irritated. A lot depends on who the senior note holders are.
If its a bank holding the top tier, as you might guess, they will often just liquidate. Other senior investors, however, are more likely to freeze out the junior investors and keep the income for themselves without liquidating. Not a bad setup if you are getting something like 100% coverage on the interest you expected when you bought the damn things. You have no balance sheet issues and the market is so out of whack you are likely to take a loss if you sell. So... why liquidate?
Much different the plight of the junior note holder who now can kiss any income goodbye and has little, if any, recourse if the seniors take over the show.
If you guessed that this particular scene is getting a lot of play right now, you've been paying close attention.