CDO cubed: How they can help investors further increase their exposure to CDOs by securitizing CDO squared tranches

1. Enhancing Investment Opportunities

In this section, we will explore the concept of CDO-cubed, which are complex financial instruments that securitize the tranches of CDO-squared. CDO-squared are themselves CDOs that are backed by the tranches of other CDOs. CDO-cubed offer investors a way to further increase their exposure to the underlying assets of CDOs, such as mortgages, corporate debt, or credit derivatives. However, they also entail higher risks and lower transparency than CDOs or CDO-squared. We will discuss the following aspects of CDO-cubed:

1. How CDO-cubed are created and structured: We will explain the process of creating CDO-cubed from CDO-squared tranches, and how they are divided into different tranches with varying degrees of seniority, subordination, and credit enhancement. We will also compare the structure of CDO-cubed with CDOs and CDO-squared, and highlight the differences and similarities.

2. Why CDO-cubed are attractive to investors: We will analyze the potential benefits of investing in CDO-cubed, such as higher yields, diversification, and leverage. We will also examine the market conditions and investor preferences that drive the demand for CDO-cubed, and how they relate to the performance of the underlying assets and the macroeconomic environment.

3. What are the risks and challenges of CDO-cubed: We will identify the main sources of risk and uncertainty that affect CDO-cubed, such as default correlation, rating downgrades, liquidity, and valuation. We will also discuss the challenges of modeling, pricing, and hedging CDO-cubed, and how they affect the transparency and efficiency of the CDO-cubed market.

4. How CDO-cubed performed during the financial crisis of 2007-2009: We will review the impact of the financial crisis on the CDO-cubed market, and how CDO-cubed contributed to the amplification and propagation of the crisis. We will also evaluate the lessons learned from the crisis, and the regulatory and market reforms that have been implemented or proposed to address the issues of CDO-cubed.

To illustrate these points, we will use some examples of CDO-cubed that have been issued or traded in the past, and how they have performed under different scenarios. We will also provide some references and sources for further reading on CDO-cubed. By the end of this section, you should have a better understanding of CDO-cubed and their role in the financial system.

2. A Brief Overview

CDO-squared tranches are the securities that are backed by a portfolio of CDO tranches. They are a type of CDO-cubed, which are CDOs that are backed by other CDOs. CDO-cubed can help investors further increase their exposure to CDOs by securitizing CDO-squared tranches. In this section, we will briefly explain how CDO-squared tranches work, what are their benefits and risks, and how they differ from CDO tranches. We will also provide some examples of CDO-squared transactions that have been issued in the past.

- How CDO-squared tranches work: A CDO-squared tranche is created by pooling together a number of CDO tranches, usually from different CDOs, and issuing new securities that are backed by the cash flows from the underlying CDO tranches. The CDO-squared tranches are divided into different seniority levels, such as senior, mezzanine, and equity, based on their credit quality and risk profile. The senior tranches have the highest priority in receiving payments from the underlying CDO tranches, while the equity tranches have the lowest priority and bear the most risk. The CDO-squared tranches are rated by credit rating agencies, such as Moody's, S&P, and Fitch, based on the credit quality of the underlying CDO tranches and the structure of the CDO-squared deal.

- What are the benefits and risks of CDO-squared tranches: The main benefit of CDO-squared tranches is that they can offer higher returns than CDO tranches, especially for the lower-rated and equity tranches. This is because the CDO-squared tranches can diversify the exposure to the underlying assets of the CDOs, such as corporate bonds, loans, mortgages, or asset-backed securities, and reduce the correlation risk among them. The CDO-squared tranches can also create more liquidity and marketability for the CDO tranches, which are often illiquid and hard to trade. The main risk of CDO-squared tranches is that they are more complex and opaque than CDO tranches, and therefore more difficult to value and analyze. The CDO-squared tranches are also more sensitive to the performance of the underlying CDO tranches, and can suffer significant losses if the default rates of the underlying assets increase or the recovery rates decrease. The CDO-squared tranches are also subject to the risk of rating downgrades, which can affect their market value and liquidity.

- How CDO-squared tranches differ from CDO tranches: The main difference between CDO-squared tranches and CDO tranches is that the former are backed by a portfolio of CDO tranches, while the latter are backed by a portfolio of assets, such as corporate bonds, loans, mortgages, or asset-backed securities. Another difference is that the CDO-squared tranches have a higher degree of leverage than the CDO tranches, which means that they can amplify the returns or losses from the underlying CDO tranches. A third difference is that the CDO-squared tranches have a higher level of tranche diversification than the CDO tranches, which means that they can reduce the exposure to the idiosyncratic risk of the individual CDO tranches.

- Examples of CDO-squared transactions: Some examples of CDO-squared transactions that have been issued in the past are:

1. Octans II CDO-squared: This was a $1.5 billion CDO-squared deal that was issued in 2006 by Merrill Lynch. It was backed by 50 CDO tranches, mostly mezzanine and equity, from 32 different CDOs. The CDO-squared tranches were rated from AAA to B by Moody's and S&P. The deal suffered heavy losses during the financial crisis of 2007-2008, and was eventually liquidated in 2010.

2. TABASCO CDO-squared: This was a $1.1 billion CDO-squared deal that was issued in 2007 by UBS. It was backed by 52 CDO tranches, mostly mezzanine and equity, from 40 different CDOs. The CDO-squared tranches were rated from AAA to B by Moody's and S&P. The deal also experienced severe losses during the financial crisis, and was restructured in 2012.

3. CDO-squared 2019-1: This was a $500 million CDO-squared deal that was issued in 2019 by Credit Suisse. It was backed by 36 CDO tranches, mostly senior and mezzanine, from 18 different CDOs. The CDO-squared tranches were rated from AAA to BB by Fitch. The deal was one of the first CDO-squared transactions to be issued after the financial crisis, and was aimed at providing investors with exposure to the US leveraged loan market.

3. The Mechanics of Securitizing CDO-squared Tranches

Disclaimer: The following information is based on my own knowledge and may not be accurate, complete, or up-to-date. Please consult a professional financial advisor before making any investment decisions based on this information.

CDO-squared tranches are securities that are backed by a portfolio of CDO tranches. CDO tranches are securities that are backed by a portfolio of debt instruments, such as corporate bonds, mortgages, or loans. CDO-squared tranches are a way of creating more leverage and diversification for investors who want to invest in CDOs.

The mechanics of securitizing CDO-squared tranches are similar to the mechanics of securitizing CDO tranches, but with an additional layer of complexity. Here are some steps involved in the process:

1. A CDO-squared issuer (such as a bank or a hedge fund) buys a portfolio of CDO tranches from different CDO issuers. These CDO tranches have different ratings, maturities, and underlying assets.

2. The CDO-squared issuer creates a special purpose vehicle (SPV) that issues new securities called CDO-squared tranches. These tranches are backed by the cash flows from the portfolio of CDO tranches. The CDO-squared tranches are divided into different classes, such as senior, mezzanine, and equity, based on their risk and return profiles.

3. The CDO-squared issuer sells the CDO-squared tranches to investors who are willing to take different levels of risk and return. The senior tranches have the lowest risk and return, as they have the first claim on the cash flows from the portfolio of CDO tranches. The equity tranches have the highest risk and return, as they have the last claim on the cash flows and bear the first losses if any of the CDO tranches default.

4. The CDO-squared issuer uses the proceeds from selling the CDO-squared tranches to pay for the portfolio of CDO tranches. The CDO-squared issuer earns a fee for creating and managing the CDO-squared tranches.

5. The CDO-squared tranches pay periodic interest and principal payments to the investors, based on the performance of the portfolio of CDO tranches. If any of the CDO tranches default or suffer losses, the CDO-squared tranches will also be affected, starting from the equity tranches and moving up the capital structure.

An example of a CDO-squared tranche is as follows:

- A CDO-squared issuer buys a portfolio of 100 CDO tranches, each with a face value of $10 million, from different CDO issuers. The portfolio has a total face value of $1 billion and an average rating of BBB.

- The CDO-squared issuer creates an SPV that issues 10 CDO-squared tranches, each with a face value of $100 million, backed by the portfolio of CDO tranches. The CDO-squared tranches have different ratings, ranging from AAA to B, based on their seniority and subordination.

- The CDO-squared issuer sells the CDO-squared tranches to investors who have different risk appetites and return expectations. The AAA tranche has the lowest risk and return, as it has the first claim on the cash flows from the portfolio of CDO tranches. The B tranche has the highest risk and return, as it has the last claim on the cash flows and bears the first losses if any of the CDO tranches default.

- The CDO-squared issuer uses the proceeds from selling the CDO-squared tranches to pay for the portfolio of CDO tranches. The CDO-squared issuer earns a fee of 1% of the face value of the CDO-squared tranches, or $10 million, for creating and managing the CDO-squared tranches.

- The CDO-squared tranches pay periodic interest and principal payments to the investors, based on the performance of the portfolio of CDO tranches. If any of the CDO tranches default or suffer losses, the CDO-squared tranches will also be affected, starting from the B tranche and moving up the capital structure.

4. Benefits of Investing in CDO-cubed Structures

One of the most innovative and complex financial products in the market today is the CDO-cubed, or CDO$^3$. As the name suggests, a CDO-cubed is a collateralized debt obligation (CDO) that is backed by tranches of other CDOs, which are themselves backed by tranches of yet another CDO. In other words, a CDO-cubed is a securitization of securitizations of securitizations. This may sound confusing and risky, but it also offers some unique benefits for investors who are looking for higher returns and more diversification in their portfolios. In this section, we will explore some of the advantages of investing in CDO-cubed structures, as well as some of the challenges and risks involved.

Some of the benefits of investing in CDO-cubed structures are:

1. Higher yields: CDO-cubed structures typically offer higher yields than CDOs or CDO-squareds, because they are composed of lower-rated and more subordinated tranches of the underlying CDOs. These tranches have higher default risk, but also higher coupon rates, which are passed on to the CDO-cubed investors. For example, a CDO-cubed that is backed by BBB-rated tranches of CDO-squareds, which are themselves backed by BBB-rated tranches of CDOs, may offer a yield of 15% or more, compared to a yield of 10% or less for a CDO-squared or a CDO with the same rating.

2. More diversification: CDO-cubed structures provide more diversification than CDOs or CDO-squareds, because they are exposed to a larger and more varied pool of underlying assets. A CDO-cubed may have hundreds or thousands of different loans, bonds, mortgages, or other securities as its collateral, which are originated by different lenders, borrowers, issuers, and sectors. This reduces the correlation and concentration risk of the CDO-cubed, and makes it less vulnerable to specific shocks or events that may affect a particular asset class, industry, or region. For example, a CDO-cubed that is backed by CDO-squareds that are backed by CDOs that are backed by corporate loans, mortgage-backed securities, and asset-backed securities, may have a lower probability of default than a CDO-cubed that is backed by CDO-squareds that are backed by CDOs that are backed by only one type of asset, such as subprime mortgages.

3. More leverage: CDO-cubed structures allow investors to achieve more leverage than CDOs or CDO-squareds, because they can amplify the returns and risks of the underlying CDOs. A CDO-cubed is essentially a leveraged bet on the performance of the CDO-squareds, which are themselves a leveraged bet on the performance of the CDOs, which are themselves a leveraged bet on the performance of the original assets. This means that a small change in the value or cash flow of the underlying assets can have a large impact on the value or cash flow of the CDO-cubed. For example, if the default rate of the original assets increases by 1%, this may reduce the value of the CDOs by 5%, which may reduce the value of the CDO-squareds by 10%, which may reduce the value of the CDO-cubed by 20% or more. Conversely, if the default rate of the original assets decreases by 1%, this may increase the value of the CDOs by 5%, which may increase the value of the CDO-squareds by 10%, which may increase the value of the CDO-cubed by 20% or more. This creates a potential for higher returns, but also higher losses, for the CDO-cubed investors.

5. Assessing the Risks Associated with CDO-cubed Investments

When it comes to exploring innovative investment strategies, financial markets have witnessed the emergence of complex products that aim to maximize returns while diversifying risk. One such product that has gained attention in recent years is the CDO-cubed (Collateralized Debt Obligation cubed). This sophisticated financial instrument allows investors to further increase their exposure to collateralized Debt obligations (CDOs) by securitizing CDO-squared tranches. While CDO-cubed investments offer potential benefits, they also come with inherent risks that need careful assessment.

1. Understanding CDO-cubed: To grasp the risks associated with CDO-cubed investments, it is crucial to comprehend how these instruments work. CDO-cubed involves the creation of a new collateralized debt obligation by pooling together CDO-squared tranches. In simpler terms, it is the securitization of already securitized CDOs. This process aims to generate additional cash flows and enhance the potential returns for investors. However, this complexity introduces several layers of risk that demand thorough evaluation.

2. Increased Complexity: The primary risk factor associated with CDO-cubed investments is the heightened complexity of the underlying structure. As more layers of securitization are added, the transparency and understanding of the investment become increasingly challenging. Investors may find it difficult to assess the true value of the CDO-cubed and understand the interdependencies between different tranches, making it harder to gauge the potential risks involved.

3. Lack of Transparency: Due to the intricate nature of CDO-cubed investments, there is often a lack of transparency regarding the underlying assets. The original CDO-squared tranches, which are themselves comprised of various debt obligations, are further bundled together in CDO-cubed structures. This opacity can make it challenging for investors to ascertain the quality and creditworthiness of the underlying assets, leading to potential mispricing and misjudgment of risk.

4. Amplification of Risk: CDO-cubed investments amplify the risks associated with CDO-squared tranches. While CDO-squared instruments already carry inherent risks due to their exposure to subprime mortgages or other debt obligations, the securitization process in CDO-cubed structures magnifies these risks further. This amplification can lead to increased volatility and potential losses if the underlying assets perform poorly.

5. Correlation Risks: Another aspect to consider when assessing the risks of CDO-cubed investments is the correlation between the underlying assets. If the assets within the CDO-squared tranches are highly correlated, the diversification benefits of CDO-cubed structures may be limited. In times of economic downturns or market stress, the performance of the entire CDO-cubed investment could be adversely affected, as the different tranches may suffer simultaneously.

6. Market Liquidity: CDO-cubed investments often face challenges related to market liquidity. The complexity and lack of standardization make it difficult to find buyers or sellers for these instruments, especially during periods of market distress. Illiquidity can exacerbate the risks associated with CDO-cubed investments, as investors may struggle to exit their positions or realize the true value of their holdings.

7. Rating Agency Concerns: Rating agencies play a crucial role in assessing the creditworthiness of CDO-cubed investments. However, the financial crisis of 2008 highlighted concerns regarding the accuracy and reliability of ratings assigned to complex structured products. Investors should be cautious about relying solely on ratings provided by agencies, as they may not fully capture the risks embedded within CDO-cubed structures.

While CDO-cubed investments offer the potential for increased exposure to CDOs and enhanced returns, they also carry significant risks that demand careful assessment. The complexity, lack of transparency, amplification of risk, correlation risks, market liquidity challenges, and rating agency concerns all contribute to the overall risk profile of CDO-cubed investments. Investors must thoroughly analyze these factors and seek expert advice before venturing into this complex investment strategy.

6. Regulatory Framework and Compliance Considerations for CDO-cubed Investments

One of the most important aspects of investing in CDO-cubed is understanding the regulatory framework and compliance considerations that apply to these complex and risky instruments. CDO-cubed are collateralized debt obligations that are backed by tranches of CDO-squared, which are in turn backed by tranches of CDOs, which are backed by various types of debt securities such as mortgages, corporate bonds, loans, etc. This creates a multi-layered structure of securitization that can amplify the returns and risks of the underlying assets.

There are several regulatory and compliance issues that investors need to be aware of when dealing with CDO-cubed, such as:

1. Disclosure and transparency: CDO-cubed are often opaque and difficult to value, as they depend on the performance and correlation of multiple underlying assets and tranches. Investors need to have access to reliable and timely information about the composition, quality, and risk profile of the CDO-cubed and its underlying assets. This can help them assess the potential returns and losses, as well as the liquidity and marketability of the CDO-cubed. However, such information may not be readily available or standardized, as different issuers and rating agencies may use different methodologies and assumptions to evaluate and rate CDO-cubed. Therefore, investors need to exercise due diligence and caution when relying on the disclosure and transparency of CDO-cubed.

2. Regulatory capital requirements: CDO-cubed are subject to regulatory capital requirements that aim to ensure the financial stability and solvency of the institutions that issue, hold, or trade them. These requirements may vary depending on the jurisdiction, the type of institution, and the type and rating of the CDO-cubed. For example, in the US, the basel III framework imposes different risk weights and capital charges for different tranches of CDO-cubed, depending on their credit quality and seniority. In general, the lower the rating and the more junior the tranche, the higher the risk weight and the capital charge. This means that holding or investing in CDO-cubed may require a significant amount of capital, which can affect the profitability and leverage of the institutions involved.

3. legal and tax implications: CDO-cubed are subject to various legal and tax implications that may affect their attractiveness and viability as an investment option. For example, CDO-cubed may involve multiple jurisdictions, entities, and contracts, which can create legal complexities and uncertainties regarding the ownership, enforceability, and transferability of the CDO-cubed and its underlying assets. Moreover, CDO-cubed may have different tax treatments and implications depending on the jurisdiction, the type of income, and the type of investor. For instance, CDO-cubed may generate interest income, capital gains, or losses, which may be subject to different tax rates and rules. Additionally, CDO-cubed may be subject to withholding taxes, value-added taxes, or other taxes that may reduce the net returns or increase the costs of the CDO-cubed.

These are some of the regulatory framework and compliance considerations that investors need to take into account when investing in CDO-cubed. CDO-cubed are not for the faint-hearted, as they entail high levels of complexity, risk, and uncertainty. Investors need to have a thorough understanding of the structure, mechanics, and valuation of CDO-cubed, as well as the regulatory and compliance environment that governs them. Only then can they make informed and prudent decisions about whether CDO-cubed are suitable and beneficial for their investment objectives and risk appetite.

7. Strategies for Diversifying a Portfolio through CDO-cubed Exposure

One of the main challenges for investors who want to diversify their portfolio is to find assets that are not correlated with each other. This means that the performance of one asset does not depend on the performance of another. However, in the modern financial markets, many assets are influenced by the same factors, such as interest rates, inflation, economic growth, and geopolitical events. Therefore, finding truly uncorrelated assets is very difficult.

One possible solution is to invest in CDO-cubed, which are complex derivatives that offer exposure to CDO-squared tranches. CDO-squared are collateralized debt obligations that are backed by other CDOs, which are themselves backed by various debt instruments, such as mortgages, corporate bonds, or loans. CDO-cubed are created by securitizing the tranches of CDO-squared, which are the slices of risk and return that are sold to different investors.

By investing in CDO-cubed, investors can gain access to a diversified pool of underlying assets that are not directly affected by the market conditions. Moreover, CDO-cubed can offer higher returns than CDO-squared or CDOs, as they are leveraged products that amplify the returns of the underlying assets. However, CDO-cubed also entail higher risks, as they are more sensitive to the defaults and losses of the underlying assets.

There are several strategies for diversifying a portfolio through CDO-cubed exposure, depending on the investor's risk appetite, return expectations, and market views. Some of these strategies are:

1. Investing in equity tranches of CDO-cubed. These are the most junior and risky tranches that absorb the first losses of the underlying assets. They also offer the highest returns, as they receive the excess cash flows after paying the senior tranches. Investing in equity tranches of CDO-cubed can be suitable for investors who are bullish on the credit quality of the underlying assets and who are willing to take on high risks for high rewards. For example, an investor who believes that the mortgage market will recover from the subprime crisis can invest in equity tranches of CDO-cubed that are backed by CDO-squared that are backed by CDOs that are backed by subprime mortgages.

2. Investing in mezzanine tranches of CDO-cubed. These are the intermediate tranches that are exposed to moderate losses and returns of the underlying assets. They offer a balance between risk and return, as they have some protection from the equity tranches and some upside from the senior tranches. Investing in mezzanine tranches of CDO-cubed can be suitable for investors who are neutral on the credit quality of the underlying assets and who are looking for a steady income stream. For example, an investor who is indifferent about the corporate bond market can invest in mezzanine tranches of CDO-cubed that are backed by CDO-squared that are backed by CDOs that are backed by corporate bonds.

3. Investing in senior tranches of CDO-cubed. These are the most senior and safe tranches that are protected from the losses of the underlying assets. They offer the lowest returns, as they pay a fixed coupon rate to the investors. Investing in senior tranches of CDO-cubed can be suitable for investors who are bearish on the credit quality of the underlying assets and who are looking for a low-risk investment. For example, an investor who is pessimistic about the loan market can invest in senior tranches of CDO-cubed that are backed by CDO-squared that are backed by CDOs that are backed by loans.

8. Unlocking New Possibilities with CDO-cubed Investments

In this blog, we have explored the concept of CDO-cubed, a complex financial instrument that securitizes the tranches of CDO-squared, which in turn securitize the tranches of CDOs, which are backed by various debt obligations such as mortgages, loans, bonds, etc. We have seen how CDO-cubed can offer investors a way to further increase their exposure to CDOs and potentially earn higher returns, while also diversifying their risk across multiple layers of securitization. However, we have also discussed the challenges and risks associated with CDO-cubed, such as the difficulty of pricing and valuation, the lack of transparency and regulation, the possibility of contagion and systemic failure, and the ethical and social implications of creating such synthetic products. In this conclusion, we will summarize the main points of the blog and provide some insights from different perspectives on the future of CDO-cubed and its implications for the financial markets and the society.

Some of the insights that we can draw from the blog are:

1. CDO-cubed are not for the faint-hearted. They are highly complex and risky products that require a deep understanding of the underlying assets, the structure and the cash flows of the securitization process, and the market conditions and dynamics. Investors who are interested in CDO-cubed should have a high risk appetite and a long-term horizon, as well as access to reliable data and sophisticated models to assess the performance and the risk of their investments. They should also be aware of the possibility of losing their entire principal or facing legal and reputational consequences if the CDO-cubed fail or are involved in fraud or misconduct.

2. CDO-cubed are not inherently bad or evil. They are financial innovations that can serve a useful purpose in the financial system, such as enhancing liquidity, transferring risk, creating new investment opportunities, and improving the efficiency and the resilience of the markets. However, they can also be misused or abused by unscrupulous or irresponsible actors, such as greedy or fraudulent originators, rating agencies, underwriters, managers, or investors, who may exploit the information asymmetry, the moral hazard, the agency problem, or the regulatory arbitrage that exist in the securitization process. Therefore, CDO-cubed need to be regulated and supervised by competent and independent authorities, who can ensure that they are transparent, fair, and safe for the market participants and the society.

3. CDO-cubed are not the end of the securitization chain. They are part of an ongoing evolution of the financial engineering that aims to create new and more sophisticated products that can meet the diverse and changing needs and preferences of the investors and the issuers. There is no limit to the imagination and the creativity of the financial engineers, who can always find new ways to repackage and restructure existing or new assets into different tranches and layers of securitization. For example, there have been proposals to create CDO to the power of four (CDO^4), which would securitize the tranches of CDO-cubed, or even CDO to the power of n (CDO^n), which would securitize the tranches of CDO to the power of n-1, and so on. However, there is also a trade-off between the complexity and the benefit of these products, as well as a question of the social and economic value that they add to the society. Therefore, CDO-cubed and their successors should be evaluated and scrutinized not only from a financial perspective, but also from a broader and more holistic perspective that considers their impact on the welfare and the sustainability of the society.