The Complex Task of Restructuring Collateralized Debt Obligations
Collateralized debt obligations (CDOs) are complex financial instruments that bundle together collections of assets like bonds, loans, or other CDOs, and sell rights to the income streams from those underlying assets to investors[1].
When the assets underlying a CDO perform poorly, the CDO may need to be restructured. However, restructuring CDOs poses many challenges.
-Why CDOs May Need Restructuring
There are a few key reasons why a CDO may need to undergo restructuring[2]:
- Defaults on the underlying assets – If many of the loans, bonds or other assets underlying the CDO default, the CDO will not generate enough cashflow to pay investors as expected. This may prompt a restructuring.
- Rating downgrades – CDOs receive credit ratings based on the perceived riskiness of their underlying assets. If those ratings are downgraded significantly, it can impact the CDO’s ability to attract investors and service its existing debts. This can necessitate a restructuring.
- Liquidity issues – Most CDOs have triggers that force early payouts to investors if the market value of the CDO’s assets falls below certain thresholds. These payouts can create temporary liquidity issues that require restructuring.
Challenges With Restructuring CDOs
Restructuring a distressed CDO can be enormously complex for several reasons:
Difficulty Valuing Assets
- Many CDOs hold esoteric, illiquid assets that are challenging to accurately value[3]. This makes it hard to determine the scale of losses across the CDO structure.
- Valuation disputes may arise between various classes of investors who have opposing interests. This can impede agreement on restructuring terms.
Complex Deal Structures
- CDOs often have intricate deal structures with many interdependent securities. This web of connections significantly complicates restructuring efforts[4].
- Restructuring one class of securities may necessitate changes across other parts of the CDO capital structure.
Collective Action Problems
- CDOs can have hundreds of investors, making consensus and collective action difficult[5]. A few holdout investors could derail a wider restructuring agreement.
- Investors may pursue individual legal actions rather than collaborating on a collective restructuring plan. This further impedes progress.
Costs and Delays From Litigation
- Restructuring negotiations can spur legal disputes between investors which take time to resolve in court[6].
- Ongoing litigation drains money that could otherwise repay investors or improve the CDO’s capital position.
Restructuring Solutions and Mitigation Tactics
Firms looking to restructure distressed CDOs have several options to help address these challenges:
- Appoint a Receiver – This independent third party takes full control of CDO restructuring negotiations on behalf of investors[7]. This helps overcome coordination issues.
- Litigation Trusts – These structures isolate disputed assets to resolve legal claims without blocking wider restructuring progress[8].
- Credit Bidding – This allows investors to exchange debt they are owed for ownership stakes in CDO assets. This can help expedite restructuring deals[9].
- Specialist Valuation Firms – Hiring third party experts to value illiquid CDO assets can help settle investor disputes if all parties commit to accepting the results[10].
Skilled legal and restructuring advisors are indispensable when navigating the intricacies of distressed CDO deals. Their expertise in intercreditor negotiations, credit bidding mechanisms, and designing litigation trusts can pave the way for successful restructurings even in complex cases.
-The Future of CDO Restructurings
Since the 2008 financial crisis triggered widespread CDO defaults, restructurings have become relatively commonplace[11]. However, ongoing litigation continues to drag out timeframes, with some pre-crisis deals still working through disputes in 2024[12].
Technology solutions like blockchain-based CDOs and smart contract automation may streamline coordination and settlements between investors in future restructurings[13]. But market veterans caution that no technology can wholly eliminate the intrinsic complexity risks that collateralized instruments entail[14].
While CDOs appeal to investors seeking higher yields from complex structured products, all parties should enter such deals with eyes wide open to the obstacles they can face if restructuring becomes necessary down the line.
Resources
Images:
CDO Diagram
A diagram of a typical CDO structure. Source: Investopedia
-Videos:
A 3 minute video introduction to CDOs from MooMooMath and Science
Articles:
-Investopedia’s overview of CDOs
Litigation Trusts as a Solution to Mass Tort Liability
Analysis of using litigation trusts to resolve legal disputes from Harvard Corporate Governance blog