Analytical Challenges in Secondary-Market CDO Trading

Abstract

Secondary trading in the collateralized debt obligation (CDO) market came into its own in 2003 and has continued at a robust pace in 2004. One reason is the significant increase in resources available for analyzing outstanding CDOs, chiefly the availability of CDO-specific cash flow models. This article provides a step-by-step guide to evaluating a secondary CDO. The authors pay particular attention to two popular analytical methods: net asset value analysis and cash flow modeling. These two techniques have improved investors? understanding of CDOs and therefore secondary-market liquidity. The authors suggest a methodology to produce a range of constant annual default rates for the purpose of modeling structured-finance-backed CDOs and suggest some negotiating points for primary CDO purchasers to ensure the liquidity of their CDOs in the secondary market.