Managed or Static CDOs

In a managed transaction, a third party asset manager is chosen to select the portfolio and to manage it during the life of transaction. Typically the manager has the ability to remove “credit impaired” and “credit improved” assets at any time and may also have a discretionary trading allowance, typically up to 15 or 20 per cent of the total portfolio balance per annum. Additionally, as the assets may prepay or amortise earlier than the intended life of the liabilities, the manager may reinvest the prepaid or amortised amounts from the assets during the reinvestment period.

Static transactions have no provision for removal or replacement of assets or reference obligors. The SPE is typically invested in the same assets or credits for the life of the transaction. Hence if there are rating downgrades or defaults in the assets, there is nothing that can be done inside the CDO to mitigate this.

Often the largest issue, after credit risk, is reinvestment risk.  Assets can often prepay depending on the interest rate and economic conditions at the time.  The risk when there is a reinvestment period is that market conditions can change a few years into a reinvestment period and it can be difficult to find replacement investments on similar terms. For example, a CDO can be structured with a covenant that the weighted average spread over LIBOR must meet a minimum threshold.  After a few years into the reinvestment period, spreads in the market may have contracted and the portfolio manager is unable to find reinvestment assets that allow the portfolio to meet the minimum weighted average spread covenant.  Thus, returns to investors can be damaged (particularly at the equity or first loss level) if large amounts of cash are being held in the transaction at a lower return.  This risk is not present in static CDOs.