Why CDO Equity Tranches Support Senior Tranches and Require a Sponsor

# Why does/did a CDO need a "sponsor"?


# Why does/did a CDO need a "sponsor"?












I've been reading a lot of about the "Magnetar trade" (see pro-publica article here and the links therein, as well as this paper), and I'm slightly confused by the argument about how Magnetar (and similar firms) spurred the creation of additional CDOs, which might be related to a deeper misunderstanding of how the individual tranches related to the whole CDO.

So my understanding of the argument is that Magnetar bought the riskiest equity tranches of the CDO (thereby being known as the "sponsor"), which few investors wanted, which then opened them up to buying the higher rated senior or mezzanine tranches. This was great for Magnetar since they held short positions (CDSs) in those particular asset classes, and by buying the (undervalued) equity tranche they helped spur the creation of a larger CDO market in which to short.

What I'm unclear about is why these CDO's needed the equity tranche sponsored. Why was it not profitable (or seem profitable) for the banks that were creating these CDOs to make products with only mezzanine and senior tranches? Since it seems investors were buying individual tranches anyway, it isn't like the equity portion of the CDO was driving the return. I.e. those buying the higher tranches weren't necessarily being directly exposed to the equity tranche and their interest rate was based only on the assets in their particular tranche.

## Answer by AlRacoon (score 2)

https://quant.stackexchange.com/a/38675

The sponsor of the CDO is the collateral manager. In order for a CDO to be issued, someone has to buy the assets that are underlying or backing the tranched default obligations. In other words, the sponsor is buying the loans which will be the source of the interest and principal which will be used to pay the promises of the tranched debt obligations that are sold.

In the situation you describe, you are describing a CDO squared. In this case, the assets supporting the default obligations are tranches of other CDOs. Someone still has to purchase and manage this portfolio of assets, which is the responsibility of the sponsor. As the underlying assets are themselves tranches of existing CDOs (which in this case is the equity tranche), those CDOs will also have a sponsor to manage the underlying collateral (which in this case will be the actual loans).

The equity tranche has the highest coupon given that it is the first loss tranche. As long as the assets underlying the CDO continue to pay, the equity tranche will be unimpaired and can itself be the source of high coupons for the CDO squared.

## Answer by Daneel Olivaw (score 1)

https://quant.stackexchange.com/a/38676

> "Why was it not profitable (or seem profitable) for the banks that were creating these CDOs to make products with only mezzanine and senior tranches?"

As far as my understanding of the CDO market goes, in order to have senior tranches you need to have equity tranches: roughly speaking the equity tranche is there to absorb losses and protect the senior tranches.

When creating a CDO, or in general any securitized product with tranches, you are determining a series of "rules" to allocate losses if there are ever any. This is how you can create $\text{A}$-rated and $\text{C}$-rated securities from $\text{B}$-rated underlyings: by redistributing losses. Without the equity tranche, senior and mezzanine tranches would be less protected from defaults in the underlying basket and as such would have to offer higher returns.

I am unsure about the conventional terminology, but in this case the way I understand it is that Magnetar is the "sponsor" because, by accepting to hold the riskiest tranche, it enables the structuring of tranches with more seniority and therefore the creation of the CDO.