Manager Incentives in Collateralized Debt Obligations

71 Pages Posted: 9 May 2005

See all articles by Kedran Rae Garrison

Kedran Rae Garrison

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA)

Date Written: August 15, 2005

Abstract

This paper quantifies under-investment and asset substitution problems in the collateralized debt obligation or "CDO" market. CDOs are closed-end, actively-managed, highly leveraged bond funds. Using observed and historical default rates, I differentiate the costs of financial and agency-induced stress and weigh against effort benefits. For most parameterizations ex-ante effort benefits greatly outweigh risk-shifting costs. I also analyze various payout policies and covenants for their ability to curtail manager risk-shifting while not overly restricting effort. Excess interest diversions, contingent trading limits, and coverage test "haircuts" of lower-priced assets are effective measures and increase allowable leverage and equity returns.

Keywords: Capital Structure, Asset Substitution, Under-investment, Manager Incentives, Computational Finance, Collateralized Debt Obligations, CDO

JEL Classification: G3,G32,G24,G35,G2

Suggested Citation

Garrison, Kedran Rae, Manager Incentives in Collateralized Debt Obligations (August 15, 2005). Available at SSRN: https://ssrn.com/abstract=720481 or http://dx.doi.org/10.2139/ssrn.720481

Kedran Rae Garrison (Contact Author)

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA) ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States

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