Manager Incentives in Collateralized Debt Obligations
71 Pages Posted: 9 May 2005
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: Suggested Citation