Manager Incentives In Collateralized Debt Obligations

This paper quantifies under-investment and asset substitution problems in the collateralized debt obligation or quot;CDOquot; 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 quot;haircutsquot; of lower-priced assets are effective measures and increase allowable leverage and equity returns.