What Is Warehousing?
Warehousing is an intermediate step in a collateralized debt obligation (CDO) transaction that involves purchasing loans or bonds that will serve as collateral in a contemplated CDO transaction. The warehousing period typically lasts three months, and it comes to an end upon closing of the transaction when they are ultimately securitized and sold as part of the CDO.
Key Takeaways
- Warehousing is the accumulation and custodianship of bonds or loans that will become securitized through a CDO transaction.
- A collateralized debt obligation (CDO) is a complex structured-finance product that is backed by a pool of loans and other interest-bearing assets.
- This intermediate step before the transaction is finalized typically lasts three months, during which time the underwriting bank is subject to the risks involved in holding those assets.
Understanding Warehousing
A CDO is a structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. The pooled assets, comprising mortgages, bond, and loans, are debt obligations that serve as collateral — hence the name collateralized debt obligation. The tranches of a CDO vary substantially with their risk profile. Senior tranches are relatively safer because they have priority on the collateral in the event of a default. The senior tranches are rated higher by credit rating agencies but yield less, while the junior tranches receive lower credit ratings and offer higher yields.
An investment bank carries out the warehousing of the assets in preparation of launching a CDO into the market. The assets are stored in a warehouse account until the target amount is reached, at which point the assets are transferred to the corporation or trust established for the CDO. The process of warehousing exposes the bank to capital risk because the assets sit on its books. The bank may or may not hedge this risk.