DEFINITION of Bespoke CDO
A bespoke collateralized debt obligation (CDO) is a structured financial product that a dealer creates for a specific group of investors. The bespoke CDO is structured according to the investors' needs. The investor group then typically buys a single tranche of the bespoke CDO. The remaining tranches are then held by the dealer, who will usually attempt to hedge against losses. A bespoke CDO is also referred to as a bespoke tranche or a bespoke tranche opportunity.
BREAKING DOWN Bespoke CDO
Bespoke CDOs can be traditional CDOs pooling classes of debt with income streams, but the term is usually referring to synthetic CDOs that invest in credit default swaps (CDS). A bespoke CDO is simply a tool that allows investors to target very specific risk/return profiles for their investment strategies or hedging requirements. If an investor wants to make a large, targeted bet against the goat cheese industry, there will be a dealer who can build up a bespoke CDO to do that for the right price.
Bespoke CDO or Bespoke Tranche Opportunity?
Bespoke CDOs and CDOs in general have faded from public view due to their prominent role in the financial crisis that followed the mortgage meltdown from 2007-09. The fact that Wall Street was creating these complex, highly structured investments that were hard to understand and difficult to value was seen as part of the overall lack of common sense that led to the massive market crash and eventual government bailout.
Despite this, CDOs are a useful tool for moving risk to willing parties and freeing up capital for other uses. Wall Street is always looking for ways to move around risk and unlock capital, so the bespoke CDO became the bespoke tranche opportunity. This rebranding hasn't changed the tool itself, but there is presumably a bit more scrutiny going into the pricing models so that the owners don’t find themselves once again holding obligations they don’t properly understand.
Pros and Cons of Bespoke CDOs
The obvious advantage of a bespoke CDO is that the buyer can customize it according to his market thesis. The disadvantage is that there is typically there is little to no secondary market for bespoke CDOs, so pricing must be calculated based on complex theoretical financial models. Those models can make assumptions that turn out to be catastrophically wrong, costing the holder dearly and leaving them with a financial instrument they are unable to sell at any price.