How CDOs Work
CDOs are like subsidiaries. There are many variations of CDOs (cashflow, arbitrage, synthetic), I will only talk about the ones GKK has. They start out by the sponsor (GKK) putting up $100 million of equity, much like how you would start a company. Then they borrow $900 million at L+0.5%. They can't just turn around and take the $900 million out of the CDOs and into GKK corporate's pocket. That is why you have restricted cash. They either stay in the CDO company structure, or they get paid according to seniority(which GKK owns the most junior ones).
GKK as manager and equity tranche owner can decide what assets they want to invest in to earn a return. Of course we want the assets(called collaterals of the CDO bonds) to generate a higher interest than our liabilities. No matter what GKK does with the $1 billion, the senior tranches will get their interest first, be it all in cash or REOs, CMBS, whole loans. The interest will be paid from the CDO's assets(loans, MBS, interest/principal received). GKK gets to keep any interest income over and above what is owed to the senior tranche holders, as long as the CDOs pass an overcollateralization test. Which is just a test to ensure there are enough collaterals (assets) in the CDOs to pay off the senior tranche principal.
CDOs typically have reinvestment periods of 3-5 years after their birth, during which time principal payments from the loans we make can be rolled into new investments. The alternative is to pay down the senior tranche. This is like you being a landlord, when you receive rent, you first pay your mortgage, then you can decide to keep the rest or make additional payment on your principal. Of course GKK would want to keep more interest-earning assets in the CDO. When the reinvestment period ends, all principal payment received will be used to pay down debt. As debt goes down, so does the CDO's assets, therefore decreasing the total interest income and distribution to GKK. This is what we mean by "runoff". Eventually, when all loans are paid back, GKK will get their $100 million back as well, barring any discount payoff/default.
To answer jets111, having more restricted cash would not help the valuation of a CDO. It just means you are not using your borrowings to generate a return. It is like taking out a mortgage and let it sit in your bank account. It would not increase your house's net value.
Now if we assume GKK is closing down shop and liquidating. From PlanMaestro's CDO reports we can expect at least $25 million of cashflow from CDO 2006. CDO 2005 could contribute another $20 million to GKK but since it is failing O/C, the 20 million will be used to pay down debt (like you being forced to pay more principal on your mortgage). Based on the OC, I estimate the present value of the cash inflow to GKK, along with the principal payment at the end of CDOs' lives, to be $100 million+.
If they just let Realty go and no more further legal entanglements with the lenders. We have:
$200 million unrestricted cash @ corporate
$100 million conservative estimate of CDOs' worth if sold today
$xx million CMBS held at corporate level (more like $20 mil but assume this is zero)
less:
($32 million) of the unrestricted cash belongs to Realty
($105 million) preferred stocks at par $25 + $5 on 3.6 million shares
with 52 millions shares outstanding we have $3.13/share
