What is a Collateralized Debt Obligation (CDO)?

What is a Collateralized Debt Obligation (CDO)?

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors.

A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.

A collateralized debt obligation is a complex structured finance product that is backed by a pool of loans and other assets.

These underlying assets serve as collateral if the loan goes into default.

Though risky and not for all investors, CDOs are a viable tool for shifting risk and freeing up capital.

How Does a Collateralized Debt Obligation Work?

It is generally believed that banks repackage individual loans, mortgages, and bonds in the form of collateralized debt obligations which they sell to customers. However, aside from the banks, there are other parties that can create CDOs, they are;

  • CDO managers: These are professional managers in charge of the selection of collateral that backs CDOs.
  • Securities firms
  • Financial regulators and agencies
  • Investors; through hedge funds, pension funds, and others)
  • Rating agencies.

CDOs are categorized in tranches and attract different levels of risks, while the senior tranches have fewer risks, the lower tranches have higher risks such as default. For instance, in cases of default, senior tranches are given priority in terms of repayment over junior tranches.

Structure of a Collateralized Debt Obligation

Historically, the underlying assets in collateralized debt obligations included corporate bonds, sovereign bonds, and bank loans. A CDO gathers income from a collection of collateralized debt instruments and allocates the collected income to a prioritized set of CDO securities.

See also :  What is Basis Trading?

Similar to equity (preferred stock and common stock), a senior CDO security is paid before a mezzanine CDO. The first CDOs comprised cash flow CDOs, i.e., not subject to active management by a fund manager. However, by the mid-2000s during the lead up to the 2008 recession, marked-to-market CDOs made up the majority of CDOs. A fund manager actively managed the CDOs.

How Are Collateralized Debt Obligations (CDO) Created?

To create a collateralized debt obligation (CDO), investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.

These tranches of securities become the final investment products, bonds, whose names can reflect their specific underlying assets.

Advantages of Collateralized Debt Obligations

Collateralized debt obligations allow banks to reduce the amount of risk they hold on their balance sheet. The majority of banks are required to hold a certain proportion of their assets in reserve. This incentivizes the securitization and sale of assets, as holding assets in reserves is costly for the banks.

Collateralized debt obligations allow banks to transform a relatively illiquid security (a single bond or loan) into a relatively liquid security.

Mortgage-Backed Collateralized Debt Obligation

A mortgage-backed CDO owns parts of many individual mortgage bonds. On average, a mortgage-backed CDO owns parts of hundreds of individual mortgage bonds. The mortgage bonds, in turn, contained thousands of individual mortgages. Thus, a mortgage-backed CDO is seen to reduce the risk of a small-scale housing crisis by diversifying across many mortgage bonds.

A mortgage-backed CDO was considered a very safe investment instrument prior to the 2008 financial crisis. However, such CDOs were particularly susceptible to a systemic collapse of the global housing market. In 2007-2008, house prices fell across the world.

See also :  What is the Double Top?

What Went Wrong With Collateralized Debt Obligation

Unfortunately, the extra liquidity created an asset bubble in housing, credit cards, and auto debt. Housing prices skyrocketed beyond their actual value. People bought homes just so they could sell them.6 The easy availability of debt meant that people used their credit cards too much. That drove credit card debt to almost $1 trillion in 2008.8

The banks that sold the CDOs didn’t worry about people defaulting on their debt. They had sold the loans to other investors, who then owned them. That made them less disciplined in adhering to strict lending standards. Banks made loans to borrowers who weren’t creditworthy, which ensured disaster.

Buyers may not have done enough research to be sure the CDO packages were worth their prices, but research wouldn’t have done much good, because even the banks didn’t know. The computer models based the CDOs’ value on the assumption that housing prices would continue to go up. If they were to fall, the computers couldn’t price the products.

This opacity and the complexity of CDOs created a market panic in 2007. Banks realized that they couldn’t price the products or the assets they were still holding. Overnight, the market for CDOs disappeared. Banks refused to lend each other money, because they didn’t want more CDOs on their balance sheets in return.

It was like a financial game of musical chairs when the music stopped, and resulting panic caused the 2007 banking crisis.