Collateralized debt obligation

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A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS).[1] Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS).[2][3] Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns.[4] Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.[5]

The CDO is "sliced" into sections known as "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority.[6] If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first.[7] The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual.[8]

Separate special purpose entities—rather than the parent investment bank—issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as "CDO-Squared", "CDOs of CDOs" or "synthetic CDOs".[8]

In the early 2000s, the debt underpinning CDOs was generally diversified,[9] but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this had changed. CDO collateral became dominated by high risk (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually subprime mortgages.[10] These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages,[11] and are credited with giving lenders greater incentive to make subprime loans,[12] leading to the 2007–2009 subprime mortgage crisis.[13]

  1. ^

    An "asset-backed security" is sometimes used as an umbrella term for a type of security backed by a pool of assets—including collateralized debt obligations and mortgage-backed securities. Example: "A capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs" (italics added). Source: Vink, Dennis (August 2007). "ABS, MBS and CDO compared: an empirical analysis" (PDF). Munich Personal RePEc Archive. Retrieved 13 July 2013..

    Other times it is used for a particular type of that security—one backed by consumer loans. Example: "As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO, [and s]ecuritization issues backed by consumer-backed products—car loans, consumer loans and credit cards, among others—are called ABS ..." (italics added). Source: Vink, Dennis (August 2007). "ABS, MBS and CDO compared: an empirical analysis" (PDF). Munich Personal RePEc Archive. Retrieved 13 July 2013.

    See also: "What are Asset-Backed Securities?". SIFMA. Archived from the original on 29 June 2018. Retrieved 13 July 2013. Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically the assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.

  2. ^ Lepke, Lins and Pi card, Mortgage-Backed Securities, §5:15 (Thomson West, 2014).
  3. ^ Cordell, Larry (May 2012). "COLLATERAL DAMAGE: SIZING AND ASSESSING THE SUBPRIME CDO CRISIS" (PDF).
  4. ^ Azad, C. "Collateralized debt obligations (CDO)". www.investopedia.com. Investopedia. Retrieved 31 January 2018.
  5. ^ Kiff, John (November 2004). "CDO rating methodology: Some thoughts on model risk and its implications" (PDF).
  6. ^ Koehler, Christian (31 May 2011). "The Relationship between the Complexity of Financial Derivatives and Systemic Risk". Working Paper: 17. SSRN 2511541.
  7. ^ Azad, C. "How CDOs work". www.investinganswers.com. Investing answers. Retrieved 31 January 2018.
  8. ^ a b Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2014 ed.).
  9. ^ McLean, Bethany and Joe Nocera, All the Devils Are Here, the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010, p. 120.
  10. ^ Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, aka The Financial Crisis Inquiry Report, p.127
  11. ^ Cite error: The named reference FCIR-130 was invoked but never defined (see the help page).
  12. ^ Cite error: The named reference FCIR-133 was invoked but never defined (see the help page).
  13. ^ Lewis, Michael (2010). The Big Short: Inside the Doomsday Machine. England: Penguin Books. ISBN 9781846142574.