What is Collateralized Debt Obligation (CDOs) and How Does it Works

A sophisticated structured finance instrument known as a collateralized debt obligation (CDO) is offered to institutional investors and backed by a collection of loans and other assets. As its name suggests, a CDO is a specific kind of derivative because its value is generated from another underlying asset. In the event of a loan default, these assets become the collateral.

What is Collateralized Debt Obligation (CDOs)

Michael Milken, known as the "junk bond king," was the head of Drexel Burnham Lambert, a defunct investment bank that built the first CDOs in 1987. The Drexel bankers produced these early CDOs by assembling junk bond portfolios from various corporations. Because the underlying assets' guaranteed repayments serve as the collateral that underpins the value of the CDOs, they are referred to as "collateralized" securities.

Investment banks compile cash flow-generating assets such as bonds, mortgages, and other debt instruments and repackage them into several classes, or tranches, according to the investor's level of credit risk tolerance to construct a CDO.

These securities tranches culminate into bonds, the ultimate investment instruments whose names may correspond to the particular assets they represent. For example, mortgage-backed securities (MBS) consist of mortgage loans, whereas asset-backed securities (ABS) consist of credit card, vehicle, or business debt.

Collateralized loan obligations (CLOs) are single securities backed by a pool of debt that frequently contains corporate loans with a low credit rating. Collateralized bond obligations (CBOs) are investment-grade bonds backed by a pool of high-yield but lower-rated bonds.

Collateralized debt obligations are intricate, including the work of multiple professionals in their creation:

 

• Securities companies, who authorise the collateral selection, arrange the notes into tranches and market them to investors
• CDO managers, who frequently oversee CDO portfolios and choose the collateral
• rating agencies, which evaluate and issue credit ratings to CDOs
• Financial guarantors: in return for premium payments, they guarantee to compensate investors for any losses they may incur on the CDO tranches.
• investors like hedge funds and pension funds

 

In the end, other securities companies introduced CDOs with different assets and more steady income streams. These included credit card receivables, vehicle loans, school loans, and aeroplane leases. CDOs, however, continued to be a niche commodity until the US housing boom of 2003–2004. Subprime mortgage-backed securities caught the interest of CDO issuers as a potential new collateral source.

CDOs and the Subprime Mortgage Crisis

As issuers started using securities backed by subprime mortgages as collateral in the early 2000s, collateralized debt obligations saw an exponential increase in popularity. CDO sales increased by nearly ten times from $30 billion in 2003 to $225 billion in 2006.

Many of these subprime mortgages required no down payment or very little, and many did not demand evidence of income. Lenders frequently employed instruments like adjustable-rate mortgages, in which the interest rate increased throughout the loan, to balance the risk they were taking on.

Rating agencies could present investing in these mortgage-backed securities to investors as appealing and low-risk because this industry had minimal government supervision. Due to the increasing demand for mortgage-backed securities brought about by CDOs, lenders were able and willing to issue more subprime mortgages. With the demand from CDOs, lenders could have made more loans to subprime borrowers.

It was discovered by confident investors and banking officials that many of the subprime mortgages supporting their investments were engineered to collapse. However, the prevailing opinion was that investors and debtors would be bailed out if real estate prices rose. But prices stopped rising; they sharply dropped when the housing bubble burst. Subprime borrowers were underwater because their homes were worth less than their mortgage debt. As a result, there were many defaults.

These subprime mortgages served as the collateral for the CDO market, which collapsed in response to the U.S. housing market slump. CDOs were among the instruments that performed the poorest during the subprime crisis, which started in 2007 and ended in 2009. Several of the biggest financial services companies suffered losses of up to hundreds of billions of dollars due to the CDO bubble crash.

Due to these losses, investment banks were forced to file for bankruptcy or get government bailouts. This affected the stock market, real estate market, and other financial institutions at this time, contributing to the worsening of the Great Recession.

Collateralized debt obligations remain popular for structured finance investments, even considering their part in the financial crisis. Because they are ultimately a mechanism for shifting risk and freeing up capital—two objectives investors rely on Wall Street to accomplish and for which Wall Street has always had an appetite—CDOs and the even more notorious synthetic CDOs are still in use.

Benefits Collateralized Debt Obligation (CDOs)

CDOs have advantages and disadvantages, just like any other kind of asset. Their two primary drawbacks—their intricacy, which made it challenging to appropriately evaluate them—and their susceptibility to repayment risk, particularly from subprime borrowers, contributed to their involvement in the housing bubble and the subprime mortgage crisis.

But there are also the following two key advantages:

• Diversification: Investors are exposed to various risks because the debt packaged in a CDO is spread over numerous mortgages or other loans. As long as each collateralized loan is not entirely made up of subprime loans, each CDO has some degree of diversification.
• Liquidity: A bank's holdings of a single bond or loan are comparatively illiquid. On the other hand, a CDO makes those into liquid assets. Banks can increase lending and make more money if they have more liquid investments.

How are Collateralized Debt Obligations (CDO) Created?

Investment banks assemble cash flow-generating assets, like bonds, mortgages, and other financial instruments, to form collateralized debt obligations (CDOs). Then, depending on the investor's level of credit risk tolerance, they repackage these assets into several classes or tranches. These securities tranches culminate into bonds, the ultimate investment instruments whose names may correspond to the particular assets they represent.

What Should the Different CDO Tranches Tell an Investor?

A CDO's tranches reflect its risk profiles. Senior debt, for example, would have a better credit rating than junior and mezzanine debt. Bondholders in the other tranches receive payment based on their credit ratings, with the lowest-rated credit tranche receiving payment last in the event of a loan failure. Senior bondholders receive payment first from the collateralized pool of assets. Due to their priority claim over the collateral, the senior tranches are typically the safest.

What Is a Synthetic CDO?

A synthetic collateralized debt obligation (CDO) is a CDO that makes investments in non-cash assets and can provide investors with very high yields. They do not, however, operate in the same manner as classic CDOs, which generally invest in conventional debt instruments like bonds, mortgages, and loans. Instead, they make money by investing in noncash derivatives like credit default swaps (CDSs), options, and other contracts. Credit risk assumed by the investor determines the division of synthetic CDOs into credit tranches.

Conclusion

A structured financial instrument backed by a collection of loans and other assets is called a collateralized debt obligation (CDO). A financial institution may hold it and then sell it to investors. A CDO's tranches, with senior having the highest credit rating, mezzanine coming next, and junior after that, indicate to investors the amount of risk they are taking. Senior bondholders receive payment from the pool of collateral assets first, followed by junior bondholders, in the event of an underlying loan default.

CDOs contained enormous bundles of subprime mortgages during the early 2000s housing bubble. The CDO market collapsed as the housing bubble burst and subprime borrowers defaulted at exorbitant rates. As a result, some investment banks had to be bailed out by the government or went bankrupt. Despite this, investment banks continue to use CDOs.

Reference

• Investopedia

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