CDO stands for Collateralized Debt Obligation and it involves the pooling of debt to reduce risk and raise returns. CDOs have been widely blamed for the 2008 financial crisis, but most people do not know what they are. When a lot of debt (such as home mortgages) is pooled together, bonds can be issued on this debt. The debt is split into different tranches, and each tranche is assigned a different payment priority and interest rate. This process is known as securitization.
When there is a lack of debt to securitize, it is possible to create a synthetic product by pooling all of the lowest tranches (highest interest payments, highest risk) to create a new product known as a CDO. The theory behind this is that even though the assets behind the bonds are risky, by pooling large amounts together it is possible to minimize risk whilst still receiving the high interest rates.
The problem with CDOs is that although they are split into tranches with the top tranche being rated AAA (i.e. no risk) and the bottom tranche being rated as junk, they are all based on the same asset - the worst subprime mortgages from a large mortgage pool.
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS).[1] Originally developed for the corporate debt markets, over time CDOs evolved to encompass the mortgage and mortgage-backed security ("MBS") markets.[2]
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. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority.[3] 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. 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.[4]
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".[4]
In the early 2000s, CDOs were generally diversified,[5] but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this changed. CDO collateral became dominated not by loans, but by lower level (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually sub-prime mortgages,[6] and are known as a synthetic CDO. These CDOs have been called "the engine that powered the mortgage supply chain" for sub-prime mortgages,[7] and are credited with giving lenders greater incentive to make sub-prime loans[8] leading up to the 2007-9 subprime mortgage crisis.
CDOs might lead to another financial crisis....
Collateralized debt obligations (CDOs), the bad boys of the financial crisis of 2008, are coming back.
CDOs are securities that hold different types of debt, such as mortgage-backed securities and corporate bonds, which are then sliced into varying levels of risk and sold to investors. With the Federal Reserve committed to keeping interest rates low, investors — such as pension funds seeking higher returns — are driving demand once again for these structured securities, which are riskier but provide more bang for the buck than safer bets such as Treasuries and investment-grade corporate bonds.
This year, Deutsche Bank launched an $8.7 billion CDO in two tranches with payments ranging from 8% to 14.6%, garnering strong interest from investors, according to a January 24 story in Bloomberg News. In the U.S., firms such as Redwood Trust have started selling CDOs backed by commercial real estate for the first time since the credit crunch, Bloomberg reported in a January 14 article.
