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What are collateralized debt obligations?

Collateralized debt obligations (CDOs) are supported by a string of loans and other assets that are collateralized by the assets under consideration.

CDOs were first constructed by the investment bank Dexel Burnham Lambert back in the late 1980s. Michael Milken, who is also known in the industry as the ‘junk bond king’ created these instruments for institutional investors. These instruments went on to be one of the most significant factors that led to the crisis of 2008.

In this article, we’re going to explore what CDOs are, how they work, and what their pros and cons are from an investor risk perspective.

Understanding collateralized debt obligations

CDOs are complex financial products that are made up of pooled loans, which are then sold to investors as assets. To create such a CDO, investment banks usually gather cash flow paying assets like loans, bonds, and other forms of debt – and package them into discrete classes of risk.

These classes, or tranches, are the levels of risk associated with each package that the investor can buy. The higher the risk, the lower the tranche, but the higher the return. Since senior tranches get paid before junior tranches in case of a contingency (like liquidation), the lower tranches assume more risk – and hence get rewarded with more returns,

Mortgage-backed securities, for instance, are mortgage loans and asset-backed securities that contain corporate debt, auto loans, or even credit card debt.

The creation of a CDO

CDOs are complex instruments and have a lot of moving parts. Typically, hence, several financial institutions have to work in tandem to create these assets and make them investment-worthy. Here are some usual players involved:

  • Securities firms: These are institutions that approve the collateral underlying the securities. For instance, if the CDO comprises mortgages, these firms will select the tranches, assess their risk, and sell them to investors.
  • CDO managers: These are professional asset and portfolio managers that also help select the collateral and manage these tranches day to day.
  • Ratings agencies: The top ratings agencies in the U.S.A. are S&Ps, Moody’s, and Fitch. These companies analyse the risk associated with these created CDOs and assign them credit ratings. These serve as additional references to investors.
  • Financial guarantors: These are institutions or people who promise to reimburse investors in case there are any losses on the CDO tranches. They act like insurance on these investments and guarantee the collateral in exchange for a nominal premium payment.
  • Ultimate investors: These are the people that actually buy the CDOs. Usually, CDO investors are large pension funds, mutual funds, and hedge funds.

CDOs and the 2008 financial crisis

The CDOs that we just discussed were a ticking time bomb just waiting to explode in 2008. In the lead-up to the bubble, subprime loans lent out by banks fuelled a housing bubble. These loans, which were given out to lenders with little or no credit history, were bundled up into CDOs and sold to investors under false pretences.

Ratings agencies assigned high credit ratings to these CDOs, leading investors to buy riskiest tranches for very high returns for supposedly low risk.

When this bubble burst, therefore, property values plummeted and the houses which were supposed to be the collateral for these CDOs also fell to zero. This triggered a domino effect, which swept through the financial system as a series of huge losses, both to banks and to retail investors.

Pros and cons a a glance

Potential for high returns: Junior tranches can offer significantly higher returns compared to traditional bonds.CDOs, especially junior tranches, are complex and can be highly susceptible to defaults in the underlying debt.
CDOs provide exposure to a diversified pool of debt instruments, potentially mitigating risk associated with one or two individual holdings.CDO structures can be intricate, making it difficult to understand the true risk profile.
Tranched structures allow investors to choose their risk level based on their investment goals.Credit rating agencies have a history of assigning inflated ratings to CDOs, particularly those backed by risky subprime mortgages.

Frequently Asked Questions

What is the difference between a CDO and an asset-backed security?

Asset-backed securities are usually backed by a single asset class like auto loans, credit card debt, or student loans. CDOs can comprise a wider variety of instruments, including a mix of several ABSs.

Do CDOs still exist?

When the housing bubble burst and subprime borrowers went into default at high rates, the CDO market went into a meltdown. This caused many investment banks to either go bankrupt or be bailed out by the government. Despite this, CDOs are still in use by investment banks today.

How do banks make money on CDOs?

For mortgage-backed CDOs, banks make money in two ways: they get back the capital they lent out to borrowers, which can now be used to lend to another set of borrowers; and second, they make money by structuring these instruments which are sold to investors at a premium.

How big is the CDO market?

According to some research reports, the CDO market in 2021 was worth more than $25 billion.

What is the difference between a CDO and an ETF?

Like CDOs, ETFs funnel the current cash flows (interest and dividend) of the underlying assets to the shareholders. But unlike CDOs, ETFs reinvest the principal repayments into the portfolio. Also, ETFs are meant to be a going concern, whereas CDOs are meant to have a finite lifespan.

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