Collateralized Debt Obligation (CDO)

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A Brief Overview

Institutional investors today have the option to invest in a wide range of financial products. Among them exist collateralized debt obligations (or CDOs). This article seeks to shed light on all that CDOs entail.

What Is a Collateralized Debt Obligation?

A CDO refers to a compounded structured finance product that is supported by a string of loans as well as other assets and then made available for purchase to institutional investors. A CDO can be categorised as a derivative as its value is derived from another asset that underlies its worth. These assets under consideration serve as collateral in the event that the loan is defaulted.

Examining the Scope of Collateral Debt Obligations

Collateral debt obligations first began to see themselves being constructed in 1987 by the erstwhile investment bank called Drexel Burnham Lambert. Here, Michael Milken served supreme as the “junk bond king”. He, along with other bankers working at Drexel Burnham Lambert developed early CDOs by creating portfolios made up of junk bonds that had been issued by varied companies. The term collateralised is tethered to CDOs as they gave their word regarding the repayments of the underlying assets which are what provide CDOs with their value.

Following the creation of CDOs by Drexel Burnham Lambert bankers, other securities firms followed suit. These firms began launching CDOs that held other assets that were tethered to more reliable income streams. These ranged from student loans and aircraft leases to credit card receivables and automobile loans. Until 2004, however, CDOs continued to remain an obscure product within the world of investments. The U.S. housing boom in 2004 changed this and resulted in CDO issuers to direct their attention towards subprime mortgage-backed securities. These would begin to form the source of collateral applicable to CDOs.

The popularity of collateralised debt obligations gained credence at a rapid pace and CDO sales rose almost ten times from the period between 2003 which saw a USD 30 billion worth valuation to a USD 225 billion worth valuation in 2006. However, following the growth in their popularity owed in part to the U.S. housing correction, CDOs became one of the worst-performing instruments in the subprime crisis which began in 2007 and reached a boiling point in 2009. Once the CDO bubble burst, there were losses that ran into billions of dollars and impacted some of the biggest institutions offering financial services. These losses led to investment banks going bankrupt or to the American government intervening and bailing them out. Ultimately, these triggers escalated the financial crisis plaguing the world i.e., the Great Recession.

Now, despite the part played by collateralised debt obligations in the financial crisis, they still occupy an active area within the realm of structured finance investing. CDOs along with their infamous counterparts – synthetic CDOs – are still utilised as they serve as a tool for redistributing risk and freeing up capital. Each of these outcomes is heavily relied upon and is needed by financial markets.

Understanding the Collateralised Debt Obligations Process

In order to create a CDO, investment banks pool together assets capable of generating cash-flow ranging from bonds and mortgages to other forms of debt. These assets are then repackaged and shuffled into obscure classes (or tranches) keeping in mind the extent of the credit risk an investor can assume.

These tranches applicable to securities serve as the final investment products and their names are used to indicate the underlying assets to which they are tethered. Take for instance mortgage-backed securities (or MBSs) that are made up of mortgage loans while asset-backed securities (or ABSs) constitute auto loans, credit card debt and/ or corporate debt.

Alternative forms of CDOs consist of the following.

  1. Collateralised bond obligations (or CBOs) serve as investment-grade bonds that are upheld by a group of bonds that have a lower rating but have a high yield.
  2. Collateralised loan obligations (or CLOs) – these are single securities that are upheld by a collection of debt that is primarily oriented towards corporate loans that have a modest credit rating.

There exist several complexities pertaining to collateralised debt obligations owing to which there exist a number of professionals that are enlisted in their creation.

  • Securities firms are responsible for approving the selected collateral and help structure the notes into tranches such that they can be sold to investors
  • CDO managers are responsible for selecting collateral as well as managing CDO portfolios
  • Rating agencies are tasked with assessing CDOs and assigning them with credit ratings
  • Financial guarantors are in charge of reimbursing investors in the event that they incur any losses with regard to the CDO tranches in lieu of premium payments
  • Investors range from pension funds to hedge funds and are involved in the process as well

Wrapping Up

The tranches applicable to CDOs are named in accordance with the risk profile tethered to them i.e., they can be split into senior, mezzanine, and junior debts. However, the actual structure applicable here varies and is dependent upon the individual product under consideration. As a general rule, senior tranches tend to be the safest investments as they have the primary claim on the collateral. While senior debt is ordinarily assigned a higher rating in comparison to junior tranches, the coupon rates applicable are lower. Prior to being invested in, institutional investors partake in due diligence to ensure that their investment is worthy of the money they would spend on it.