A synthetic investment product that represents different loans bundled together and sold by the lender
Over 2 million + professionals use CFI to learn accounting, financial analysis, modeling and more. Unlock the essentials of corporate finance with our free resources and get an exclusive sneak peek at the first module of each course. Start Free
A Collateralized Debt Obligation (CDO) is a synthetic investment product that represents different loans bundled together and sold by the lender in the market. The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period. A collateralized debt obligation is a type of derivative security because its price (at least notionally) depends on the price of some other asset.
Structure of a Collateralized Debt Obligation
Historically, the underlying assets in collateralized debt obligations included corporate bonds, sovereign bonds, and bank loans. A CDO gathers income from a collection of collateralized debt instruments and allocates the collected income to a prioritized set of CDO securities.
Similar to equity (preferred stock and common stock), a senior CDO security is paid before a mezzanine CDO. The first CDOs comprised cash flow CDOs, i.e., not subject to active management by a fund manager. However, by the mid-2000s during the lead up to the 2008 recession, marked-to-market CDOs made up the majority of CDOs. A fund manager actively managed the CDOs.
Advantages of Collateralized Debt Obligations
- Collateralized debt obligations allow banks to reduce the amount of risk they hold on their balance sheet. The majority of banks are required to hold a certain proportion of their assets in reserve. This incentivizes the securitization and sale of assets, as holding assets in reserves is costly for the banks.
- Collateralized debt obligations allow banks to transform a relatively illiquid security (a single bond or loan) into a relatively liquid security.
The Housing Bubble and Collateralized Debt Obligations
Historically, houses were seen to be fundamentally different from other assets such as bonds and shares of companies. Therefore, the housing market was analyzed in a different way compared to the market for other investment instruments. Transactions in the housing market are usually high-value transactions involving individuals, and the relative frequency of such transactions is low compared to a bond or share, which may change hands multiple times during a day’s trading.
In 2003, Alan Greenspan, then the chairman of the Federal Reserve, cut the target federal funds rate to 1% from a high of 6.5% in 2001. The move incentivized banks to increase lending to take advantage of the easy credit available. Banks also provided housing loans to borrowers who would not usually qualify for mortgage loans in the past.
Mortgage-Backed Collateralized Debt Obligation
A mortgage-backed CDO owns parts of many individual mortgage bonds. On average, a mortgage-backed CDO owns parts of hundreds of individual mortgage bonds. The mortgage bonds, in turn, contained thousands of individual mortgages. Thus, a mortgage-backed CDO is seen to reduce the risk of a small-scale housing crisis by diversifying across many mortgage bonds.
A mortgage-backed CDO was considered a very safe investment instrument prior to the 2008 financial crisis. However, such CDOs were particularly susceptible to a systemic collapse of the global housing market. In 2007-2008, house prices fell across the world.
Related Reading
Thank you for reading CFI’s guide on Collateralized Debt Obligation (CDO). To keep learning and advancing your career, the following resources will be helpful:
FAQs
Subprime Mortgage Exposure: Many CDOs were heavily exposed to subprime mortgages, which began defaulting at alarming rates as housing prices declined. This led to significant losses for investors holding CDO tranches backed by these mortgages.
Are CDOs still legal? ›
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.
What is a CDO for dummies? ›
A Collateralized Debt Obligation (CDO) is a synthetic investment product that represents different loans bundled together and sold by the lender in the market. The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period.
Is CDO risky? ›
The risk and return for a CDO investor depends both on how the tranches are defined, and on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches.
Are banks still selling bespoke tranche opportunities? ›
Today, many large banks are involved in the trade of bespoke tranche opportunities, including Citigroup Inc. (ticker: C), Deutsche Bank AG (DB), Goldman Sachs Group Inc. (GS) and JPMorgan Chase & Co. (JPM).
Did JP Morgan sell CDOs? ›
According to the SEC's complaint, J.P. Morgan sold approximately $150 million of so-called “mezzanine” notes of the Squared CDO's liabilities to more than a dozen institutional investors who lost nearly their entire investment.
Are banks selling CDO again? ›
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.
What replaced the CDO? ›
Similar to a CDO, a BTO consist of different tranches that make up a pool of bonds and thus creating a security. The creation of a BTO starts with an investor that tells a bank a mixture of derivatives he wants to invest in. All these 'bets' are then packaged by a bank into one tranche of a BTO.
Can anyone buy a CDO? ›
Typically, retail investors can't buy a CDO directly. Instead, they're purchased by insurance companies, banks, pension funds, investment managers, investment banks, and hedge funds. These institutions look to outperform the interest paid from bonds, such as Treasury yields.
Who invented CDOs? ›
Who created the CDO? Drexel Burnham Lambert Inc. Bankers invented collateralized debt obligations (CDOs) in 1987. In the credit derivatives market, where the value of a derivative is “derived” from the value of other assets, CDOs became a significant player within ten years.
MBS, as their name implies, are made up of mortgages—home loans bought from the banks that issued them. In contrast, CDOs are much broader: They may contain corporate loans, auto loans, home equity loans, credit card receivables, royalties, leases, and, yes, mortgages.
Why were CDOs rated AAA? ›
By combining the risk from debt instruments, CDOs make it possible to recycle risky debt into AAA-rated bonds that are considered safe for retirement investing and for meeting reserve capital requirements.
Do CDOs pay interest? ›
The ownership of the loans or assets is transferred to a special purpose vehicle (SPV), which is different from the company or entity issuing the CDO. A large number of CDOs pay interest semi-annually or quarterly. The type of collateral for a CDO can be any loan, such as a mortgage, automobile or student loan.
What are the disadvantages of CDOs? ›
CDO Disadvantages
If the underlying assets decline in value, investors can lose all of their money. If the underlying assets are not diversified, the entire CDO can collapse. As seen in 2008, CDOs organized in high-risk markets can lead to the major financial collapse of particular markets or large-scale economies.
Why would investors buy CDO? ›
Financial institutions may sell CDOs to investors because the funds they receive can be used to create new loans. Additionally, selling CDOs move the loans' risk of default from the bank to the investors. CDOs also give banks new products to sell, which can boost share prices and bonuses for management.
Why did the Reconstruction Finance Corporation fail? ›
The publication of the identity of banks receiving RFC loans, which began in August 1932, reduced the effectiveness of RFC lending. Bankers became reluctant to borrow from the RFC, fearing that public revelation of a RFC loan would cause depositors to fear the bank was in danger of failing, and possibly start a panic.
What happened to CDOs in 2008? ›
CDOs and the financial crisis
They are also infamous for their role in the financial crisis of 2008, when they were packaged with subprime mortgages, rated as safer than they truly were and offloaded to investors while the very banks peddling them took out short positions at the same time.
What are the challenges faced by the CDO? ›
CDOs grapple with the task of instilling a data-centric mindset within their organizations, encountering various hurdles in the process. The main challenges were based on: Difficulty in Changing Organizational Behaviors and Attitudes (70%) Absence of Data-Driven Culture or Decision-Making (59%)
