What is Collateralized Debt Obligation (CDO)?

What if you have multiple products and you want to sell all these products, but individually selling all these products can be a bit slow. But what if you create a combo basket of all these products and sell them togetherly.

Surprisingly similar things happen in the financial world as well, let’s talk about banks that have a lot of different types of loans available, like home loans, car loans, and even credit card debt. Instead of holding onto them for years, banks bundle all these loans into one big package and this cumulative package is known as the Collateralized Debt Obligation (CDO). It’s simply a mix of different debt products crafted into a single product that can be sold to investors.

How Does a Collateralized Debt Obligation (CDO) Work?

The journey of creating a CDO is like a financial assembly line. It turns everyday loans into a complex investment product through a few key steps.

It all starts when a bank or a financial institution gathers a huge pile of loans. These can be anything from mortgages to business loans. This large pool of loans acts as the “collateral” that supports the CDO.  In simple terms, it’s the assurance that money will keep coming in from the borrowers who originally took those loans.   

Next, the bank sells this pile of loans to a brand-new, separate company. This new company is called a Special Purpose Entity (SPE), and this step is most important. By selling the loans, the bank gets them off in their own books. This means the risk that people might not repay their loans is now passed on from the bank to someone else.   

The SPE now needs cash to pay the bank for all those loans. To get this money, it issues and sells bonds to investors and these bonds are the CDOs. The money from the investors goes back to the bank, which is now free to use that cash to give out even more loans.   

And just like that, the system is up and running. The people who took out the original loans keep paying their monthly installments. This money now flows to the SPE, which then passes it along to the investors who bought the CDO bonds. This steady stream of payments is how the investors earn a return.   

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The Structure of a CDO

CDOs are complex due to their structure and it doesn’t act like one big investment block, instead it is divided into different layers which are called “tranches” – meaning slices in French.   

Picture it like a multi-story building where the money from the loan payments flows from the top to the bottom.   

• Senior Tranche: This is the top most level and is the safest slice of the CDO, here investors who buy these tranches are the very first to get paid from it because it is very safe as the interest rates offered are very low. This slice usually gets a top ‘AAA’ credit rating and is popular with less risk taking investors.  
• Mezzanine Tranche: This is the middle floor and is a bit riskier than the senior tranche. Investors get paid once everyone on the top level has been paid in full. To make up for this extra risk, a higher interest or return is offered..   
• Equity Tranche: This is the ground level and is considered as the riskiest part. These investors are the absolute last in line to get paid and if people start defaulting on their loans and the money dries up, this tranche is the first to lose everything. But with great risk comes the potential for the greatest reward, so it offers the highest potential returns.   

Types of Collateralized Debt Obligations 

1. Collateralized Loan Obligations (CLOs): These are packed with business or corporate loans.   
2. Collateralized Bond Obligations (CBOs): These are backed by a collection of corporate bonds.   
3. Mortgage-Backed CDOs: These were the worst performing and most problematic CDOs during the 2008 crisis. They are filled with mortgage-backed securities (MBS), which are themselves pools of home loans.   
4. Synthetic CDOs: These are the most mind-bending of all as they don’t actually hold any loans. Instead, they are made up of financial bets called credit default swaps (CDS), which work like insurance policies on loans. They let investors bet on whether loans will be repaid without ever owning them.   

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The Role of CDOs in the 2007-2008 Financial Crisis

In the early 2000s, investors all over the world were hungry for CDOs. To keep making more of them, banks needed a constant supply of new loans to stuff inside. This created a giant “demand engine” for mortgages, due to which lending standards were neglected and banks started handing these to people who have shaky credit histories as well and the main goal was simply to create more loans, package them into CDOs, and sell them off for a quick fee. 

Also during this time we have noticed that credit rating agencies, like Moody’s and S&P gave many of these CDOs, even the ones filled with the riskiest subprime mortgages, their highest ‘AAA’ rating because the same banks that were creating the CDOs were also paying the agencies to rate them and the computer models used to predict risk were deeply flawed with assumptions that house prices would always go up, and that a wave of mortgage defaults in one part of the country which wouldn’t affect another. 

When the US housing market finally started to wobble in 2007, the whole system fell apart, people with subprime mortgages began to default on their loans in huge numbers leading to slow funds accumulation in CDOs and all these losses completely wiped out the equity and mezzanine tranches. Even the “super-safe” AAA-rated senior tranches started to lose money. The value of these CDOs plummeted, causing devastating losses for banks and investors everywhere, setting off a chain reaction, freezing up credit markets and pushing the world into the worst financial crisis since the Great Depression.

The Evolution of CDOs

After the 2008 crisis, the world of finance knew things needed to be changed and Governments stepped in by introducing new rules to stop a disaster like that from ever happening again.

The most important act was the Dodd-Frank Act in which the idea was to mandate the sponsors of residential mortgage backed securities retain at least 5% of the credit risk associated with the mortgage they securitize and the idea is that if they have their own money on the line, they’ll be much more careful about making sure the loans inside are actually good quality.   

The “CDO” brand name became so toxic after the crisis that it’s rarely used now. Instead, the market has shifted towards their cousin, the Collateralized Loan Obligation (CLO). CLOs are mostly backed by corporate loans, which are seen as more stable and easier to understand than the subprime mortgages of the past. The structures are also generally safer, with more built-in protection for investors.   

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Conclusion

Collateralized Debt Obligation is just a financial tool in the market, if used responsibly, it can be a good thing, helping to spread risk around the economy and freeing up banks money giving them a higher lending power and investors more choices.

Although after the 2008 crisis lesson, we have learnt what can happen if complexity is used to hide risk, and the chase for fees goes completely aside. Through CDOs we know that while financial innovation can be a force for good, it must be balanced with strong rules, clear transparency, and common sense. 

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