Collateralized Debt Obligation (CDOs): What It Is, How It Works

What Is a Collateralized Debt Obligation (CDO)?

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors.

A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.

Understanding Collateralized Debt Obligations (CDOs)

The earliest CDOs were constructed in 1987 by the former investment bank Drexel Burnham Lambert, where Michael Milken, then called the "junk bond king," reigned. The Drexel bankers created these early CDOs by assembling portfolios of junk bonds, issued by different companies. CDOs are called "collateralized" because the promised repayments of the underlying assets are the collateral that gives the CDOs their value.

To create a CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.

These tranches of securities become the final investment products, bonds, whose names can reflect their specific underlying assets. For example, mortgage-backed securities (MBS) are comprised of mortgage loans, and asset-backed securities (ABS) contain corporate debt, auto loans, or credit card debt.

Other types of CDOs include collateralized bond obligations (CBOs)—investment-grade bonds that are backed by a pool of high-yield but lower-rated bonds, and collateralized loan obligations (CLOs)—single securities that are backed by a pool of debt, that often contain corporate loans with a low credit rating. 

Collateralized debt obligations are complicated, and numerous professionals have a hand in creating them:

• Securities firms, who approve the selection of collateral, structure the notes into tranches and sell them to investors
• CDO managers, who select the collateral and often manage the CDO portfolios
• Rating agencies, who assess the CDOs and assign them credit ratings
• Financial guarantors, who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments
• Investors such as pension funds and hedge funds

Ultimately, other securities firms launched CDOs containing other assets that had more predictable income streams. These included automobile loans, student loans, credit card receivables, and aircraft leases. However, CDOs remained a niche product until 2003–2004, during the U.S. housing boom. Issuers of CDOs turned their attention to subprime mortgage-backed securities as a new source of collateral for CDOs.

CDO Structure

The tranches of CDOs are named to reflect their risk profiles; for example, senior debt, mezzanine debt, and junior debt—pictured in the sample below along with their Standard and Poor's (S&P) credit ratings. But the actual structure varies depending on the individual product.

In the table, note that the higher the credit rating, the lower the coupon rate (rate of interest the bond pays annually). If the loan defaults, the senior bondholders get paid first from the collateralized pool of assets, followed by bondholders in the other tranches according to their credit ratings; the lowest-rated credit is paid last.

The senior tranches are generally safest because they have the first claim on the collateral. Although the senior debt is usually rated higher than the junior tranches, it offers lower coupon rates. Conversely, the junior debt offers higher coupons (more interest) to compensate for their greater risk of default; but because they are riskier, they generally come with lower credit ratings.

CDOs and the Subprime Mortgage Crisis

Collateralized debt obligations exploded in popularity in the early 2000s, when issuers began to use securities backed by subprime mortgages as collateral. CDO sales rose almost tenfold, from $30 billion in 2003 to $225 billion in 2006.

These subprime mortgages often had no or very low down payments, and many did not require proof of income. To offset the risk lenders were taking on, they often used tools such as adjustable-rate mortgages, in which the interest rate increased over the life of the loan.

There was little government regulation of this market, and ratings agencies were able to make investing in these mortgage-backed securities look attractive and low-risk to investors. CDOs increased the demand for mortgage-backed securities, which increased the number of subprime mortgages that lenders were willing and able to sell. Without the demand from CDOs, lenders would not have been able to make so many loans to subprime borrowers.

Some banking executives and investors did realize that a number of the subprime mortgages that backed their investments had been designed to fail. But the general consensus was that as long real estate prices continued to go up, both investors and borrowers would be bailed out. However, prices did not continue to rise; the housing bubble burst and prices declined steeply. Subprime borrowers found themselves underwater on homes that were worth less than what they owed on their mortgages. This led to a high rate of defaults.

The correction in the U.S. housing market triggered an implosion in the CDO market, which was backed by these subprime mortgages. CDOs became one of the worst-performing instruments in the subprime meltdown, which began in 2007 and peaked in 2009. The bursting of the CDO bubble inflicted losses running into hundreds of billions of dollars for some of the largest financial services institutions.

These losses resulted in the investment banks either going bankrupt or being bailed out via government intervention. This impacted the housing market, stock market, and other financial institutions, and helped to escalate the global financial crisis, the Great Recession, during this period.

Despite their role in the financial crisis, collateralized debt obligations are still an active area of structured finance investing. CDOs and the even more infamous synthetic CDOs are still in use, as ultimately they are a tool for shifting risk and freeing up capital—two of the outcomes that investors depend on Wall Street to accomplish, and for which Wall Street has always had an appetite.

Benefits of CDOs

Like all types of assets, CDOs have benefits as well as drawbacks. Their role in the housing bubble and the subprime mortgage crisis was the result of their main disadvantages: complexity, which made them difficult to value accurately; and being vulnerable to repayment risk, particularly from subprime borrowers.

However, there are also two main benefits:

• Diversification: Because the debt bundled in a CDO is spread over many mortgages or other loans, investors are exposed to a range of risks. As long as not all the loans used as collateral are subprime loans, there is an element of diversification in each CDO.
• Liquidity: A single bond or loan is a relatively illiquid asset for a bank to hold. A CDO, however, turns those into liquid assets. Holding more liquid assets means banks can expand their lending and generate more revenue.

The Bottom Line

A collateralized debt obligation (CDO) is a structured finance product that is backed by a pool of loans and other assets. It can be held by a financial institution and sold to investors. The tranches of a CDO tell investors what level of risk they are taking on, with senior having the highest credit rating, then mezzanine, then junior. In the case of a default on the underlying loan, senior bondholders are paid from the pool of collateral assets first and junior bondholders last.

During the housing bubble in the early 2000s, CDOs held huge bundles of subprime mortgages. 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.