What is a Collateralized Debt Obligation (CDO)?

A collateralized debt obligation (CDO) is like an office potluck...

When the office throws a holiday party, several people bring their favorite dish (debt) to the table. Then, everyone grabs a plate and picks the items that they like best. One person might take a lot of meatballs and choose none of the crab cakes. Someone else might focus on the desserts, leaving everything else behind. Your coworkers (investors) each transform the variety of dishes (debts) into a meal they prefer.

The structure of a collateralized debt obligation (CDO) is a little complicated. It might be easiest to start at the end and work backward.

A CDO sells securities to investors, much like a corporation sells bonds. Each security has a repayment schedule and gets graded by a credit rating agency. Some of the securities are highly rated, with AAA scores, and offer lower returns on investment for lower risk of default. Others get scored much lower, perhaps BB. Lower rated bonds tend to offer higher yields in exchange for a higher risk that they may default or stop paying interest.

Companies issue bonds with the expectation that their business income will cover the borrowing costs. Likewise, a CDO needs a revenue stream to make the payments on the securities they issue. However, unlike a business that sells products to consumers, a CDO purchases a revenue stream from a financial institution.

Banks earn money by lending lump sums of cash, then receiving a stream of payments (that include interest) over a long time. The total scheduled payments add up to more than what was lent out.

The amount of additional payments depends on the interest rate that is charged and the length of the loan. A CDO purchases the right to that flow of cash. So, when a borrower makes a payment to their lender, that payment gets diverted to the CDO. Then, the CDO uses that money to make its payment to the investors who purchased the CDO securities.

Collateralized debt obligations (CDOs) work by purchasing debts, repackaging them, and then selling new financial securities backed by the debt payments.

To get started, the CDO will borrow some money from a major investor, called a warehousing loan. It then uses the borrowed money to purchase debts obligations from lenders. For example, if Bank of America loaned you $10,000 at 10% interest for five years, your loan can be sold to someone else. The purchaser of the loan becomes entitled to the payments you make on the loan.

With several of these debts in the CDO’s portfolio, it can then use them as assets to underpin their debt issuance. The CDO will create financial securities that are collateralized by the underlying assets it owns.

These asset-backed securities (ABSs) are divided into CDO tranches, which have preferential payment terms. Pension funds, hedge funds, investment banks, insurance companies, and major financial institutions are usually the purchasers of these securities.

With the money raised by selling these ABSs, the CDO pays off the warehousing loan and buys even more debts. Then, for a few years — called the expansion period — the CDO manager uses the cash flow it receives to buy even more debts. At a certain point in time, the expansion period ends, and the repayment period begins.

During the repayment period, the revenues received by the CDO from the people that borrowed the original money are used to pay off the securities. The top tier, called the senior tranche, receives the first payments that the CDO receives from the underlying debts.

If there are enough revenues after the senior level is paid off, the junior tranches get paid. Then, if there is still enough money, the high-yield mezzanine tranche receives its higher return on investment. Finally, if all the ABSs get repaid, the equity tranche (the lowest and riskiest tranche) of the CDO keeps the rest.

The term “collateralized debt obligation,” or CDO, is a catchall term that refers to any investment vehicle that uses debt obligations as collateral for financial securities commonly known as derivatives.

Those debt obligations can be any form of debt — They could be corporate bonds, business loans, student loans, auto loans, credit card debt, mortgages, home equity loans, or any other form of credit. The lender carries the debt as an asset on its balance sheet. Any of these assets can be purchased by a CDO and used as collateral to issue asset-backed securities (ABS).

There are subtypes of CDOs that focus on specific types of debt obligations. For example, a collateralized loan obligation (CLO) is a select type of CDO that only uses leveraged business loans (corporate debt from investment-grade businesses that pledge their revenues to repay the loan) as collateral.

Another special type of CDO is made up of home mortgage loans. These are called mortgage-backed securities (MBSs), which became infamous in the years after the Great Recession.

Because a CDO can be made up of any debt, there can be a CDO that is formed by purchasing the financial securities issued by other CDOs. These are called CDO-squared,. These CDOs issue debt backed by debts that are themselves supported by debts. You can imagine how difficult it would be to understand the underlying credit risk of the derivative assets.

There is also another level to these sophisticated financial instruments. They are called synthetic CDOs, and they use credit default swaps (CDS) as their collateral.

A CDS is like an insurance policy against the default of a borrower. If a person or business can’t make their payments, the CDS steps in to protect the lender. Now, imagine using a CDS as collateral for an asset-backed security. The investor only gets paid if the underlying debt doesn’t. A synthetic CDO is made up of these credit default swaps. That means it is debt issued on the default of debt.

There is even a synthetic CDO-squared – Debt that gets paid if the underlying credit default swaps don’t get paid. As you may be able to tell, these financial instruments are incredibly complex and can be extremely difficult to value correctly.

It is now widely believed that subprime mortgages packaged into mortgage backed securities (MBSs, one type of CDO) were a primary cause of the housing bubble that formed in the mid-2000s. When that bubble popped, it caused a global financial crisis. The increase in the complexity of synthetic CDOs and other sophisticated financial instruments is believed to have blurred the underlying risk of these investments.

Some of these MBSs were made up of subprime loans, which carried a higher risk of mortgage defaults that were packaged together. By combining these risky loans and selling them as a package, the credit ratings on these MBSs were challenging to assess. In many cases, they received an excellent rating despite default risks that were highly correlated and not well understood.

The investors rarely appreciated the amount of underlying risk that was present. Meanwhile, loan originators became a lot less concerned with the ability of the borrower to repay the loan – seeing as the bank would immediately sell the mortgage and would not bear any of the risks of default.

Following the Great Recession, the federal government intervened by passing the Dodd-Frank Act. The act established new oversight agencies, including the Financial Stability Oversight Council, the Office of Credit Rating, and the Federal Insurance Office. These agencies are charged with monitoring the financial markets and identifying threats to the economy from undue risks. The act also expanded the power of the Securities and Exchange Commission to regulate the complex financial instruments that are believed to have led to the financial crisis.

With the increased scrutiny and the lessons of the past, one would hope that the situation would not repeat itself. However, it is not always apparent that excessive risks are being taken until an unforeseen occurrence reveals it. While we can be confident that another recession will occur, we can’t know when or if CDOs will be involved.