What Are Collateralized Debt Obligations?

A collateralized debt obligation is a complex financial instrument and a derivative, which means that it derives its value from a set of underlying assets, specifically bonds, commercial and residential mortgages, student loans, auto loans and other debt types.[1]

"The purpose of a CDO is to provide investors with exposure to a group of underlying assets, while also providing some level of liquidity and risk diversification," says Harry Turner, a former hedge fund manager and founder of The Sovereign Investor, an investment education website.

While CDOs are often made up of loans issued to consumers and businesses, they're not accessible to everyday investors, at least not directly. Instead, the financial institutions that create CDOs sell them only to institutional investors.[2]

Let's review how CDOs work, plus consider real-life examples, such as the role they played in the Great Recession of 2008.

Banks and financial institutions create CDOs by using complex computer models to package debt accounts and determine their value. The CDO may include only one type of debt or multiple types.[3]

Financial institutions typically borrow money in the form of a warehousing loan, which they use to buy up debts to create the CDO. It then combines your loan and others in the portfolio and determines a value at which it will sell the CDO to institutional investors.[1] Rating agencies like Moody's and Standard & Poors analyze the CDOs and assign them a rating, giving investors an idea of how risky they are.[3, 4]

Also, as their name suggests, CDOs are collateralized by the repayment of the underlying loans.[1]

Financial institutions divide CDOs into different tranches, which represent different levels of risk: [3]

• Senior tranche: Typically have high credit ratings and a low risk of default. They're also first in line to be paid from the underlying loans. However, they typically have the lowest interest rates.

• Mezzanine tranche: Typically have a lower credit rating, meaning a higher risk of default, but they're not the riskiest CDOs. They're typically paid second after senior tranche CDOs but offer slightly higher interest rates.

• Junior tranche: Typically have the lowest credit ratings, meaning a greater risk of default than mezzanine tranches, and they're last in line to be paid. To make up for the increased risk, they offer the highest interest rates.

The money the financial institution raises by selling the CDO is used to pay off the original loan used to buy all the debt obligations. Then, for a few years, it'll continue to buy more debt accounts during what's called the expansion period.[1]

Once that period is over, the financial institution uses payments from the underlying loans to pay back the investors based on the tranche order: senior, mezzanine and junior. The institution keeps any remaining funds after all tranches have been paid.[1]

Let's say that a financial institution has purchased millions of dollars worth of different types of debt to develop a CDO. Here's how it might be structured:

Mortgage-backed securities (MBS) can be considered a type of CDO, but unlike most CDOs, they only invest in one type of debt: mortgage loans.[1]

Mortgage-backed securities are well known for their part in the Great Recession. Lenders had relaxed their underwriting criteria to the point that many homebuyers were getting into mortgage loans they couldn't afford to repay. However, many of these subprime loans were packaged into CDOs and assigned a high credit rating, leading institutional investors to believe that they were less risky than they actually were.[4]

"One of the key problems with CDOs was that they created a moral hazard," says Turner. "By securitizing the mortgages and packaging them into CDOs, banks could transfer the risk off of their balance sheets to third-party investors. This encouraged them to make riskier and riskier loans (subprime) in the knowledge that they weren't bearing the default risk."

As the housing market crashed and subprime borrowers stopped making payments, the banks and other financial institutions that invested in these mortgage-backed CDOs sustained massive losses, triggering a domino effect that led to a global financial crisis.[5]

Why do firms invest in collateralized debt obligations?

CDOs are attractive as an investment because they can sometimes provide a better return than financial instruments with a similar maturity, or the date on which the life of the loans within the CDO ends.[3]

Should I invest in CDOs?

CDOs are only accessible to institutional investors, which include large investment firms, pensions, insurance companies, hedge funds, mutual funds and similar firms. As such, it's not possible for retail investors to buy them directly.[2, 6]

"However,” says Turner, “a retail investor can gain indirect exposure to CDOs by investing in a fund that owns them."

How long have CDOs been around?

CDOs were developed in 1987 by bankers at Drexel Burnham Lambert Inc., which is no longer operating. They were originally made up of junk bonds, which typically have a higher risk of default than most corporate bonds. Since then, banks have expanded CDOs to incorporate a variety of commercial and consumer debt.[3]