Collateralized Debt Obligation Definition
Collateralized debt obligation (CDO) is a Structured product used by banks to unburden themselves of risk, and this is done by pooling all debt assets (including loans, corporate bonds, and mortgages) to form an investable instrument (slices/trances) which are then sold to investors ready to assume the underlying risk.
How does Collateralized Debt Obligation (CDO) Work?
Collateralized Debt Obligations (CDO) creation can be understood as a 5-step process:
Step #1 – Pooled Assets
Banks prepare a list of all the pooled assets (secured and unsecured) like car loans, mortgage loans, commercial loans, etc. that can be included a part of CDOs
Step #2 – Banks form a diversified portfolio
Once the list of pooled assets is prepared, than the Bank started with an aggregation of various debt assets, such as Loans issued corporates and individuals, Corporate bonds invested in, Mortgages, and other debt instruments like credit card receivables.
Step #3 – Investment Banks
A Bank may rope in an investment bank to sell this diversified portfolio
Step #4 – Formation of Tranches
The cash inflows from the portfolio created are sliced into the number of investable tranches. These tranches are characterized by a degree of riskiness. The tranches created are classified as:
- “super senior,” the safest and first one to receive the payouts. But, have the lowest interest rate
- “mezzanine financingMezzanine FinancingMezzanine financing is a type of financing that combines the characteristics of debt and equity financing by granting lenders the right to convert their loan into equity in the event of a default (only after other senior debts are paid off).,” moderate risk, and a bit higher interest rate
- “equity”/ ”toxic waste,” junior trancheJunior TrancheA junior tranche is a type of unsecured debt that is deemed riskier yet pays a high interest rate. It is also known as a mezzanine tranche and it absorbs any losses accrued or gains on the value of securities., most risky and offers the highest interest rate. The payouts are made after all payouts are made for super senior and mezzanine tranches
Step #5 – Selling of Tranches to Investors.
Depending on the risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation. of various investor groups, these tranches are offered. The most senior tranche is often sold to institutions looking for highly-rated instruments, such as pension funds. The lowest rated tranches are often retained by the CDO (Collateralized Debt Obligations) issuers. This gives the bank an incentive to monitor the loan.
Mezzanine tranches are often bought by other banks and financial institutions.
This entire process of aggregation of assets and slicing them and selling it off to appropriate investors is known as securitization. The bank or the institution assuming the role of CDO issuer is known as Originating Institution. And this entire model is known as the originate-to-distribute model.
Important Terms and Differentiation from Similar Products
Below are the important terms related to Collateralized Debt Obligation.
#1 – CDOs and CMOs
Collateralized Mortgage ObligationCollateralized Mortgage ObligationCollateralized Mortgage Obligations (CMOs) are a debt-security type that combines many mortgages & sell them as a single investment. Cash flow occurs when debtors repay the loans, following which the CMO investors get their returns. , as the name suggests, is a structured product that pools in mortgage loans and slice them into tranches of different risk profiles, as explained in the previous section. CDOs, on the other hand, can have loans (home/student/auto, etc.), corporate bonds, mortgages, and credit card receivables, thereby expanding the choice of instruments for forming the portfolio.
- CMOs are issued by REMICs (Real Estate Mortgage Investment Conduit). CDOs are issued by SPEs (Special purpose entities) created by banks which are separately capitalized to assume a high Credit rating for issuing CDOs.
- CMOs may have different classes of securities depending on the quantum of risk associated with the mortgages and are created by breaking down coupons and principal paymentPrincipal PaymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.. CDOs, on the other hand, have tranches created by slicing down the groups of cash flows from various instruments. And there have to be at least three classifications.
#2 – CDOs and MBS
MBS or the Mortgage-backed securities are the earliest form of structured products, formally introduced in the early 80s. Structurally MBS and CDOs are similar to CDO being more complex. MBS have repackaging of mortgages into investable instruments. Based on the type of mortgage repackaged, MBS are of majorly two types: RMBS (Residential MBS) and CMBS (Commercial MBS)
#3 – CDOs and ABS
ABS or the Asset-backed Security, is similar to MBS, with the only difference that the pool of assets comprises of all debt assets other than Mortgages. CDO is a type of ABS which includes mortgages as well in the pool of assets.
#4 – CLOs and CBOs
CLOs and CBOs are subclassifications of CDO. CLOs are collateralized loan obligations that are made using bank loans. CBOs are a collateral bond obligation which is made using corporate bonds.
There are lesser-known CDO classifications as well, Structured finance back CDOs having ABS/RMBS/CMBS as underlying and Cash CDOs with cash market debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans..
Collateralized Debt Obligations and Subprime Mortgage Crisis 2008
The financial crisis of 2007 and 2008, often called the subprime crisis, had several factors, ultimately leading to a collateral failure of financial systems. Among various causes, CDOs played an important role. The crisis started with a housing bubble1, which majorly proliferated because of the availability of cheap credit and widespread use of the Originate-to-distribute model, burst around 2006 and 2007, and led to a liquidity squeeze.
The originate-to-distribute model and securitization, i.e., use of CDOs/ CMOs, etc. became popular for the following reasons:
- A low-interest rate on mortgages: Originating institutions were in a position to issue mortgages at a low-interest rate by slicing it off and spreading the risk among willing investors
- A high rating of CDOs helped banks to meet lower capital charge requirements of Basel I and II without affecting the risk profile.
Commercial papers were issued, and short term repurchase agreements (both of which are ideally short-term instruments) were done to fund the investments in structured products. The months of July August 2007 were specifically important as most of the commercial papers were maturing in this period. Banks tried ReposReposA repurchase agreement or repo is a short-term borrowing for individuals who deal in government securities. Such an agreement can happen between multiple parties into three types- specialized delivery, held-in-custody repo and third-party repo. and issuance of Commercial papers to meet the liquidity requirements at redemptions, but the impact was so widespread as all major banks were facing the same problem, that the dollar lending rates rose as high as 6/7 %.
Faced with huge losses, banks, and financial institutions with heavy investments in structured products were forced to liquidate the assets at very low prices. This further led to bankruptcies filed by prominent banks like Lehman Brothers, American home mortgage investment corp. etc. and leading to intervention and financial restructuring by International Monetary Fund in October 2009
In simple words, the rise and demise of CDOs (Collateralized Debt Obligations) turned out to be a cyclical process, initially reaching the top because of its inherent benefits, but ultimately collapsing and leading to one of the largest financial crises in recent times. CDOs are considered highly astute financial instruments that created cheap credit market infused liquidity, and freed up capital for lenders but ultimately collapsed because of a lack of comprehensive understanding of the systemic risk it may cause.
This has been a Guide to Collateralized Debt Obligations (CDO) and how it works. Here we also discuss how CDOs led to Subprime Mortgage Crisis in 2008. You can learn more about financing from the following articles –