CDOs: Complex securities backed by loans and other fixed-income assets

• A collateralized debt obligation (CDO) is a structured credit product that pools assets and packages them for sale to institutional investors.
• The assets that back these securities serve as collateral that give CDOs their value.
• Research found that CDOs were at the heart of the 2007-2008 financial crisis.

A collateralized debt obligation (CDO) is a type of security that derives its value from underlying assets. These assets could include commercial or residential mortgages, bonds, auto loans, student loans, and other types of debt. The assets are pooled and packaged into a product that can be sold to investors as an income-producing asset. The promised repayment of the underlying debt serves as collateral.

How do CDOs work?

Investment banks, retail banks, commercial banks, and other financial institutions create CDOs to sell in the secondary market. As these are extremely complex instruments, it takes sophisticated computer modeling and a team of quantitative analysts to package the debt and value the bundles of loans that make up a CDO.

Then it takes a number of professionals to get the security to market. The CDO manager selects the debt to serve as collateral, which could be anything from mortgages, student loans and auto loans to credit card or corporate debt. Once the CDO manager selects the debt to be pooled, the investment banks can get to work structuring the security. Rating agencies, like Standard & Poors and Moody's, assign credit ratings to the CDO.

Finally, the CDO is sold to institutional investors such as pension funds, insurance companies, investment managers, and hedge funds. These investors often buy CDOs in the hope that they'll offer higher returns than their fixed-income portfolios of similar maturity. CDOs aren't available to retail investors and are typically sold to institutional investors in lots valued in the millions of dollars.

Note: CDOs aren't available to retail investors and are typically sold to institutional investors in lots valued in the millions of dollars.

How CDOs are Structured

The market for CDOs exists because these securities guarantee cash flows to the owner. However, these cash flows are dependent on the cash flows from the original borrower. The investor receives interest at the stated coupon rate as well as the principal when the CDO reaches maturity. Most CDOs mature at ten years.

CDOs are divided into tranches, each of which reflects a different level of risk. Senior tranches are the least risky, with investment-grade credit ratings and a lower chance of default. If the loan should default, the holders of the senior tranche are first in line to be paid from the underlying collateral. Payment continues according to the tranches' credit ratings, with the lowest-rated tranche the last to be paid.

The mezzanine tranche comes between the senior and subordinated debt. Mezzanine tranches are rated from B to BBB. In the case of default, mezzanine is paid before the subordinated (junior) tranches. As with any fixed-income security, the safest tranche will bear the lowest coupon rate, while the junior debt will have a higher coupon rate since it carries the greatest risk of default.

Note: CDOs are divided into tranches, each of which reflects its level of risk. Senior tranches are the least risky.

Were CDOs responsible for the global financial crisis?

The first collateralized debt obligations were created by Drexel Burnham Lambert during the 1980s, when Wall Street was booming. The bank was well known for both its junk bond business and employed Michael Milken, who played a significant role in developing the junk bond market and later was jailed for violating securities laws.

Interest in CDOs waned in the 1990s but picked up significantly in the early 2000s. CDO sales went from $30 billion in 2003 to $225 billion in 2006. The US was experiencing a boom in the housing market, and financial institutions were originating mortgage-backed CDOs at a fast pace. Homebuyers were encouraged by low interest rates, easy credit, and little regulation. In 2003-2004, banks turned to subprime mortgages as a new source of collateral.

In the subprime market, banks offered mortgages to borrowers who never would have qualified under earlier standards. The underwriting process became so lax that in many cases, complete documentation of income wasn't even required. The adjustable-rate mortgage (ARM) was even more dangerous for subprime borrowers. They offered very low interest rates for the first few years of the mortgage, which could then be increased drastically a few years down the line.

CDOs issued prior to the global financial crisis consisted mainly of subprime mortgage-backed securities, and those backed by other CDOs were also common. In 2006, nearly 70% new CDO collateral consisted of subprime mortgages, while 15% were collateralized with other CDOs.

By 2006, investment banks were turning to short-term collateralized borrowing to support the CDO business. On average, they were rolling over 25% of their balance sheets every night. When the housing bubble burst, uncertainty around asset pricing led lenders to cut off the nightly borrowing, leaving the banks exposed to falling asset prices with little capital. Trading in CDOs came to a halt, and it was only with the intervention of the Federal Reserve buying CDOs that restored the market.

As Dr. Robert Johnson, professor of finance at the Creighton University's Heider School of Business, explains: "CDOs are extremely difficult to analyze and value. Issuer models failed to take into account the correlation between mortgages bundled into CDOs. In an event such as an economic downturn, the mortgages will move in sync."

Post-crisis analysis found that CDOs lay at the heart of the financial crisis. Issuers and investors ignored warnings about the ticking CDO timebomb and failed to understand and manage risk. Bank balance sheets were often not transparent, and institutions throughout the industry were deeply interconnected. Trillions of dollars in risky mortgage-backed securities were entrenched throughout the financial system.

Everything came to a head in March of 2008, when Bear Stearns found itself almost out of cash. Facing bankruptcy, the firm sold itself to JPMorgan. Lehman Brothers was next to fall. It was only government intervention that saved the financial system and economy from collapse. A government bailout program benefited some institutions that were considered "too big to fail."

Note: Analysis after the global financial crisis found that Issuers and investors ignored warnings about CDOs and failed to understand and manage risk.

Pros and cons of CDOs

Like all assets, CDOs offer advantages and disadvantages. Johnson cites diversification as one advantage. "CDOs are created by bundling debt and spreading it out over many, many mortgages. Thus the investor is exposed to a range of risk levels," he says.

Using CDOs, commercial and retail banks can reduce risk on their balance sheets. They can also exchange illiquid assets for CDOs to gain liquidity. Banks can use the additional liquidity to expand lending and generate revenue.

CDOs have two principal disadvantages. The first is their complexity, which makes them extremely challenging to analyze and value. CDOs are also vulnerable to repayment risk, as the original borrower can choose to repay the principal, thus depriving the investor of a cash flow stream that would typically last until maturity,

Are CDOs popular today?

Following the financial crisis, CDOs underwent heavy scrutiny. The result was the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The law resulted in widespread regulatory reforms aimed at ensuring the country would never experience another crisis like 2007-2008.

Among other measures, the Act was designed to protect investors, increase disclosures, require risk retention, and impose capital requirements. It required originators to retain a specified percentage of a CDO issue, in order to have "skin in the game." Investors in asset-backed securities are now required to hold more capital than if they were investing in other asset classes. Following enactment of Dodd Frank, the market has seen a steady increase in CDO issuance since 2011.

Attempts were made to weaken the Act in 2017, and in 2018, President Donald Trump signed into law the Economic Growth, Regulatory Relief and Consumer Protection Act. This new law exempted many financial institutions from Dodd-Frank regulations.

Note: The Dodd-Frank Act was designed to protect investors, increase disclosures, require risk retention, and impose capital requirements.

The financial takeaway

Collateralized debt obligations serve several purposes. They allow financial institutions to move debt off their balance sheets to gain liquidity. Investors value the cash flow from coupon payments, and hope the return on CDOs will exceed the return of standard fixed-income portfolios.

Investment in CDOs is limited to institutional investors —insurance companies, pension funds, hedge funds and the like. However, for the retail investor there are mutual funds and exchange-traded funds that include CDOs in their portfolios.