Collateralized Debt Obligation (CDO)

Collateralized Debt Obligation (CDO)

What is a guaranteed debt obligation (CDO)?

A secured debt instrument (CDO) is a complex structured financial product supported by a pool of loans and other assets and sold to institutional investors. A CDO is a special type of derivative because, as the name suggests, its value is derivative of another underlying asset. These assets become collateral in the event of loan default.

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An introduction to secured debt (CDO)

Understanding secured debt obligations

To create a CDO, investment banks pool assets that generate cash flows – such as mortgages, bonds, and other types of debt – and repackage them into separate classes or tranches based on the level of risk. credit assumed by the investor.

Types of CDO

These tranches of securities become the final investment products: bonds, whose names may reflect their specific underlying assets. For example, mortgage-backed securities (MBS) consist of mortgage loans and asset-backed securities (ABS) contain corporate debt, car loans, or credit cards. CDOs are called “collateralised” because the promised repayments of the underlying assets are the collaterals that give CDOs their value.

Other types of CDOs include covered bonds (CBOs) – investment grade bonds that are backed by a pool of high yield but lower rated bonds, and secured loan bonds (CLOs) – unique securities that are backed by a debt pool, which often contain business loans with a low credit rating.

How are CDOs structured?

CDO tranches are named to reflect their risk profiles; for example, senior debt, mezzanine debt and junior debt – shown in the sample below with their Standard and Poor’s (S&P) credit ratings. But the actual structure varies depending on the individual product.

Carla Tardi / Investopedia

In the table, note that the higher the credit rating, the lower the coupon rate (interest rate that the bond pays annually). If the loan is in default, the holders of higher-ranking bonds are first paid from the pool of guaranteed assets, followed by the holders of bonds in the other tranches according to their credit rating; the lowest rated credit is paid last.

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

Senior debt = higher credit rating, but lower interest rates. Junior debt = lower credit rating, but higher interest rates.

Learn more about creating CDOs

Guaranteed debt securities are complicated and many professionals participate in their creation:

  • Securities companies, which approve the selection of collateral, structure the notes into tranches and sell them to investors
  • CDO managers, who select guarantees and often manage CDO portfolios
  • Rating agencies, which assess CDOs and assign them credit ratings
  • Financial guarantors who agree to reimburse investors for any loss on CDO tranches in exchange for the payment of premiums
  • Investors such as pension funds and hedge funds

Key points to remember

  • A secured debt instrument is a complex structured finance product supported by a pool of loans and other assets.
  • These underlying assets serve as collateral in the event of loan default.
  • Although risky and not for all investors, CDOs are a viable tool for shifting risk and freeing up capital.

A brief history of CDOs

The first CDOs were built in 1987 by the former investment bank, Drexel Burnham Lambert – where then reigned Michael Milken, then called “king of junk bonds”. The Drexel bankers created these first CDOs by assembling portfolios of unwanted bonds issued by different companies. Ultimately, other securities companies launched CDOs containing other assets with more predictable income, such as car loans, student loans, credit card receivables, and aircraft rentals. . However, CDOs remained a niche product until 2003-2004, when the US housing boom led CDO issuers to turn to risk-backed mortgage-backed securities as a new source of collateral for CDOs.

CDOs and the global financial crisis

Guaranteed debt securities exploded in popularity, with CDO sales nearly increasing tenfold, from $ 30 billion in 2003 to $ 225 billion in 2006. But their subsequent implosion, triggered by the housing correction in the United States, has seen CDOs become one of the worst performing instruments of the subprime crisis. , which began in 2007 and peaked in 2009. The bursting of the CDO bubble has caused losses amounting to hundreds of billions of dollars for some of the largest financial services institutions. These losses led to the bankruptcy of the investment banks or their bailout via government intervention and contributed to worsening the world financial crisis, the Great Recession, during this period.

Despite their role in the financial crisis, guaranteed debt securities remain an active area of ​​investment in structured finance. Even more infamous CDOs and synthetic CDOs are still in use, because in the end they are a tool to move risk and free up capital – two of the very results that investors depend on Wall Street to accomplish, and for which Wall Street has always had an appetite.

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