What are Collateralized Debt Obligations (CDOs)?
A collateralized debt obligation, or CDO for short, is a complicated financial product that banks create to deal with credit risk. Credit risk is the possibility that borrowers won’t pay back the money they’ve borrowed. Banks face this risk whenever they lend money or buy bonds and other debt.
CDOs provide a way for banks to package up debt with credit risk and sell it to investors. This lets the banks transfer some of the credit risk to the investors who buy the CDO. Banks might create a CDO to get risky debt off their own books, or just to make money by repackaging debt in a new way that appeals to certain investors.
How CDOs Work
To make a CDO, a bank gathers up a pool of debt instruments like loans, bonds, or credit derivatives. Credit derivatives are another complex financial product that lets people trade credit risk without actually trading the underlying debt. The bank then uses this pool of debt to back a new security – the CDO.
The bank divides the CDO into different pieces called “tranches.” Each tranche has a different level of risk and potential return. The tranches work like slices of a sandwich – the lower tranches take losses first if the debts in the pool start defaulting, while the upper tranches are last in line to take losses. In exchange for this extra risk, the lower tranches pay higher interest rates.
Different types of investors buy different tranches based on their risk tolerance. More conservative investors like pension funds might buy the top tranches, while hedge funds and other risk-seeking investors buy the lower tranches.
Types of CDOs
There are a few main types of CDOs:
- Collateralized loan obligations (CLOs) are CDOs backed by pools of loans, often corporate loans.
- Collateralized bond obligations (CBOs) are CDOs backed by pools of bonds.
- Cash CDOs are CDOs backed by pools of actual physical loans or bonds.
- Synthetic CDOs are backed not by physical debt, but by credit derivatives referencing debt.
CDOs can also be managed differently:
- Static CDOs buy a fixed pool of debt that doesn’t change.
- Managed CDOs allow the manager to buy and sell debt within certain limits. This active management lets the CDO respond to market conditions, but adds risk.
The Role of CDOs in the 2008 Financial Crisis
CDOs played a big part in the 2008 global financial crisis. Leading up to the crisis, banks created many CDOs backed by risky mortgages, including subprime mortgages to borrowers with poor credit. The banks, ratings agencies and investors all underestimated the risk in these mortgage CDOs.
When the housing bubble burst and many borrowers defaulted on their mortgages, the mortgage CDOs plummeted in value. Investors in CDOs lost huge sums of money. Because CDOs connected so many banks and investors, the losses spread through the whole financial system contributing to a global financial crisis and recession.
Many observers believe CDOs allowed the unsustainable housing bubble to grow larger than it otherwise would have by letting banks move mortgage risk off their books and encouraging more reckless mortgage lending. The reliance on complex mathematical models to evaluate CDOs also came under criticism after the models failed to predict the wave of defaults.
Reforms After the Financial Crisis
In the wake of the financial crisis, reforms aimed to fix some of the problems with CDOs and prevent a repeat. The 2010 Dodd-Frank financial reform law in the US mandated that CDO creators retain some of the risk themselves so they have “skin in the game.” Global banking regulations known as Basel III increased capital requirements for banks’ CDO holdings.
Regulators also targeted conflicts of interest at credit ratings agencies, which gave overly optimistic ratings to risky CDOs leading up to the crisis. Some observers believe the agencies were conflicted because they were paid by the CDO creators.
These reforms aimed to make CDOs safer and prevent perverse incentives that encourage the creation of shaky CDOs. However, some argue the core problem with CDOs is their complexity, which makes risks hard to understand and model. As long as CDOs remain opaque and complicated, regulating and managing their risks will remain challenging.
The CDO Market Today
The CDO market shriveled after 2008 as the financial crisis soured investors on complex structured credit products. Global CDO issuance plunged from a peak of over $500 billion in 2006 to under $10 billion in 2009. However, the market has regrown in the decade-plus since the crisis. In 2019 before the COVID-19 recession, worldwide CDO issuance topped $300 billion.