What is a Collateralized Debt Obligation (CDO)?

A collateralized debt obligation, or CDO for short, is an investment bank that uses loans and other kinds of debt. The bank takes many loans, like house mortgages, car loans, student loans, and credit card debt, and puts hundreds or thousands of these loans together into one big group.

How CDOs are Structured

The bank then divides this large group of loans into “tranches.” Each tranche acts like an investment; some tranches are riskier than others.

The least risky tranches are paid back first. The bank promises people who buy these tranches will likely get their money back, so these tranches pay the lowest interest rates.

The most risky tranches are paid back last. The people who invest in these tranches might lose their money if many of the loans in the CDO go bad. But because they are taking more risk, these tranches pay the highest interest rates.

Why Banks Create CDOs

Banks created CDOs to try to make money smartly. They can charge fees to set up CDOs and invest in the CDO tranches themselves.

The idea is that by grouping many loans, some of the risk is canceled out. Even if some loans default, others will keep paying, so the CDO as a whole still makes money.

Banks also like CDOs because they let them move loans off their books. This frees up the bank to make new loans and earn more fees.

Problems with CDOs

CDOs got very popular in the early 2000s. However, they also played a significant role in causing the 2008 financial crisis. Here’s how:

Hiding Risky Loans

Some banks started putting riskier and riskier loans into CDOs to make more money. They weren’t always honest about how dangerous these loans were.

Imagine a bank making a bunch of mortgages to people with bad credit. The bank knows there’s a good chance many of these people will default on their mortgages.

But if the bank can package those risky mortgages inside a CDO, they suddenly seem much safer to investors. The bank might claim that because there are so many mortgages, only a few will likely go wrong.

False Confidence from Ratings Agencies

Banks paid companies called rating agencies to grade their CDOs. These grades were supposed to tell investors how safe or risky each tranche was.

The problem was that the banks paid those rating agencies, so they had a reason to give CDOs high ratings, even if they were risky.

Many CDOs with very risky loans got AAA ratings—the highest possible rating—which made investors think they were very safe.

Misjudging Risk

Banks and rating agencies used fancy math models to determine the riskiness of CDOs. However, these models were based on a critically wrong idea.

The models assumed that if a few loans in the CDO went terribly, most other loans would still be okay. They thought the risk of defaults wasn’t strongly connected.

In reality, the loans were much more connected than they thought. When people started defaulting on their mortgages, it caused a housing market crash that made many more people default. The models failed to account for this.

Overconfidence and Excessive Investment

Because CDOs were seen as safe investments with high returns, many investors bought them. Banks also invested heavily in CDOs themselves.

Everyone was so confident in CDOs that they had a considerable market. Banks kept making more and more, with riskier and riskier loans.

They weren’t prepared for what would happen if housing markets went down and many loans defaulted at once, but that’s precisely what happened.

The 2008 Financial Crisis

In the mid-2000s, the United States had a massive housing bubble. Banks gave out mortgages much too quickly, including many people who couldn’t afford the houses they were buying.

Many of these risky mortgages were packaged into CDOs, which caused a chain reaction when the housing bubble finally burst.

As house prices fell, many people defaulted on their mortgages, causing enormous losses for the CDOs that included those mortgages.

Investors in the riskiest CDO tranches lost nearly all their money, and even the “safest” AAA tranches lost value as mass defaults piled up.

Banks found themselves owning vast amounts of CDOs that were now nearly worthless. Many banks didn’t have enough cash to cover their losses, and some went bankrupt, most famously Lehman Brothers.

As banks struggled, they stopped lending money. This credit crunch made the housing crash even worse. With banks in crisis and unable to provide loans, the broader economy went into a severe recession.