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What Is Collateralized Debt Obligation (CDO)?
A fusion of structured finance products that are backed by a pool of loans and other assets and sold to institutional investors is called a collateralized debt obligation (CDO). A CDO’s value is derived from another underlying asset.
If the loan defaults then these assets become the collateral, hence it is a particular type of derivative.
The inception of CDOs
In 1987 the initial CDOs were established by Drexel Burnham Lambert, the former investment banker.
The portfolios of junk bonds issued by different companies were assembled by Drexel bankers in these early CDOs.
Then slowly other securities firms launched CDOs accommodating other assets that had more predictable income streams, like automobile loans, student loans, credit card receivables, and aircraft leases.
However till 2003–04 CDOs remained a niche product, then CDO issuers led by the U.S. housing boom focused on subprime mortgage-backed securities as a new source of collateral for CDOs.
Understanding Collateralized Debt Obligations
Investment banks congregate cash flow-generating assets, like mortgages, bonds, and other types of debts to create a CDO, and based on the level of credit risk assumed by the investor it is then repacked into separate classes or tranches.
Types of CDOs
These tranches of securities become the final investment products like bonds, whose names can reflect their specific underlying assets.
For instance, mortgage loans, and asset-backed securities (ABS) are part of mortgage-backed securities (MBS) that contain corporate debt, auto loans, or credit card debt.
The promised repayments of the underlying assets are the collateral giving the CDOs their value hence CDOs are called “collateralized.”
The Collateralized bond obligations (CBOs) are other types of CDOs that are investment-grade bonds that are supported by a pool of high-yield but lower-rated bonds and single securities backed by a pool of debt are collateralized loan obligations (CLOs) which often contains corporate loans with a low credit rating.
How Are CDOs Structured?
The tranches of CDOs are named to reflect their risk profiles; like, senior debt, mezzanine debt, and junior debt, depending on the individual product, the actual structure will change.
When the credit rating is high the coupon rate will be low. in case of loan default, from the collateralized pool of assets, the senior bondholders get paid first.
Then in the other tranches, according to their credit ratings, the bondholders will follow, finally, the lowest-rated credit will be paid last.
Since they have the first claim on the collateral the senior tranches are the safest.
The senior debt offers lower coupon rates even if they are rated higher than the junior tranches.
On the contrary, to compensate for their greater risk of default the junior debt offers higher coupons /more interest, but because they are riskier, they generally come with lower credit ratings.
P.S :
Senior debt – has a higher credit rating, but lower interest rates.
Junior debt – has a lower credit rating, but higher interest rates.
More About Creating CDOs
Apart from being complicated the Collateralized debt obligations has many professionals contribute to creating them:
- The securities firms – which sanctions the choosing of collateral, structure the notes into tranches and sell them to investors.
- CDO managers – who choose the collateral and many times manage the CDO portfolios.
- Rating agencies – which assess the CDOs and assign credit ratings to them.
- Financial guarantors – who promise to reimburse investors in case of any losses on the CDO tranches in trading for premium payments
- Investors – like the pension funds and hedge funds.
Conclusion
A CDO is a compound structured finance product with the backing of a pool of loans and other assets.
If the loan goes into default then these underlying assets serve as collateral.
CDOs are risky, not for all investors, but they are a viable tool for shifting risk and freeing up capital.
