Back التزام الدين المكفول Arabic Təminatlı borc öhdəlikləri Azerbaijani Obligació de deute garantida Catalan Zajištěná dluhová obligace Czech Collateralized Debt Obligation German Εγγυημένες δανειακές υποχρεώσεις Greek Obligación colateralizada por deuda Spanish Collateralized debt obligations French संपार्श्विक ऋण दायित्व Hindi Collateralized debt obligation Italian
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS).[1] Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS).[2][3] Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns.[4] Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.[5]
The CDO is "sliced" into sections known as "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority.[6] If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first.[7] The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual.[8]
Separate special purpose entities—rather than the parent investment bank—issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as "CDO-Squared", "CDOs of CDOs" or "synthetic CDOs".[8]
In the early 2000s, the debt underpinning CDOs was generally diversified,[9] but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this had changed. CDO collateral became dominated by high risk (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually subprime mortgages.[10] These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages,[11] and are credited with giving lenders greater incentive to make subprime loans,[12] leading to the 2007–2009 subprime mortgage crisis.[13]
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An "asset-backed security" is sometimes used as an umbrella term for a type of security backed by a pool of assets—including collateralized debt obligations and mortgage-backed securities. Example: "A capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs" (italics added). Source: Vink, Dennis (August 2007). "ABS, MBS and CDO compared: an empirical analysis" (PDF). Munich Personal RePEc Archive. Retrieved 13 July 2013..
Other times it is used for a particular type of that security—one backed by consumer loans. Example: "As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO, [and s]ecuritization issues backed by consumer-backed products—car loans, consumer loans and credit cards, among others—are called ABS ..." (italics added). Source: Vink, Dennis (August 2007). "ABS, MBS and CDO compared: an empirical analysis" (PDF). Munich Personal RePEc Archive. Retrieved 13 July 2013.
See also: "What are Asset-Backed Securities?". SIFMA. Archived from the original on 29 June 2018. Retrieved 13 July 2013.Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically the assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.
- ^ Lepke, Lins and Pi card, Mortgage-Backed Securities, §5:15 (Thomson West, 2014).
- ^ Cordell, Larry (May 2012). "COLLATERAL DAMAGE: SIZING AND ASSESSING THE SUBPRIME CDO CRISIS" (PDF).
- ^ Azad, C. "Collateralized debt obligations (CDO)". www.investopedia.com. Investopedia. Retrieved 31 January 2018.
- ^ Kiff, John (November 2004). "CDO rating methodology: Some thoughts on model risk and its implications" (PDF).
- ^ Koehler, Christian (31 May 2011). "The Relationship between the Complexity of Financial Derivatives and Systemic Risk". Working Paper: 17. SSRN 2511541.
- ^ Azad, C. "How CDOs work". www.investinganswers.com. Investing answers. Retrieved 31 January 2018.
- ^ a b Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2014 ed.).
- ^ McLean, Bethany and Joe Nocera, All the Devils Are Here, the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010, p. 120.
- ^ Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, aka The Financial Crisis Inquiry Report, p.127
- ^ Cite error: The named reference
FCIR-130was invoked but never defined (see the help page). - ^ Cite error: The named reference
FCIR-133was invoked but never defined (see the help page). - ^ Lewis, Michael (2010). The Big Short: Inside the Doomsday Machine. England: Penguin Books. ISBN 9781846142574.