A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS).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: .
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). In the same article above.
See also: Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS).Lepke, Lins and Pi card, Mortgage-Backed Securities, §5:15 (Thomson West, 2014). 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. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.
The CDO is "sliced" into sections known as "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. 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. 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.Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2014 ed.).
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 created insurance markets for them with "synthetic CDOs".
In the early 2000s, the debt underpinning CDOs was generally diversified,McLean, Bethany and Joe Nocera, All the Devils Are Here, the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010, p. 120. 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.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 These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages, and are credited with giving lenders greater incentive to make subprime loans, leading to the 2007–2009 subprime mortgage crisis.
Market history
Beginnings
In 1970, the US government-backed mortgage guarantor Ginnie Mae created the first mortgage-backed security (MBS), based on FHA and VA mortgages. It guaranteed these MBSs.McClean, Nocera, p. 7. This would be the precursor to CDOs that would be created two decades later. In 1971, Freddie Mac issued its first Mortgage Participation Certificate. This was the first MBS made of ordinary mortgages.History of Freddie Mac. All through the 1970s, private companies began mortgage asset securitization by creating private mortgage pools.
In 1974, the Equal Credit Opportunity Act in the United States imposed heavy sanctions for financial institutions found guilty of discrimination on the basis of race, color, religion, national origin, sex, marital status, or age.Regulation B, Equal Credit Opportunity 12 CFR 202.14(b) as stated in Closing the Gap: A Guide to Equal Opportunity Lending , Federal Reserve System of Boston. This led to a more open policy of giving loans (sometimes subprime) by banks, guaranteed in most cases by Fannie Mae and Freddie Mac. In 1977, the Community Reinvestment Act was enacted to address historical discrimination in lending, such as 'redlining'. The Act encouraged commercial banks and savings associations (Savings and loan banks) to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods (who might earlier have been thought of as too risky for home loans).Text of Housing and Community Development Act of 1977—title Viii (Community Reinvestment) .
In 1977, the investment bank Salomon Brothers created a "private label" MBS - one that did not involve government-sponsored enterprise (GSE) mortgages. However, it failed in the marketplace.McClean, Nocera, p. 12. Subsequently, Lewis Ranieri (Salomon) and Larry Fink (First Boston) invented the idea of securitization; different mortgages were pooled together and this pool was then sliced into tranches, each of which was then sold separately to different investors.McClean, Nocera, p. 5. Many of these tranches were in turn bundled together, earning them the name CDO (Collateralized debt obligation).Liar's Poker, Michael Lewis.
The first CDOs to be issued by a private bank were seen in 1987 by the bankers at the now-defunct Drexel Burnham Lambert Inc. for the also now-defunct Imperial Savings Association. During the 1990s the collateral of CDOs was generally corporate and emerging market bonds and bank loans.The Financial Crisis Inquiry Report, 2011, p. 129. After 1998 "multi-sector" CDOs were developed by Prudential Securities,The Financial Crisis Inquiry Report, 2011, pp. 129-30. but CDOs remained fairly obscure until after 2000. In 2002 and 2003 CDOs had a setback when rating agencies "were forced to downgrade hundreds" of the securities,McLean and Nocera, All the Devils Are Here, 2010 p. 121. but sales of CDOs grew—from $69 billion in 2000 to around $500 billion in 2006. From 2004 through 2007, $1.4 trillion worth of CDOs were issued.
Early CDOs were diversified, and might include everything from aircraft lease-equipment debt, manufactured housing loans, to student loans and credit card debt. The diversification of borrowers in these "multisector CDOs" was a selling point, as it meant that if there was a downturn in one industry like aircraft manufacturing and their loans defaulted, other industries like manufactured housing might be unaffected.Morgenson and Rosner Reckless Endangerment, 2010 pp. 279-280. Another selling point was that CDOs offered returns that were sometimes 2–3 percentage points higher than corporate bonds with the same credit rating.McLean and Nocera, All the Devils Are Here, 2010 p. 189.
Explanations for growth Advantages of securitization – Depository banks had incentive to "securitize" loans they originated—often in the form of CDO securities—because this removes the loans from their books. The transfer of these loans (along with related risk) to security-buying investors in return for cash frees up the banks' capital. This enabled them to remain in compliance with capital requirement laws while lending again and generating additional origination fees. Global demand for fixed income investments – From 2000 to 2007, worldwide fixed income investment (i.e. investments in bonds and other conservative securities) roughly doubled in size to $70 trillion, yet the supply of relatively safe, income generating investments had not grown as fast, which bid up bond prices and drove down interest rates.Public Radio International. April 5, 2009. "This American Life": Giant Pool of Money wins Peabody Investment banks on Wall Street answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies. Low interest rates – Fears of deflation, the bursting of the dot-com bubble, a U.S. recession, and the U.S. trade deficit kept interest rates low globally from 2000 to 2004–5, according to Economist Mark Zandi.of Moody's Analytics. The low yield of the safe US Treasury bonds created demand by global investors for subprime mortgage-backed CDOs with their relatively high-yields but credit ratings as high as the Treasuries. This search for yield by global investors caused many to purchase CDOs, though they lived to regret trusting the credit rating agencies' ratings. Pricing models – Gaussian copula models, introduced in 2001 by David X. Li, allowed for the rapid pricing of CDOs.How a Formula Ignited Market That Burned Some Big Investors| Mark Whitehouse| Wall Street Journal| September 12, 2005.
Subprime mortgage boom