Collateralized debt obligation
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]
Market history[edit]
Beginnings[edit]
In 1970, the US government-backed mortgage guarantor Ginnie Mae created the first MBS (mortgage-backed security), based on FHA and VA mortgages. It guaranteed these MBSs.[14] 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 mortgage-backed security made of ordinary mortgages.[15] All through the 1970s, private companies began mortgage asset securitization by creating private mortgage pools.[16]
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[17] 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).[18][19]
In 1977, the investment bank Salomon Brothers created a "private label" MBS (mortgage backed security)—one that did not involve government-sponsored enterprise (GSE) mortgages. However, it failed in the marketplace.[20] 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.[21] Many of these tranches were in turn bundled together, earning them the name CDO (Collateralized debt obligation).[22]
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.[23] During the 1990s the collateral of CDOs was generally corporate and emerging market bonds and bank loans.[24] After 1998 "multi-sector" CDOs were developed by Prudential Securities,[25] but CDOs remained fairly obscure until after 2000.[26] In 2002 and 2003 CDOs had a setback when rating agencies "were forced to downgrade hundreds" of the securities,[27] but sales of CDOs grew—from $69 billion in 2000 to around $500 billion in 2006.[28] From 2004 through 2007, $1.4 trillion worth of CDOs were issued.[29]
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.[30] Another selling point was that CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating.[30][31]
Concept, structures, varieties[edit]
Concept[edit]
CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO is a type of asset-backed security. To create a CDO, a corporate entity is constructed to hold assets as collateral backing packages of cash flows which are sold to investors.[98] A sequence in constructing a CDO is:
In popular media[edit]
In the 2015 biographical film The Big Short, CDOs of mortgage-backed securities are described metaphorically as "dog shit wrapped in cat shit".[109]