Collateralized debt obligation

Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with multiple tranches that are issued by special purpose entities and collaterized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed-income underlying assets^{[citation needed]}. CDOs securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

In simple terms, think of a CDO as a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first.

CDO can be created as long as global investors are willing to provide the money to purchase the pool of bonds the CDO owns. CDO volume grew significantly between 2000–2006, then declined dramatically in the wake of the subprime mortgage crisis, which began in 2007. Many of the assets held by these CDOs had been subprime mortgage-backed bonds. Global investors began to stop funding CDOs in 2007, contributing to the collapse of certain structured investments held by major investment banks and the bankruptcy of several subprime lenders.^[1][2]

A few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that CDOs, other ABSs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the subprime mortgage crisis in 2007, this view has gained substantial credibility. Credit rating agencies failed to adequately account for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs.

Many CDOs are valued on a mark to market basis and thus experienced substantial write-downs as their market value collapsed during the subprime crisis, with banks writing down the value of their CDO holdings mainly in the 2007-2008 period.

Market history and growth

The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation on June 22, 1990.^[3][4][5] A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles.

CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Economist Mark Zandi of Moody's Analytics wrote that various factors had kept interest rates low globally in the years CDO volume grew, due to fears of deflation, the bursting of the dot-com bubble, a U.S. recession, and the U.S. trade deficit. This made U.S. CDO backed by mortgages a relatively more attractive investment versus say U.S. treasury bonds or other low-yielding, safe investments. This search for yield by global investors caused many to purchase CDOs, trusting the credit rating and without fully understanding the risks.^[6]

CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDOs declined from 2000–2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets.^[7] In addition, financial innovations such as credit default swaps and synthetic CDO enabled speculation on CDOs. This dramatically increased the amount of money that moved among market participants. In effect, multiple insurance policies or wagers could be stacked on the same CDO. If the CDO did not perform per contractual requirements, one counterparty (typically a large investment bank or hedge fund) had to pay another. Michael Lewis referred to this speculation as part of the "Doomsday Machine" that contributed to the failure of major banking institutions and smaller hedge funds, at the core of the subprime mortgage crisis.^[8] There are allegations that at least one hedge fund encouraged the creation of poor quality CDOs so bets could be made against them.^[9][10][11]

Willingness to create CDOs and sell them to investors may also reflect the greater profit margins that CDOs provide to their originators, such as major investment banks and other participants in the shadow banking system, as well as in the traditional depository banking system. Investment banking and credit rating agency profits increased dramatically in the years leading up to the crisis.^[12] From 2000-2006, structured finance (which includes CDOs) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase sixfold and its earnings grew by 900%.^[13]

Further, depository banks used CDO as a form of securitization, meaning that the bank did not have to hold the loans it originated on its books and could transfer them (along with related risk) to investors. This in turn enabled the banks to lend again, remaining in compliance with capital requirement laws and generating additional origination fees.

Another factor in the growth of CDOs was the 2001 introduction by David X. Li of Gaussian copula models, which allowed for the rapid pricing of CDOs.^[14][15]

In late 2005 research firm Celent estimated the size of the global CDO market at USD 1.5 trillion and projected that the market would grow to nearly USD 2 trillion by the end of 2006. Synthetic CDO also expanded under the tenure of Federal Reserve chairman, Alan Greenspan who later expounded on the previously unrecognized risk of these devices in his testimony to a Congressional investigative committee on April 7, 2010.^[16]

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 and to sell packages of cash flows to investors. A CDO is constructed as follows:

• A special purpose entity (SPE) is designed to acquire a portfolio of underlying assets. Common underlying assets held include mortgage-backed securities, commercial real estate bonds and corporate loans.

• The SPE issues bonds to investors in exchange for cash, which is used to purchase the portfolio of underlying assets. The bonds issued are in layers with different risk characteristics called tranches. Senior tranches are paid from the cash flows from the underlying assets before the junior securities and equity securities. Losses are first borne by the equity securities, next by the junior tranches, and finally by the senior tranches.

One analogy is to think of the cash flow from the CDOs portfolio of securities (say mortgage payments from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, then junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranch investors face the losses first.

The risk and return for a CDO investor depends directly on how the tranches are defined, and only indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all asset-backed securities, enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated.

The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. Economist Mark Zandi wrote: "...the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote: "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."^[6]

In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This explains why some CDO became entirely worthless, as the equity layer tranches were paid last in the sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of which defaulted) to trickle down to the equity layers.

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