A Collateralized Debt Obligation (CDO) is a synthetic investment product that represents different loans bundled together and sold by the lender in the market. The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period. A collateralized debt obligation is a type of derivative security because its price (at least notionally) depends on the price of some other asset.
Structure of a Collateralized Debt Obligation
Historically, the underlying assets in collateralized debt obligations included corporate bonds, sovereign bonds, and bank loans. A CDO gathers income from a collection of collateralized debt instruments and allocates the collected income to a prioritized set of CDO securities.
Similar to equity (preferred stock and common stock), a senior CDO security is paid before a mezzanine CDO. The first CDOs comprised cash flow CDOs, i.e., not subject to active management by a fund manager. However, by the mid-2000s during the lead up to the 2008 recession, marked-to-market CDOs made up the majority of CDOs. A fund manager actively managed the CDOs.
Advantages of Collateralized Debt Obligations
Collateralized debt obligations allow banks to reduce the amount of risk they hold on their balance sheet. The majority of banks are required to hold a certain proportion of their assets in reserve. This incentivizes the securitization and sale of assets, as holding assets in reserves is costly for the banks.
Collateralized debt obligations allow banks to transform a relatively illiquid security (a single bond or loan) into a relatively liquid security.
The Housing Bubble and Collateralized Debt Obligations
Historically, houses were seen to be fundamentally different from other assets such as bonds and shares of companies. Therefore, the housing market was analyzed in a different way compared to the market for other investment instruments. Transactions in the housing market are usually high-value transactions involving individuals, and the relative frequency of such transactions is low compared to a bond or share, which may change hands multiple times during a day’s trading.
In 2003, Alan Greenspan, then the chairman of the Federal Reserve, cut the target federal funds rate to 1% from a high of 6.5% in 2001. The move incentivized banks to increase lending to take advantage of the easy credit available. Banks also provided housing loans to borrowers who would not usually qualify for mortgage loans in the past.
Mortgage-Backed Collateralized Debt Obligation
A mortgage-backed CDO owns parts of many individual mortgage bonds. On average, a mortgage-backed CDO owns parts of hundreds of individual mortgage bonds. The mortgage bonds, in turn, contained thousands of individual mortgages. Thus, a mortgage-backed CDO is seen to reduce the risk of a small-scale housing crisis by diversifying across many mortgage bonds.
A mortgage-backed CDO was considered a very safe investment instrument prior to the 2008 financial crisis. However, such CDOs were particularly susceptible to a systemic collapse of the global housing market. In 2007-2008, house prices fell across the world.
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