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A Collateralized Debt Obligation, or CDO, is a synthetic investment created by bundling a pool of similar loans into a single investment that can be bought or sold. An investor that buys a CDO owns a right to a part of this pool's interest income and principal.

For example, a bank might pool together 5,000 different mortgages into a CDO. An investor who purchases the CDO would be paid the interest owed by the 5,000 borrowers whose mortgages made up the CDO, but runs the risk that some borrowers don't pay back their loans. The interest rate is a function of the expected likelihood that the borrowers whose loans make up the CDO will default on their payments - determined by the credit rating of the borrowers and the seniority of their loans.

CDOs are created and sold by most major banks (e.g. Goldman Sachs, Bank of America) over the counter, i.e. they are not traded on an exchange but have to be bought directly from the bank. Securities Industry and Financial Markets Association estimates that US$ 503 billion worth of CDOs were issued in 2007.^[1]

CDOs played a prominent role in the U.S. subprime crisis, where critics say CDOs hid the underlying risk in mortgage investments because the ratings on CDO debt were based off of misleading or incorrect information about the creditworthiness of the borrowers.

How CDOs Work

Bundling debt into a CDO changes the riskiness of investing in debt in two ways:

Reduction of Statistical Outliers

First, CDOs reduce the effect of statistical outliers. Lending someone money to buy a house is risky, because that person either defaults or they don't - even if there's only a one in 5,000 chance of someone defaulting on their mortgage, if you happened to be the lender for the person who defaults, you're out of luck. CDOs turn individual loans into a portfolio in which a default by any single lender is unlikely to have an enormous impact on the portfolio as a whole. By aggregating many different mortgages together into a CDO, investors can own a small percentage of many different mortgages, and therefore the CDO's losses as a result of borrowers defaulting on their obligations usually represent the statistical averages in the market as a whole

Tranches

Second, CDOs are created in tranches - portions of the underlying debt that vary in their riskiness, despite being backed by a generic pool of bonds or loans.

Typically, a pool of debt is divided into three tranches, each of which is a separate CDO. Each tranche will have different maturity, interest rates and default risk. This allows the CDO creator to sell to multiple investors with different degrees of risk preference.

The bottom tranche will pay the highest interest rate, but will be the first to lose money if some of the loans in the pool aren't repaid. The top tranche will have the lowest interest rate, but will always be the first to be repaid - the bottom two tranches have to be wiped out before the top tranche is affected. This allows bankers to create investments with risk / reward profiles that are very different from the underlying debt in the pool. So, one pool of mortgages can be divided into three CDOs, one with an "AAA" debt rating that pays low interest, one with an intermediate debt rating with moderate interest, and one with a low debt rating with high interest. This is important because some asset manager are only allowed to invest in "AAA" rated debt - dividing a pool of debt that is not AAA rated into three different CDO tranches means at least some portion of that debt is now AAA rated and can be purchased by institutions that can only invest in AAA debt.

For example: A bond pool of $100 million is divided into three tranches and is expected to earn 15%, or $15 million in interest per annum. The pool is divided into 3 tranches, A ($25 million), B ($50 million) and C ($25 million), where A is senior to B, and B is senior to C. The associated interest rate with each tranche is 10%, 15% and 20% respectively. Therefore, if none of the bonds default, A receives $2.5 million, B receives $ 7.5 million, and C receives $ 5 million. However, if there is a default and the interest income is reduces to $11 million - in this case, since A and B are senior to C, they will be settled before C is settled. As a result, tranche A and B receives their full interest of $ 2.5 million and $7.5 million, whereas tranche C only receives $ 1 million.

CDO Market

Global CDO Issuance^[2]

According to data from Securities Industry and Financial Markets Association global CDO issuance increased from $157 billion in 2004, to $503 billion in 2007.^[3] The total outstanding CDO is estimated to be over $2 trillion.^[4]

CDOs are structured by investment banks and are bought by all types of asset managers, including hedge funds, insurance companies, banks and pension funds. CDOs can also be purchased through most retail brokerage accounts.

For an example of CDO prospectus look at Triaxx Prime CDO 2006-1.

Other Types of CDOs

Collateralized mortgage obligations (CMOs) and collateralized bond obligations (CBOs) are examples of CDOs in which the loans that make up the pool of debt in the CDO are mortgages and bonds, respectively.

Synthetic CDOs

The term synthetic applies to a CDO in which the underlying assets are credit default swaps (CDS) rather than debt instruments like bonds or loan.

Credit default swaps are insurance on debt. The buyer of the insurance pays a certain amount to the seller in exchange for protection from default. In effect, these securities behave very similarly to the underlying debt, but are easier to buy and sell.

CDO^2

CDO Squared, Cubed, etc refers to a security that is constructed from pools of CDOs rather than a pool of debt instruments such as loan or bond. Essentially, this is a CDO of CDOs.

Criticisms of CDOs

CDOs have been criticized as being highly complex instruments that are difficult to value. Warren Buffet is on record for calling CDOs financial weapons of mass destruction -- since he believes, contrary to the philosophy behind CDOs, that default risk is correlated and cannot be diversified away.^[5] CDOs and other such debt-related derivatives have been blamed for making the 2007 credit crisis a lot more severe than it should have been and have led to the failure of institutions such as Lehman Brothers (LEH), MBIA (MBI) and AIG. ^[6]

For an illustrated explanation, visit Anatomy of a CDO at the Wall Street Journal

References

1. ↑ SIFMA, Global CDO Market Issuance Data, Retrieved September 23, 2008
2. ↑ SIFMA.org, Retrieved September 23, 2008
3. ↑ SIFMA.org, Retrieved September 23, 2008
4. ↑ Celent.com, Retrieved Sept. 23, 2008
5. ↑ Berkshire Hathaway 2002 Annual Statement, Page 15, Retrieved 9/22/08
6. ↑ MBIA slumps on concern about CDO exposures, Marketwatch.com.