Understanding How Collateralized Debt Obligations Work
CDOs are not a standard financial instrument offered to retail investors. They are generally sold to institutional investors such as investment banks, pension funds, insurance companies, hedge funds, etc. To better understand how they work, it helps to know a similar type of investment called a mortgage-backed security.
Mortgage-Backed Securities vs Collateralized Debt Obligations
Mortgage Backed Securities or MBSs are a way for mortgage companies to resell the debt they plan to collect from their customers. Rather than waiting years or even decades to collect repayments, the mortgage company can raise capital by taking the loans on their books, packaging them into a new financial instrument, and then reselling them to investors.
MBSs are generally desirable because they deliver a higher rate of interest than U.S. treasuries. However, because of their composition, there are mixed opinions on their safety.
While MBSs are collateralized by the property associated with the mortgages that they hold, they often receive mid-level credit ratings. This is due to the questionable creditworthiness of those repaying the mortgages. Unfortunately, that’s a problem for potential investment groups such as a pension fund which can usually only engage in the safest assets available.
For this reason, banks started creating a derivative of MBSs called CDOs. CDOs contained more than just mortgages. They can also hold a mixture of corporate bonds, auto loans, and other debt instruments such as credit card receivables.
However, the real difference between an MBS and a CDO is in their structure. Rather than have just one broad level of credit, CDOs divided the assets within the portfolio into different tiers or “tranches”.
CDO Tranches
The tranch of each CDO carries its own rate of return as well as the degree of risk. They are generally classified as followed:
● Senior - The safest tranche but also carries the lowest interest rate.
● Mezzanine - Medium level of safety and also a mid-level interest rate.
● Equity - The lowest level of safety but also carries the highest interest rate.
Under this structure, in the event of a default, the senior tranche would receive first priority, followed by the mezzanine and equity tranches. In other words, senior and mezzanine tranche investors would continue to receive interest payments while the equity tranche investors may not.
Because each tranche acts as essentially its own asset class, it can receive its own unique credit rating. This helps the bank to appeal to a wider range of investors by matching the tranch to their appetite for reward and risk. Investment groups that may have found MBSs to be too risky could buy senior CDOs instead. Meanwhile, hedge funds that sought to deliver the highest returns possible for their clients may find the equity CDOs more appealing.
What Are the Benefits of a CDO?
From the perspective of both the banks issuing CDOs and investors, there was a lot to love.
Investors received:
● A rate of return that was above those offered by the U.S. Treasury or other fixed-income assets
● Diversification from the various assets packaged into the CDO
● A sense of security depending on the type of tranche they had selected.
Simeltenoushly, the banks got the ability to turn illiquid assets (like a loan) into immediate capital. This enabled them to turn around and loan that money out again (i.e. the money multiplier effect).
CDOs and the Subprime Mortgage Crisis
CDOs gained in popularity throughout the early 2000s because of their ability to transform illiquid assets into immediate revenue. This led to an increased demand for mortgage companies to lend as much money as possible. Unfortunately, many started to relax their standards and looked past important applicant criteria such as their credit history and ability to repay the loan - a practice called subprime lending.
While the economy prospered and homeowners were happy to see their properties rise in value, there was a major problem developing with CDOs. Instead of limiting these subprime mortgages to the lowest level, highest risk equity tranche, they began to find their way to all of the tranches - even the senior and mezzanine levels. Investors who were assured their money was secure were actually sitting on top of toxic assets and taking on more risk than they knew.
Ultimately, the situation came to a head when mortgage borrowers began defaulting on their loans. Without repayments flowing in, CDOs began to default on their interest payments. This was a significant blow to institutional investors, and major banks like Bear Stearns and Lehman Brothers even filed for bankruptcy. The overall economy fell into what became dubbed the Great Recession, and home values dropped to levels not seen in years. Ultimately, the entire situation resulted in government intervention and financial restructuring by International Monetary Fund in October 2009.
The Bottom Line
Collateralized debt obligations are financial instruments that bundle together various forms of debt and then resell them to major investment groups. They are a derivate of mortgage-backed securities but are divided into various tranches to better match the investor's risk-reward profile.
CDOs gained a lot of popularity in the early 2000s because they enabled banks to turn long-term debt into immediate capital. However, as banks started engaging in more subprime mortgages, CDOs became not as safe as they were advertised to investors. This ultimately contributed to the end of the housing bubble and the Great Recession that followed.