Collateralized Debt Obligations (CDOs)

Thorny theories, prickly policies, complicated issues and complex arguments explained by the experts.

Collateralized debt obligations (CDOs) are among the new financial products that were developed following the widespread adoption of securitization. These are claims on payment flows coming from a pool or pools of assets. These assets (called collateral) are held by an accounting entity created for the purpose (often called a special purpose vehicle or entity) and the cash flows that derive from these assets are bought by investors. Thus for example, a CDO structure might comprise a pool of car loans, corporate loans and credit card loans (which are the collateral) and the repayments from these loans become the cash flows to the investor. The investor pays money to buy a portion of these flows (called a tranche) depending on his or her desire to hold risk. The first repayments on these loans go to the ’senior’ tranches, the next set go to the ‘junior’ tranches and the last set of payments goes to the ‘equity’ tranches. Being first in line (and therefore facing less risk) means that the investors earn less in senior tranches than in junior and equity tranches.

There are numerous variants of CDOs. The one just described is often called a cash flow CDO (since the major way in which the investor earns returns is through the cash flows from the underlying asset pools). In a market value CDO , investors earn returns by investing in a special purpose entity which buys and sells collateral assets (much in the way a mutual fund buys securities) to earn capital gains. In a synthetic CDO the investor does not have claims on a pool
of assets directly but through being party to a credit default swap agreement on a pool of assets. As long as the underlying loans do not default, according to this agreement, the investor will earn a premium. If the assets default, however, the investor will be out of the capital used to purchase the swap. As with the cash flow CDO in the synthetic CDO the investor can choose the level of risk and return he or she is willing to take by choosing the tranche (equity,
junior, mezzanine, or senior). Senior tranches face the least risk and equity tranches face the most risk of losing out on the premium as the assets on which the CDS is written default.

The CDO market grew by leaps and bounds between 2000 and 2005. In 2005-2006 over half a trillion dollars of these securities were issued. Not everyone is a fan though. Warren Buffet, for example, suggests that rather than spread risk more widely , such instruments serve to increase the uncertainty about the value of the pool of assets. See Braintruster Henry Liu’s case study of AIG, which shows how CDOs contributed to the credit crisis.