Collateralized Debt Obligation - Explained
What is a Collateralized Debt Obligation?
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Table of ContentsWhat is a Collateralized Debt Obligation?How Does a Collateralized Debt Obligation Work?The History of CDOsCDOs and the Global Financial Crisis
What is a Collateralized Debt Obligation?
A collateralized debt obligation (CDO) is asset-backed security sold to investors in the market. CDOs represent different assets pooled together and repackaged by banks to be sold to investors in the market. A collateralized debt obligation is also classified as a structured financial product, the structure of this product is dependent on the different assets repackaged in the product. The pooled assets in a CDO are essentially loans, bonds and mortgages, these assets represent the collateral for the financial product. Initially, CDOs were offered in the corporate debt markets, they are sold in tranches to willing investors. In the present day, CDOs are being used to refinance mortgage-backed securities.
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How Does a Collateralized Debt Obligation Work?
It is generally believed that banks repackage individual loans, mortgages, and bonds in the form of collateralized debt obligations which they sell to customers. However, aside from the banks, there are other parties that can create CDOs, they are;
- CDO managers: These are professional managers in charge of the selection of collateral that backs CDOs.
- Securities firms
- Financial regulators and agencies
- Investors; through hedge funds, pension funds, and others)
- Rating agencies.
CDOs are categorized in tranches and attract different levels of risks, while the senior tranches have fewer risks, the lower tranches have higher risks such as default. For instance, in cases of default, senior tranches are given priority in terms of repayment over junior tranches.
The History of CDOs
Collateralized debt obligations (CDOs) first emerged in 1987, when it was used to describe junk bonds that were bundled together and issued by companies in the market. The earliest CDOs were those offered by Drexel Burnham Lambert in 1987, at this time, CDOs represented mere junk bonds repackaged and sold to investors by companies. Subsequently, securities firms and other parties extended CDOs to a number of assets outside junk bonds, these include loans, mortgage, and bonds. In the early 2000s, CDOs in the United Securities became a term for financial products backed by mortgages and assets offered by companies to investors in the market.
CDOs and the Global Financial Crisis
Between 2003 and 2006, collateralized debt securities had become popular in the United States, they became widely accepted financial products in the U.S with a significant dollar amount accorded to them. For instance, as of 2003, the sale of CDOs generated about $30 but by 2006, the sales realized from CDOs were almost ten times higher with a dollar amount of $225 in that year. However, the Great Recession/depression in 2008 significantly affected the performance of CDOs. During the market meltdown, CDOs recorded losses in billions and this had great effects on companies and investors who purchased them. Despite the losses accrued by CDOs during the Global financial crisis, they are still recognized as a form of structure asset-backed financial products up till today.