Collateralized debt obligations (CDOs) were the wizardry of Wall Street, and soon became its burden. Although CDOs were initially created to provide returns on investments with customizable risk, they ended up becoming a liability for all involved. They even contributed to the subprime meltdown.

Basic CDOs are investment-grade securities backed by a pool of bonds, loans and other assets. A financial institution, such as a bank, will purchase these CDOs and divide them into tranches, or pieces of the CDO that are grouped according to risk and are available for purchase. Tranches are then sold to investors based on their desired amount of risk, with a higher risk tranche paying out a higher premium.

This article is meant to give background and insight into the CDO market. Understanding this financial history may help investors avoid similar pitfalls in the future. (To learn more about how these structured products contributed to keeping borrowing rates low, read CDOs And The Mortgage Market.)

A Brief History of the CDO Market
Although CDOs are made up of many different types of borrowing instruments, the troubled CDO market made mortgages the main underlying debt instruments. Then, under the false premise that home values always rise, mortgage brokers were putting people in homes that they couldn't afford. Despite this, interest could be capitalized on the loan value to protect the lender, because loan-to-value (LTV) calculations were below original home values. (For background on the subprime meltdown, check out Who Is To Blame For The Subprime Crisis?)

Wall Street would collect these individual mortgages from the banks and pool them with other forms of debt. As an aggregate, the pool would be sliced into risk levels, or tranches, with the top tranche getting paid first, and so on. Thus, the investment bank could offer synthetic securities to its institutional client base, and the securities would meet whatever risk parameter (investment grade rating) the financial institutions sought.

This method worked well until the housing bubble began to burst in 2007, and home values started to fall precipitously with the increase in five-year adjustable rate mortgages (ARMs). Homeowners who had enjoyed a low interest rate suddenly saw these rates reset, creating significantly higher mortgage payments. This effect was compounded by rising unemployment rates and gas prices, as well as low savings and climbing home-equity debt. This is the backdrop that affected the fixed-income market.

How CDOs Affected the Fixed-Income Market
As the housing bubble collapsed, home values dropped below original LTV parameters; once people started to feel the financial strain, mortgage increased and foreclosures rose. Investment analysts saw this well before it worked its way through the system, and started the selling. This pushed down the value of the CDOs as the asset backing, or collateral, was showing numerous weaknesses. The exiting of this investment vehicle was so fast that an active market of buyers and sellers no longer existed. This resulted in a bid-ask spread that widened so much that trades ceased, all because of the confusion as to what these CDOs were now worth. (Learn more by reading Conquering the LTV Calculation.)

How CDOs Fit Into the Subprime Crisis
A new accounting rule called mark to market (MTM) accounting added to the already building financial storm. This financial principle dictates that investment securities should be valued every quarter based on prices readily observed in the market. Since the CDO market was no longer liquid, ask prices were too high and bids were too low. When marking these securities to market prices, financial institutions had to mark them down to their bid prices, which affected equity balances in these financial institutions.

As a result, investors in these financial institutions saw the securities decrease in value and continue in a downward spiral. Since the subprime mortgages were the first of the CDO tranches to fail, they were blamed for the financial mess of 2008; however, the housing market and MTM accounting also share the blame. (Learn more about MTM accounting and its place in the subprime meltdown. Read Mark-To-Market Mayhem.)

As home prices fell, foreclosure was not the only problem that arose. For many years, increasing home prices led to an increase in disposable income for many homeowners, as they could leverage their homes for other loans. As housing prices fell and disposable income disappeared, many other credit products began to default as well - particularly consumer credit cards and automobile loans. This had a huge impact on CDOs as they differed from other collateralized securities, such as collateralized mortgage obligations (CMOs), in that they represented many different types of debt.

Bringing It All Together
Let's take a look at how the credit debacle unfolded: First, commission-based mortgage brokers talked credit-impaired John Doe into a more expensive house (and hence more debt) than he could afford. Banks gave Doe the mortgage since they rarely saw home values depreciate. Since Doe had a house that was appreciating in value, he was able to get more credit and higher loans to purchase other goods. The banks sold these debts to investment banks, which aggregated them and split them into different classes called collateralized debt obligations (CDOs) and sold the different investment classes to financial institutions.

Following this, interest rates went up and home prices went down. Analysts predicted the CDOs would be impaired, but they didn't know the amount. This valuation quagmire led to very low bid prices on the CDOs, which fanned the flames of loss under MTM accounting. In turn, the investors within financial institutions that had CDOs had to mark down their investments, which led to the subprime mess. Hypothetically, John Doe may face foreclosure, his mortgage broker may be out of a job, his bank may be out of business and his 401(k) may be significantly lower, all because home prices don't always appreciate. (For an expanded view, check out The Fuel That Fed The Subprime Meltdown.)

Conclusion
CDOs were designed to be Wall Street's next best thing. However, due to the financial industry underpinnings that led to the perfect financial storm, they became the bane of existence for all within their reach. Unfortunately, it is likely that Wall Street will once again put stock in something unrealistic or short-sighted. Therefore, it's up to investors to understand CDO history and prevent it from happening again.

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