Collateralized Debt Obligation - CDO

AAA

DEFINITION of 'Collateralized Debt Obligation - CDO'

A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. A collateralized debt obligation (CDO) is so-called because the pooled assets – such as mortgages, bonds and loans – are essentially debt obligations that serve as collateral for the CDO. The tranches in a CDO vary substantially in their risk profile. The senior tranches are relatively safer because they have first priority on the collateral in the event of default. As a result, the senior tranches of a CDO generally have a higher credit rating and offer lower coupon rates than the junior tranches, which offer higher coupon rates to compensate for their higher default risk.

INVESTOPEDIA EXPLAINS 'Collateralized Debt Obligation - CDO'

As many as five parties are involved in constructing CDOs:

  • Securities firms, who approve the selection of collateral, structure the notes into tranches and sell them to investors;
  • CDO managers, who select the collateral and often manage the CDO portfolios;
  • Rating agencies, who assess the CDOs and assign them credit ratings;
  • Financial guarantors, who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments; and
  • Investors such as pension funds and hedge funds.

    The earliest CDOs were constructed by Drexel Burnham Lambert – the home of former “junk bond king” Michael Milken – in 1987 by assembling portfolios of junk bonds issued by different companies. Securities firms subsequently launched CDOs for a number of other assets with predictable income streams, such as automobile loans, student loans, credit card receivables and even aircraft leases. However, CDOs remained a niche product until 2003-04, when the U.S. housing boom led the parties involved in CDO issuance to turn their attention to non-prime mortgage-backed securities as a new source of collateral for CDOs.
     
    CDOs subsequently exploded in popularity, with CDO sales rising almost 10-fold from $30 billion in 2003 to $225 billion in 2006. But their subsequent implosion, triggered by the U.S. housing correction, saw CDOs become one of the worst-performing instruments in the broad market meltdown of 2007-09. The bursting of the CDO bubble inflicted losses running into hundreds of billions on some of the biggest financial institutions, resulting in them either going bankrupt or being bailed out through government intervention, and contributing to escalation of the global financial crisis during this period.
     

VIDEO

RELATED TERMS
  1. Collateralized Mortgage Obligation ...

    A type of mortgage-backed security in which principal repayments ...
  2. Bespoke CDO

    A type of collateralized debt obligation (CDO) that a dealer ...
  3. Off Balance Sheet - OBS

    An asset or debt that does not appear on a company's balance ...
  4. Toxic Assets

    An asset that becomes illiquid when its secondary market disappears. ...
  5. Tranches

    A piece, portion or slice of a deal or structured financing. ...
  6. Collateralized Bond Obligation ...

    An investment-grade bond backed by a pool of junk bonds. Junk ...
Related Articles
  1. Insurance

    CDOs And The Mortgage Market

    These structured products contribute to keeping borrowing rates low.
  2. Investing Basics

    CMO vs CDO: Same Outside, Different Inside

    The concept of collateralizing and structured financing predates the market for collateralized mortgage obligations and collateralized debt obligations.
  3. Bonds & Fixed Income

    3 Bonds You May Have Never Heard Of

    These lesser-known bonds may give your portfolio a boost when other investments products fall short.
  4. Insurance

    Behind The Scenes Of Your Mortgage

    Four major players slice and dice your mortgage in the secondary market.
  5. Credit & Loans

    Down The Rabbit Hole: Deciphering CDOs

    Warren Buffett claims that understanding these instruments would mean reading 750,000 pages of text. Read on to learn the basics.
  6. Retirement

    Collateralized Debt Obligations: From Boon To Burden

    CDOs were to be Wall Street's boon - instead they went bust. Find out what went wrong.
  7. Mutual Funds & ETFs

    Fatal Seduction Of The Municipal Bond Insurers

    Learn how a foray into CDOs and other exotic products ruined an industry's image.
  8. Entrepreneurship

    The Rise And Demise Of New Century Financial

    A case study in how poor planning toppled a subprime mortgage giant.
  9. Investing

    What is a tranche?

    "Tranche" is actually a French word meaning "slice" or "portion". In the world of investing, it is used to describe a security that can be split up into smaller pieces and subsequently sold to ...
  10. Investing Basics

    The Strange New World Of The Bitcoin Exchange Futures Market

    We explain the basics of the Bitcoin exchange and futures market.

You May Also Like

Hot Definitions
  1. Portfolio Turnover

    A measure of how frequently assets within a fund are bought and sold by the managers. Portfolio turnover is calculated by ...
  2. Commercial Paper

    An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories ...
  3. Federal Funds Rate

    The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution ...
  4. Fixed Asset

    A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be ...
  5. Break-Even Analysis

    An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even ...
  6. Key Performance Indicators - KPI

    A set of quantifiable measures that a company or industry uses to gauge or compare performance in terms of meeting their ...
Trading Center