Collateralized Debt Obligation - CDO


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.


Loading the player...

BREAKING DOWN '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.

  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. Synthetic CDO

    A form of collateralized debt obligation (CDO) that invests in ...
  6. Tranches

    A piece, portion or slice of a deal or structured financing. ...
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. Investing Basics

    A Primer On Collateralized Debt Obligation (CDOs)

    A collateralized debt obligation, or CDO, is a structured financial product backed by a pool of loans. When a retail or commercial bank approves loans such as mortgages, auto loans or credit ...
  4. 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.
  5. Insurance

    Behind The Scenes Of Your Mortgage

    Four major players slice and dice your mortgage in the secondary market.
  6. 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.
  7. 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.
  8. Entrepreneurship

    The Rise And Demise Of New Century Financial

    A case study in how poor planning toppled a subprime mortgage giant.
  9. 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.
  10. Financial Advisors

    Ditching High-Yield Bonds for Plain Vanilla Ones

    In a low-rate environment, it's tempting to go for higher yield bonds. However, you might be better off sticking with the plain vanilla ones.
  1. Do negative externalities affect financial markets?

    In economics, a negative externality happens when a decision maker does not pay all the costs for his actions. Economists ... Read Full Answer >>
  2. Why do banks securitize some debts, and how do they sell them to investors?

    Banks may securitize debt for reasons that include risk management, balance sheet issues, greater leverage of capital and ... Read Full Answer >>
  3. What role did junk bonds play in the financial crisis of 2007-08?

    Junk bonds were the at heart of the financial crisis of 2007-2008. Toxic assets related to the subprime housing market pushed ... Read Full Answer >>
  4. Can private investors benefit from collateralized debt obligations (CDO)?

    Although individuals involved in the private banking industry may buy into collateralized debt obligations, or CDOs, they ... Read Full Answer >>
  5. What is the difference between a collateralized debt obligation (CDO) and an asset ...

    An asset-backed security (ABS) is a security created by pooling non-mortgage assets that is then resold to investors. A collateralized ... Read Full Answer >>
  6. How did the financial crisis affect the banking sector?

    Over the short term, the financial crisis affected the banking sector by causing banks to lose money on mortgage defaults, ... Read Full Answer >>
  7. Were collateralized debt obligations (CDO) responsible for the 2008 financial crisis?

    Though collateralized debt obligations (CDOs) played a leading role in the 2007-08 financial crisis, they were not the only ... Read Full Answer >>
  8. Are accounts receivable used when calculating a company's debt collateral?

    On a company’s balance sheet, any cash flow-generating assets are recorded as debt collateral or collateralized debt obligations ... Read Full Answer >>
  9. 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 ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  2. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  3. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  4. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  5. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the ...
Trading Center