Collateralized debt obligations (CDOs) are making a comeback after being one of the drivers of the 2008 financial crisis. Investors searching for yield in a low interest rate environment are investing in CDOs once again.
There is an understandable concern that CDOs could cause another market meltdown. However, the CDO market has matured in the wake of the financial crisis. More stringent capital requirements and awareness of CDO risks have returned these derivatives to a tool for risk management as opposed to unfettered speculation.
Structure of CDOs
A CDO is a type of security that holds pooled debt, such as corporate bonds or mortgage-backed securities (MBS). This debt is sliced into different tranches, or levels of risk. The individual tranches are then sold to investors. The senior tranches have a higher degree of safety, since they have higher credit ratings or are based upon higher-quality debt. The more junior tranches pay a higher amount of interest, but they also have greater risk.
There are three main types of CDOs. Cash CDOs hold portfolios of assets, such as loans, corporate bonds or MBS. Synthetic CDOs have exposure to a portfolio of fixed income assets through credit default swaps that are derivatives. Hybrid CDOs are a mixture of assets and exposure through credit default swaps.
CDOs in 2008
Defaults on CDOs backed by subprime mortgages were one of the causes of the 2008 financial crisis. The banks had an inventory of junior tranches of CDOs that they wanted to sell off. The credit rating agencies gave the junior tranches good credit ratings, even though they were backed by subprime debt. Since the junior tranches had good credit ratings, banks sold them to pension funds and other institutional investors. These investors are generally only allowed to invest in debt with high credit ratings and could not have bought them without high credit ratings.
The banks paid the credit rating agencies to provide the credit ratings for the tranches. In retrospect, this was a conflict of interest. The credit rating agencies were not independent in evaluating the tranches, since the banks were their clients.
The agencies also incorrectly assumed that housing prices would continue to rise. The tranches were highly diversified from a geographic perspective. The banks mistakenly thought that if housing prices were hurt in one area of the country, they would be offset by strong housing markets in other locations. They did not foresee a nationwide housing crisis. A massive tide of delinquencies and defaults overwhelmed the market, causing defaults on the CDOs.
Comeback for CDO Markets
CDOs are making a comeback. In the current low interest rate environment, CDOs offer a higher yield than what is available on corporate debt or government debt. Investors seeking yield are beginning to invest in CDOs once again. There were around $20 billion in CDOs issued in 2014, up from $5 billion in 2013.
Experts note that the CDO market has changed. The assets backing CDOs have shifted from residential mortgages to commercial mortgages. Commercial real estate did not have as much of a downturn compared to residential real estate. There is ostensibly less risk associated with commercial mortgages.
Investors are more aware of the risks associated with CDOs. They are, therefore, being priced accordingly. In addition, there are more stringent capital requirements in place to ensure that counterparties are able to fulfill their obligations under the terms of the agreements. Dodd-Frank and Basel III both require banks to keep more capital on hand to prevent another meltdown.
Credit rating agencies are much more cautious as well. The Justice Department sued Standard & Poor's for its role in the financial crisis. The company agreed to settle the suit for $1.38 billion in February 2015. The credit rating agencies will be much less likely to provide good credit ratings for risky CDOs moving forward.