Though collateralized debt obligations (CDOs) played a leading role in the Great Recession, they were not the only cause of the disruption, nor were they the only exotic financial instrument being used at the time.
CDOs are risky by design, and the decline in value of their underlying commodities, mainly mortgages, resulted in significant losses for many during the financial crisis.
What is a CDO?
A CDO is a type of financial instrument that pays investors out of a pool of revenue-generating sources. One way to imagine a CDO is a box into which monthly payments are made from multiple mortgages. It is usually divided into three tranches, each representing different risk levels.
As borrowers make payments on their mortgages, the box fills with cash. Once a threshold has been reached, such as 60% of the month's commitment, bottom-tranch investors are permitted to withdraw their shares. Commitment levels such as 80% or 90% may be the thresholds for higher-tranch investors to withdraw their shares. Bottom-tranch investing in CDOs is very attractive to institutional investors because the instrument pays better than T-Bills despite being considered almost risk-free.
What Went Wrong?
For years prior to the 2007-08 crisis, CDOs proliferated throughout what is sometimes called the shadow banking community.
As the practice of merging assets and splitting the risks they represented grew and flourished, the economics of CDOs became ever more elaborate and rarefied. A CDO-squared, for example, consists of the middle tranches of multiple regular CDOs, which have been aggregated to create more "risk-free" investments for banks, hedge funds and other large investors looking for ballast.
The middle tranches of these could then be combined into a still more abstracted instrument called a CDO-cubed. By this point, the returns investors were drawing were three times removed from the underlying commodity, which was often home mortgages.
Mortgages as Underlying Commodities
The strength of a CDO is also its weakness; by combining the risk from debt instruments, CDOs make it possible to recycle risky debt into AAA-rated bonds that are considered safe for retirement investing and for meeting reserve capital requirements. This helped to encourage the issuance of subprime, and sometimes subpar, mortgages to borrowers who were unlikely to make good on their payments.
All of this culminated in the passage of the 2007 Bankruptcy Bill. This bill reformed the practice of personal bankruptcy with an eye toward limiting abuse of the system. The bill also increased the cost of personal bankruptcy and left insolvent homeowners without recourse when they found themselves unable to pay their mortgages.
What followed was a domino-like collapse of the intricate network of promises that made up the collateralized debt markets. As millions of homeowners defaulted, CDOs failed to reach their middle and upper tranches, CDO-squared and CDO-cubed investors lost money on so-called "riskless" investments.