Loading the player...

What is a 'Collateralized Debt Obligation - CDO'

A collateralized debt obligation (CDO) is 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 is named for the pooled assets — such as mortgages, bonds and loans — that are essentially debt obligations that serve as collateral for the CDO. The tranches in a CDO vary substantially in their risk profiles. The senior tranches are generally safer because they have first priority on payback from 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.

BREAKING DOWN 'Collateralized Debt Obligation - CDO'

Collateralized debt obligations are created by as many as five parties:

  • 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 History of CDOs

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 and the Global Financial Crisis

CDOs subsequently exploded in popularity, with CDO sales rising almost tenfold 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.

Despite their role in the financial crisis, collateralized debt obligations are still an active area of structured finance. CDOs and even the more infamous synthetic CDOs are still in use, as they are ultimately a tool for shifting risk and freeing up capital, two things Wall Street always has an appetite for.  

RELATED TERMS
  1. Warehousing

    Warehousing is an intermediate step in a collateralized debt ...
  2. Bespoke CDO

    A bespoke CDO is a customized structured financial product created ...
  3. Collateralized Loan Obligation ...

    Collateralized loan obligations are securities backed by a pool ...
  4. Additional Collateral

    Additional assets put up as collateral by a borrower against ...
  5. Secured Creditor

    A secured creditor is any creditor or lender associated with ...
  6. Tranches

    Tranches are portions of debt or securities that are structured ...
Related Articles
  1. Personal Finance

    CDOs and the Mortgage Market

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

    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

    Who Was to Blame for the Subprime Crisis?

    From lenders to buyers to hedge funds, when it comes to the subprime mortgage crisis, everyone had blood on their hands.
  4. Insights

    The Fuel That Fed The Subprime Meltdown

    Take a look at the factors that caused this market to flare up and burn out.
  5. Investing

    The Goldman Sachs Accusation Explained

    Despite the airtime this scandal has received, the details aren't clear. Find out what happened and how it affects you.
  6. Small Business

    Bailout Acronyms 101

    The subprime meltdown gave rise to a mouthful of financial acronyms. Learn how to sort through this alphabet soup.
  7. Personal Finance

    Behind the scenes of your mortgage

    Four major players slice and dice your mortgage in the secondary market
  8. Insurance

    The Rise And Fall Of The Shadow Banking System

    We look at the evolution, failure and fallout from the shadow banking system.
  9. Investing

    Why You Shouldn't Trust Ratings From Rating Agencies

    When the U.S. debt was downgraded, what does that really mean?
RELATED FAQS
  1. The Differences Between a Collateralized Debt Obligation (CDO) and an Asset Backed ...

    Learn about the differences in relationships between asset-backed securities (ABS) and collateralized debt obligations (CDOs) Read Answer >>
  2. Why do banks securitize some debts, and how do they sell them to investors?

    Learn how and why banks securitize debt, how the securitized debt is sold to other investors, and how different the different ... Read Answer >>
  3. What is a tranche?

    A tranche is a security, like a collateralized mortgage obligation, that can be split up into smaller pieces and subsequently ... Read Answer >>
  4. Asset-Based Lending Vs. Asset Financing

    Is there an actual difference between asset-based lending and asset financing? Read Answer >>
  5. What are the main categories of debt?

    Learn about the different types of debt available for consumers including secured debt, unsecured debt, revolving debt and ... Read Answer >>
  6. What is the difference between secured and unsecured debts?

    Learn about the differences between secured and unsecured debt — and how banks buffer risks associated with each type of ... Read Answer >>
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  2. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  3. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  6. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
Trading Center