Loading the player...

What is a '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.

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.
     

RELATED TERMS
  1. Bespoke CDO

    A type of collateralized debt obligation (CDO) that a dealer ...
  2. Synthetic CDO

    A form of collateralized debt obligation (CDO) that invests in ...
  3. Broad Index Synthetic Trust Offering ...

    Proprietary name used by J.P. Morgan for creating collateralized ...
  4. Sequential Pay CMO

    A type of collateralized mortgage obligation (CMO) in which there ...
  5. Tranches

    A piece, portion or slice of a deal or structured financing. ...
  6. Asset-Backed Security - ABS

    A financial security backed by a loan, lease or receivables against ...
Related Articles
  1. Investing

    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.
  2. Investing

    The Return of CDOs After the 2008 Financial Crisis

    Learn how the market for CDOs is coming back after the 2008 financial crisis, and understand how the market for these products has changed.
  3. Financial Advisor

    Collateralized Debt Obligations: From Boon To Burden

    CDOs were to be Wall Street's boon - instead they went bust. Find out what went wrong.
  4. 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.
  5. Investing

    Understanding Structured Finance

    Structured finance refers to a complex financial transaction involving large financial institutions and companies with unique needs.
  6. Personal Finance

    Why Are Mortgage Rates Increasing?

    Learn how the secondary mortgage market and investor demand affect the cost of home ownership.
  7. Investing

    3 Bonds You May Have Never Heard Of

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

    The Fuel That Fed The Subprime Meltdown

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

    What Are Tranches?

    “Tranche” is a French word that refers to a slice.
  10. Insights

    The Big Short Explained

    Oscar-nominated film The Big Short explains the complex financial instruments that helped fuel the financial crisis of 2008-09.
RELATED FAQS
  1. What is the difference between a collateralized debt obligation (CDO) and an asset ...

    Discover the relationships between asset-backed securities (ABS), collateralized debt obligations (CDOs) and mortgage-backed ... Read Answer >>
  2. Were Collateralized Debt Obligations (CDO) Responsible for the 2008 Financial Crisis?

    Collateralized debt obligations are exotic financial instruments that can be difficult to understand, Learn the role they ... Read Answer >>
  3. Are all mortgage backed securities (MBS) also collateralized debt obligations (CDO)?

    Learn more about mortgage-backed securities, collateralized debt obligations and synthetic investments. Find out how these ... Read Answer >>
  4. What's the difference between a collateralized debt obligation (CDO) and a collateralized ...

    Find out how a collateralized mortgage obligation (CMO) is similar to a collateralized debt obligation (CDO), as well as ... Read Answer >>
  5. 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 >>
Hot Definitions
  1. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  2. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  3. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  4. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  5. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
  6. Dilution

    A reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can also occur ...
Trading Center