Understanding Collateralized Debt Obligations (CDOs)

What are they?

Collateralized debt obligations (CDOs) are a type of structured security whose value and payments are derived from a portfolio of fixed-income underlying assets.

Before the subprime mortgage crisis, proponents of CDOs claimed that these securities reduced risk through diversification. This is why CDOs made up of poor quality or riskier assets still received high credit ratings. However, others warned that CDOs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely. They proved to be right.

How are they structured?

To create a CDO, a corporate entity is created to hold the underlying assets as collateral and to sell packages of cash flows (interest and principal payments) to investors. A CDO is structured as follows:

1) A special purpose entity (SPE) acquires a portfolio of underlying assets. Common underlying assets held include:

Mortgage-backed securities
Commercial real estate bonds
Corporate loans
2) The SPE issues bonds (CDOs) in different tranches and the proceeds are used to purchase the portfolio of underlying assets. The senior CDOs are paid from the cash flows from the underlying assets before the junior securities and equity securities.

Example:

You want to buy a house
You go to your local bank and are approved for a mortgage loan
Your loan is packaged with countless others and sold as a CDO to investors. The loan is no longer on your bank’s balance sheet and the bank has capacity to lend more money
Every month, you still continue to make interest and principal payments to your bank
The bank forwards your payments to the CDO, and the CDO pays investors in order of seniority
Significance

From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. As delinquencies and defaults on subprime mortgages occured, CDOs backed by significant subprime loans experienced severe rating downgrades, resulting in a decline in value of affiliated CDOs. Due to mark-to-market accounting, banks and funds holding CDOs were forced to mark down the value of CDOs held on their balance sheets. This significantly impacted quarterly earnings for many banks as they continued to write down the value of CDOs on their books, exacerbating the subprime mortgage crisis.

Synthetic CDOs

Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets with the use of credit default swaps.

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Featured Video

Still confused? The video below simply explains how CDOs work and how they contributed to the subprime mortgage crisis.

Video Source:
http://marketplace.publicradio.org/