What Are Collateralized Debt Obligations (CDOs)?
CDOs, or collateralized debt obligations, are financial tools banks use to repackage individual loans into products sold to investors on the secondary market. These packages consist of auto loans, credit card debt, mortgages, or corporate debt. They are called "collateralized" because the promised repayments of the loans are the collateral that gives the CDOs their value.
Collateralized debt obligations are a particular kind of derivative. Derivatives are products that derives their value from another underlying asset. Like put options, call options, and futures contracts, derivatives have long been used in the stock and commodities markets.
- Alternate name: Collateralized loan obligations (CLOs) are CDOs made up of bank debt.
- Acronym: CDO
How CDOs Work
CDOs are called “asset-backed commercial paper” if they consist of corporate debt. Banks call them “mortgage-backed securities” if the loans are mortgages. If the mortgages are made to those with a less-than-prime credit history, they are called “subprime mortgages.”
Banks sell CDOs to investors for three reasons:
- The funds they receive give them more cash to make new loans.
- The process moves the loans' risk of default from the bank to the investors.
- CDOs give banks new and more profitable products to sell, which boosts share prices and managers' bonuses.
At first, CDOs were a welcome financial innovation. They provided more liquidity in the economy. CDOs allowed banks and corporations to sell off their debt, thereby freeing up more capital to invest or lend.
At first, the spread of CDOs was a welcome boost to the U.S. economy. The invention of CDOs also helped to create new jobs.
Unlike a mortgage on a house, a CDO is not a product you can touch or see to find out its value. Instead, a computer model creates it. After the invention of CDOs, thousands of college and higher-level graduates went to work in Wall Street banks as “quant jocks.” Their job was to write computer programs that would model the value of the bundle of loans that made up CDOs. Thousands of salespeople were also hired to find investors for these new products.
The Rise of CDOs
Although CDOs fell out of favor after the financial crisis of 2007, they began to creep back into the market in 2012.
Adjustable-rate mortgages offered "teaser" low-interest rates for the first three to five years. Higher rates kicked in after that. Borrowers took the loans, knowing they could only afford to pay the low rates. They expected to sell their houses before the higher rates were triggered.
The quant jocks designed CDO tranches to take advantage of these different rates. One tranche held only the low-interest portion of mortgages. Another tranche offered just the part with the higher rates. That way, conservative investors could take the low-risk, low-interest tranche, while aggressive investors could take the higher-risk, higher-interest tranche. All went well as long as housing prices and the economy continued to grow.
What Went Wrong With CDOs
Unfortunately, the extra liquidity created an asset bubble in housing, credit cards, and auto debt. Housing prices skyrocketed beyond their actual value. People bought homes just so they could sell them. The easy availability of debt meant that people used their credit cards too much. That drove credit card debt to almost $1 trillion in 2008.
The banks that sold the CDOs didn't worry about people defaulting on their debt. They had sold the loans to other investors, who then owned them. That made them less disciplined in adhering to strict lending standards. Banks made loans to borrowers who weren't creditworthy, which ensured disaster.
From the buyers' perspective, CDOs may have become too complicated. The buyers didn't know the value of what they were buying. They relied on their trust in the banks selling the CDOs.
Buyers may not have done enough research to be sure the CDO packages were worth their prices, but research wouldn't have done much good, because even the banks didn't know. The computer models based the CDOs' value on the assumption that housing prices would continue to go up. If they were to fall, the computers couldn't price the products.
This opacity and the complexity of CDOs created a market panic in 2007. Banks realized that they couldn’t price the products or the assets they were still holding. Overnight, the market for CDOs disappeared. Banks refused to lend each other money, because they didn’t want more CDOs on their balance sheets in return.
It was like a financial game of musical chairs when the music stopped, and resulting panic caused the 2007 banking crisis.
The Role of CDOs in the Subprime Mortgage Crisis
The first CDOs to go decline were the mortgage-backed securities. When housing prices started to drop in 2006, the mortgages on homes bought in 2005 were soon "upside down," in turn creating the subprime mortgage crisis. The Federal Reserve assured investors that the crisis was confined to housing. In fact, some welcomed it and said that housing prices had been in a bubble and needed to cool down.
What they didn't realize was how derivatives multiplied the effect of any bubble and any subsequent downturn. Not only banks were left holding the bag, but so were pension funds, mutual funds, and corporations. It wasn't until the Federal Reserve and the Treasury started buying these CDOs that a semblance of functioning returned to the financial markets.
The Dodd Frank-Wall Street Reform Act of 2010 was adopted with the intention of preventing the same sort of exposure that led to several banks’ collapse during the crisis. This federal law was weakened in 2017, when small banks were removed from coverage, and the Trump administration sought to repeal it altogether.
- Collateralized debt obligations (CDOs) are bundles of debt that banks package for resale to investors.
- CDOs are difficult to evaluate, because all of the debts are lumped together.
- CDOs at first drove the economy before they escalated beyond control and led to the crash of 2007.
- CDOs had fallen out of favor as an investment vehicle, but by 2012 they had already started coming back under somewhat different structures.