CDO

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS).An “asset-backed security” is sometimes used as an umbrella term for a type of security backed by a pool of assets’including collateralized debt obligations and mortgage-backed securities (Example: “The capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs”. (italics added) (source: )’and sometimes for a particular type of that security’one backed by consumer loans (example: “As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO, [and] Securitization issues backed by consumer-backed products’car loans, consumer loans and credit cards, among others’are called ABS … (italics added, source , see also ) Originally developed for the corporate debt markets, over time CDOs evolved to encompass the mortgage and mortgage-backed security (“MBS”) markets. Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. The CDO is “sliced” into “tranches”, which “catch” the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most “junior” tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently coupon payments (and interest rates) vary by tranche with the safest/most senior tranches paying the lowest and the lowest tranches paying the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as “super senior”); Junior AAA; AA; A; BBB; Residual. Separate special purpose entities’rather than the parent investment bank’issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as “CDO-squared” or “CDOs of CDOs.” In the early 2000s, CDOs were generally diversified, but by 2006
2007’when the CDO market grew to $100s of billions’this changed. CDO collateral became dominated not by loans, but by lower level (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages. These CDOs have been called “the engine that powered the mortgage supply chain” for nonprime mortgages, and are credited with giving lenders greater incentive to make non-prime loans leading up to the 2007-9 subprime mortgage crisis.