What Are Collateralized Debt Obligations?
Pros, Cons and How CDOs Caused the Financial Crisis
CDOs, or collateralized debt obligations, are financial tools that banks use to repackage individual loans into a product 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.
CDOs are a particular kind of derivative. As its name implies, a derivative is any financial product that derives its value from another underlying asset. Derivatives like put options, call options, and futures contracts have long been used in the stock and commodities markets.
CDOs are called asset-backed commercial paper if the package consists 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 sold CDOs to investors for three reasons:
- The funds they received gave them more cash to make new loans.
- It moved the loan's risk of default from the bank to the investors.
- CDOs gave banks new and more profitable products to sell. That boosted 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. That freed up more capital to invest or loan. The spread of CDOs is one reason why the U.S. economy was robust until 2007.
The invention of CDOs also helped create new jobs. Unlike a mortgage on a house, a CDO is not a product that you can touch or see to find out its value. Instead, a computer model creates it. 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 a CDO. Thousands of salespeople were also hired to find investors for these new products.
As competition for new and improved CDOs grew, these quant jocks made more complicated computer models. They broke the loans down into "tranches," which are simply bundles of loan components with similar interest rates.
Here's how that works. 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 the house 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.
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 so they could sell them. The easy availability of debt meant 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 now owned them. That made them less disciplined in adhering to strict lending standards. Banks made loans to borrowers who weren't credit-worthy. That ensured disaster.
What made things even worse was that CDOs became too complicated. The buyers didn't know the value of what they were buying. They relied on their trust of the bank selling the CDO. They didn't do enough research to be sure the package was worth the price. The 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 fell, the computers couldn't price the product.
How CDOs Caused the Financial Crisis
This opaqueness and the complexity of CDOs created a market panic in 2007. Banks realized they couldn't price the product 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 sheet in return. It was like a financial game of musical chairs when the music stopped. This panic caused the 2007 banking crisis.
The first CDOs to go south were the mortgage-backed securities. When housing prices started to drop in 2006, the mortgages of homes bought in 2005 were soon upside-down. That created the subprime mortgage crisis. The Federal Reserve assured investors it was confined to housing. In fact, some welcomed it and said that housing 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 they were also holding the pension funds, mutual funds, and corporations. It was until the Fed and the Treasury started buying these CDOs that a semblance of functioning returned to the financial markets.