Understanding Collateralized Debt Obligations or CDOs

How the Collateralized Debt Obligation Brought Down Wall Street and the World

Collateralized Debt Obligations
A collateralized debt obligation, or CDO, is a special type of complex security that was responsible for nearly destroying the U.S. economy only a few short years ago. They're making a comeback. Tetra Images / Getty Images

Collateralized debt obligations, or CDOs, destroyed the economy a few years ago.  They're making a comeback.  What are they?  How do they work?

The short version: A collateralized debt obligation is created when a financial institution, such as a bank, takes the debts owed by lots of borrowers, puts them together into a “pool”, divides that pool into different categories based on risk called “tranches” and then sells off those tranches to investors such as hedge funds.

The long version: Considered a major cause of the Credit Crisis, collateralized debt obligations, or CDOs for short, are a type of investment known as asset backed securities, or ABS as they are commonly referred to on Wall Street. The value of a collateralized debt obligation comes from an underlying portfolio (collection) of fixed-income investments such as mortgages, corporate bonds, municipal bonds, or whatever else Wall Street decided to package into a specific CDO.

To complicate matters, collateralized debt obligations are divided into groups known as tranches. The word tranch comes from the french for “slice” or “pieces” and represents a different part of the same portfolio. A senior tranch in a collateralized debt obligation, for instance, would be entitled to the safest position. If the underlying assets in the collateralized debt obligation were to begin to go bad - for instance, homeowners stopped making their mortgage payments - the most junior tranches would absorb the losses first.

Let’s imagine you own a bank called North Star Bank Corporation. You package together a group of $500 million home mortgages with similar characteristics into a new collateralized debt obligation - on Wall Street you’d give it some prosaic name such as the North Star Bank Corporation Homeowners Series CDO.

You use what is known as a waterfall capital structure and divide the collateralize debt obligation into five tranches:

Tranche A of the CDO - Absorb the first 20% of losses on the collateralized debt obligation portfolio

Tranche B of the CDO - Absorbs the second 20% of losses on the collateralized debt obligation portfolio

Tranche C of the CDO - Absorbs the third 20% of losses on the collateralized debt obligation portfolio

Tranche D of the CDO - Absorbs the fourth 20% of losses on the collateralized debt obligation portfolio

Tranche E of the CDO - Absorbs the fifth and final 20% of losses on the collateralized debt obligation portfolio.

If you were the bank, you would likely want to keep Tranche E of the CDO for yourself because it is the safest. Even if half of the borrowers don’t make their payments, you are still going to get your money back and your investment will remain sound. You’d be likely to sell off the collateralized debt obligation tranches A,B,C, and possibly even D, however, because you could generate a lot of cash and fees upfront to put back to work in your bank or pay out to your shareholders as dividends.

So how could these cause a global financial meltdown? Banks, insurance groups, hedge funds, and other institutions used lots of borrowed money to invest in collateralized debt obligations.

At the same time, the people packaging these together began accepting lower quality assets, fueled by the housing boom, because times were good and money was flowing freely.

When housing prices fell, the economy went down, and people were unable to pay their bills, the whole thing went up like a pile of hay covered in gasoline. Part of the reason was a rule known as mark to market.

The theory behind mark to market and collateralized debt obligations is that accountants want investors to get a rough idea of the value of a company’s assets if they had to sell everything in current market conditions. The problem is that many banks or institutions are not going to sell their assets during total meltdowns because they have the resources to continue holding - and in some cases continue purchasing - these securities.

When the credit crisis began, certain institutions that got into trouble had to sell their bad CDOs at fire sale prices. This required, under the accounting rules in place, everyone else to take massive losses on their books even if they had experienced no losses up until that point. Banks are required to maintain a certain percentage of equity to the amount of loans they lend out to customers. Those write-offs, even if just on paper, reduced the amount of money the banks could lend based on those equity ratios.

This created what is known in financial circles as a death spiral or negative feedback loop. The problem began to feed on itself as write downs begat more write downs. This led banks to fear that their competitors would go bankrupt, so they stopped lending money to each other, as well.