Updated July 17, 2023
Definition of Collateral Debt Obligation
A collateralized debt obligation or CDO is a group of pooled debt assets such as corporate bonds, loans, government debt, and mortgages, etc. The grouped debt assets are thereafter divided into tranches that are purchased by the investors. Since a CDO derives its value from the underlying assets being debt assets, a CDO is said to be a derivative instrument.
Explanation
The collateralized debt obligations are backed up by the loans.It is used by the banks to get a little relief from the workload. The debt assets in collateralized debt obligations are pooled and then divided into tranches, which are purchased by the investors. The risk and interest rates of these tranches differ from each other. The priority is given to the senior tranches so they are safer but pay a low rate of interest as compared to the junior tranches. The value of collateralized debt obligation comes from the value of the other assets, such as auto loans, government debt, and mortgages, etc. so it is a kind of derivative. CDOs are backed up by assets and in a case where loan assets default in payments, these assets serve as collateral.
How Does It Work?
All the assets which can be included as a part of collateralized debt obligation are listed by the banks such as commercial loan, car loans, mortgage loans, etc. Once the list is prepared by the bank then the bank attempts to structure a diversified portfolio. The bank also tries to sell this diversified portfolio to the investment banks. The pooled debt asset is thereafter divided into numerous tranches; these tranches possess differences in the risk and rate of interest and can be classified as:
- Senior Tranche: They receive priority in payment and are the safest but the rate of interest in it is low.
- Mezzanine Financing Tranche: There is a rational risk in it but the rate of interest is higher than the senior tranches.
- Junior tranche: They enjoy the highest rate of interest but they are riskier than Senior as well as Mezzanine tranches.
These tranches are purchased by the investors according to their will or attitude of taking a risk. The senior tranche is usually purchased by the investors seeking to get the highest rate of interest. The junior tranches are usually purchased by the issuer itself. While the mezzanine tranches are sold to the financial institution or other banks.
Examples of Collateralized Debt Obligations
Let us take an example of Mortgage-Backed Securities. These are the CDOs that include in their portfolio debt assets such as corporate debt, credit card debt, automobile loans, and other similar loans. The reason why mortgage-backed securities can be termed as collateralized debt obligations is that CDOs get their value from the security of getting the repayments received.
Types of Collateral Debt Obligations
- Collateralized bond obligations (CBOs): These types of CDOs are backed up by leveraged fixed income securities.
- Collateralized loan obligations (CLOs): These types of CDOs are backed up by leveraged bank loans.
- Structured finance CDOs (SFCDOs): These types of CDOs are backed up by structured funds.
- Collateralized synthetic obligations (CSOs): These types of CDOs are backed up by credit derivatives.
Structure of Collateralized Debt Obligation
The collateralized debt obligation assets are comprised of sovereign bonds, corporate bonds, and bank loans. The collection of collateralized debt instruments is the source of income of the CDOs which is distributed to the CDO securities. A senior CDO security is paid first after that which the payouts are made to the mezzanine CDO. The first CDO was not subjected to be managed by the fund manager actively but by the mid-2000s, the CDs are actively managed by the fund manager.
How Collateralized Debt Obligation Grew the Economy?
The practice of dividing the risk and pooling of assets exemplified grew and flourished which made the economics of CDOs more detailed. The CDOs were composed of the middle tranches due to which these were of lesser or no-risk investment. The investment was suitable for big investors, banks, etc., seeking to get a stable income.
Advantages
Some of the advantages are:
- Unburden the bank: The Collateralized debt obligation helps the bank in sharing the burden of workload and it makes it easy for the bank to look and work on other things.
- Lesser risk on the balance sheet: The collateralized debt obligations lessens the risk of the balance sheet as a specific fraction of assets of banks are to be kept as a reserve.
- Liquidity: The collateralized debt obligations helps the bank in altering illiquid security into liquid security.
Criticism of Collateralized Debt Obligations
During and after the 2008 crisis, CDOs were highly criticized due to their inefficiency. CDOs multiplied the losses faced by the investors back then. Some of the criticismsare mentioned below:
- Joseph Stiglitz highly criticized the collateralized debt obligation and he considered it as the ‘one of the key culprits’ of the crisis.According to him, it is the reason why F-rated security converted to A-rated.
- Morgen’s son criticized the collateral debt obligation by saying that the agencies had bluffed to change ‘dross into gold’.
- CDOs were criticized due to the inefficiency of it to assess the accurate risk factor in the securities.
Conclusion
Collateralized debt obligation had a history of both rising and downfalls. There are many advantages in CDOS like they remove the burden from the bank, reduces risk on the balance sheet, and help in maintaining liquidity which helps them to rise but due to the inefficiency of the CDOs to assess the accurate risk, they faced the downfall.
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