Collateralized Debt Obligation

November 21, 2023 - Around 2 mins mins to read

A type of financial instrument known as Collateralized Debt Obligations (CDOs) was first introduced in the United States in 1987 by Drexel Burnham Lambert, a former investment bank. However, it was during the global financial crisis of 2008 that these derivatives gained significant attention.

Essentially, CDOs are a combination of multiple smaller loans that are bundled together and offered to institutional investors. These smaller loans can include various types such as mortgages, automobile leases, and student loans. The main concept behind a CDO is to consolidate these loans into a larger asset, which is then sold to a larger investment company. In this process, the original lenders receive a lump sum of money, while the new investor acquires the loans and their associated collateral.

Collateral refers to any asset (such as property, car, or commodities) that a borrower provides to a lender in order to secure a loan. In the case of CDOs, the collateral typically consists of cars or properties. Banks are usually responsible for creating CDOs and offering them to institutional investors.

When banks select a mix of loans and assets for a CDO, they aim to strike a balance between risk and reward. There is a wide range of assets that can be included in a CDO. For example, mortgage-backed securities consist of mortgage loans, while asset-backed securities include corporate and private debt, automobile leases and loans, and credit card debt. A CDO can incorporate any of these loan and debt obligations.

Between 2003 and 2007, CDOs were considered a promising investment option for institutional investors. However, their popularity declined rapidly with the sub-prime mortgage crisis that hit the United States in 2007. Unfortunately, many of the CDOs sold during the period from 2006 to 2008 were comprised of mortgage-backed securities, which carried higher risk. As more people defaulted on their mortgages, the value of these CDOs plummeted.

Since the burst of the housing bubble in the United States, CDOs have lost their status as one of the preferred derivative investment options. Nevertheless, banks still utilize them on a smaller scale to generate liquidity more quickly.

Collateralized debt obligations remain among the riskier investment opportunities available. However, their practical usefulness for banks cannot be denied. Investors who are more inclined to take on higher-risk investments are also attracted to CDOs, as the potential gains sometimes outweigh the risks. Additionally, CDOs offer a means to diversify investment portfolios.