Collateralized Debt Obligations
Collateralized debt obligations (CDOs) are securitized interests in pools of asset-backed securities. CDOs are mostly about repackaging and transferring credit risk, and investors bear the credit risk of the collateral. While it is possible to issue a CDO backed entirely by high-quality bonds, the structure is more relevant for collateral comprised partially or entirely of marginal obligations.
With a CDO, the investment is actually made in a cash flow rather than in the asset itself. There are different levels of risk and reward, yet the same portfolio of securities generates the cash flow. In a sense, then, the investor is relying on (or investing in) their belief in the system or mathematical model which is behind the construction of the various tranches.
CDOs were first issued in the 1980's, and became a growing sector of the securities market. These investments are put together in a wide variety of ways and are made up of different assets, but the principles behind a CDO remain essentially the same.
A CDO has a sponsoring organization, which establishes a special purpose vehicle to hold collateral and issue securities. Sponsors can include banks, other financial institutions or investment managers. Expenses associated with running the special purpose vehicle are subtracted from cash flows to investors. Often, the sponsoring organization retains the most subordinate equity tranch of a CDO.
From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. As delinquencies and defaults on subprime mortgages occurred, CDOs backed by significant mezzanine subprime collateral experienced severe rating downgrades and possibly future losses.
As the mortgages underlying the CDO's collateral declined in value, banks and investment funds holding CDOs faced difficulty in assigning a precise price to their CDO holdings. The pricing challenges arose because CDOs do not actively trade and mortgage defaults take time to lead to CDO losses.
In June 2007, two hedge funds managed by Bear Stearns Asset Management Inc. faced cash or collateral calls from lenders that had accepted CDOs backed by subprime loans as loan collateral. The now defunct Bear Stearns, at that time the fifth-largest investment bank in the U.S., said on July 18, 2007 that investors in its two failed hedge funds would get little if any money back after "unprecedented declines" in the value of securities used to bet on subprime mortgages.
Issuance of new CDOs slowed significantly in the second-half of 2007 and the first quarter of 2008 due to weakness in subprime collateral, the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds, and a general downturn in the global credit markets.