Collateralized debt obligation

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets. The CDO is 'sliced' into 'tranches', which 'catch' the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most 'junior' tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as 'super senior'); Junior AAA; AA; A; BBB; Residual.Because most traditional mortgage investors are risk-averse, either because of the restrictions of their investment charters or business practices, they are interested in buying the higher-rated segments of the loan stack; as a result, those slices are easiest to sell. The more challenging task is finding buyers for the riskier pieces of at the bottom of the pile. The way mortgage securities are structured, if you cannot find buyers for the lower-rated slices, the rest of the pool cannot be sold.CDOs prolonged the mania, vastly amplifying the losses that investors would suffer and ballooning the amounts of taxpayer money that would be required to rescue companies like Citigroup and the American International Group.' ...'As usual, the ratings agencies were chronically behind on developments in the financial markets and they could barely keep up with the new instruments springing from the brains of Wall Street's rocket scientists. Fitch, Moody's, and S&P paid their analysts far less than the big brokerage firms did and, not surprisingly wound up employing people who were often looking to befriend, accommodate, and impress the Wall Street clients in hopes of getting hired by them for a multiple increase in pay. ... Their failure to recognize that mortgage underwriting standards had decayed or to account for the possibility that real estate prices could decline completely undermined the ratings agencies' models and undercut their ability to estimate losses that these securities might generate.'An 'asset-backed security' is sometimes used as an umbrella term for a type of security backed by a pool of assets—including collateralized debt obligations and mortgage-backed securities. Example: 'A capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs' (italics added). Source: Vink, Dennis (August 2007). 'ABS, MBS and CDO compared: an empirical analysis' (PDF). Munich Personal RePEc Archive. Retrieved 13 July 2013..mw-parser-output cite.citation{font-style:inherit}.mw-parser-output .citation q{quotes:''''''''''''}.mw-parser-output .citation .cs1-lock-free a{background:url('//upload.wikimedia.org/wikipedia/commons/thumb/6/65/Lock-green.svg/9px-Lock-green.svg.png')no-repeat;background-position:right .1em center}.mw-parser-output .citation .cs1-lock-limited a,.mw-parser-output .citation .cs1-lock-registration a{background:url('//upload.wikimedia.org/wikipedia/commons/thumb/d/d6/Lock-gray-alt-2.svg/9px-Lock-gray-alt-2.svg.png')no-repeat;background-position:right .1em center}.mw-parser-output .citation .cs1-lock-subscription a{background:url('//upload.wikimedia.org/wikipedia/commons/thumb/a/aa/Lock-red-alt-2.svg/9px-Lock-red-alt-2.svg.png')no-repeat;background-position:right .1em center}.mw-parser-output .cs1-subscription,.mw-parser-output .cs1-registration{color:#555}.mw-parser-output .cs1-subscription span,.mw-parser-output .cs1-registration span{border-bottom:1px dotted;cursor:help}.mw-parser-output .cs1-ws-icon a{background:url('//upload.wikimedia.org/wikipedia/commons/thumb/4/4c/Wikisource-logo.svg/12px-Wikisource-logo.svg.png')no-repeat;background-position:right .1em center}.mw-parser-output code.cs1-code{color:inherit;background:inherit;border:inherit;padding:inherit}.mw-parser-output .cs1-hidden-error{display:none;font-size:100%}.mw-parser-output .cs1-visible-error{font-size:100%}.mw-parser-output .cs1-maint{display:none;color:#33aa33;margin-left:0.3em}.mw-parser-output .cs1-subscription,.mw-parser-output .cs1-registration,.mw-parser-output .cs1-format{font-size:95%}.mw-parser-output .cs1-kern-left,.mw-parser-output .cs1-kern-wl-left{padding-left:0.2em}.mw-parser-output .cs1-kern-right,.mw-parser-output .cs1-kern-wl-right{padding-right:0.2em}.Other times it is used for a particular type of that security—one backed by consumer loans. Example: 'As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO, ecuritization issues backed by consumer-backed products—car loans, consumer loans and credit cards, among others—are called ABS ...' (italics added). Source: Vink, Dennis (August 2007). 'ABS, MBS and CDO compared: an empirical analysis' (PDF). Munich Personal RePEc Archive. Retrieved 13 July 2013.See also: 'What are Asset-Backed Securities?'. SIFMA. Retrieved 13 July 2013. Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically the assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans. A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets. The CDO is 'sliced' into 'tranches', which 'catch' the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most 'junior' tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as 'super senior'); Junior AAA; AA; A; BBB; Residual. Separate special purpose entities—rather than the parent investment bank—issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as 'CDO-Squared', 'CDOs of CDOs' or 'synthetic CDOs'. In the early 2000s, the debt underpinning CDOs was generally diversified, but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this had changed. CDO collateral became dominated by high risk (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually subprime mortgages. These CDOs have been called 'the engine that powered the mortgage supply chain' for subprime mortgages, and are credited with giving lenders greater incentive to make subprime loans, leading to the 2007-2009 subprime mortgage crisis. In 1970, the US government backed mortgage guarantor Ginnie Mae created the first MBS (mortgage-backed security), based on FHA and VA mortgages. It guaranteed these MBSs. This would be the precursor to CDOs that would be created two decades later. In 1971, Freddie Mac issued its first Mortgage Participation Certificate . This was the first mortgage-backed security made of ordinary mortgages. All through the 1970s, private companies began mortgage asset securitization by creating private mortgage pools. In 1974, the Equal Credit Opportunity Act in the United States imposed heavy sanctions for financial institutions found guilty of discrimination on the basis of race, color, religion, national origin, sex, marital status, or age This led to a more open policy of giving loans (sometimes subprime) by banks, guaranteed in most cases by Fannie Mae and Freddie Mac. In 1977, the Community Reinvestment Act was enacted to address historical discrimination in lending, such as 'redlining'. The Act encouraged commercial banks and savings associations (Savings and loan banks) to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods (who might earlier have been thought of as too risky for home loans). In 1977, the investment bank Salomon Brothers created a 'private label' MBS (mortgage backed security)—one that did not involve government-sponsored enterprise (GSE) mortgages. However, it failed in the marketplace. Subsequently, Lewis Ranieri (Salomon) and Larry Fink (First Boston) invented the idea of securitization; different mortgages were pooled together and this pool was then sliced into tranches, each of which was then sold separately to different investors. Many of these tranches were in turn bundled together, earning them the name CDO (Collateralised debt obligation). The first CDOs to be issued by a private bank were seen in 1987 by the bankers at the now-defunct Drexel Burnham Lambert Inc. for the also now-defunct Imperial Savings Association. During the 1990s the collateral of CDOs was generally corporate and emerging market bonds and bank loans. After 1998 'multi-sector' CDOs were developed by Prudential Securities, but CDOs remained fairly obscure until after 2000. In 2002 and 2003 CDOs had a setback when rating agencies 'were forced to downgrade hundreds' of the securities, but sales of CDOs grew—from $69 billion in 2000 to around $500 billion in 2006. From 2004 through 2007, $1.4 trillion worth of CDOs were issued. Early CDOs were diversified, and might include everything from aircraft lease-equipment debt, manufactured housing loans, to student loans and credit card debt. The diversification of borrowers in these 'multisector CDOs' was a selling point, as it meant that if there was a downturn in one industry like aircraft manufacturing and their loans defaulted, other industries like manufactured housing might be unaffected. Another selling point was that CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Around 2005, as the CDO market continued to grow, subprime mortgages began to replace the diversified consumer loans as collateral. By 2004, mortgage-backed securities accounted for more than half of the collateral in CDOs. According to the Financial Crisis Inquiry Report, 'the CDO became the engine that powered the mortgage supply chain', promoting an increase in demand for mortgage-backed securities without which lenders would have 'had less reason to push so hard to make' non-prime loans. CDOs not only bought crucial tranches of subprime mortgage-backed securities, they provided cash for the initial funding of the securities. Between 2003 and 2007, Wall Street issued almost $700 billion in CDOs that included mortgage-backed securities as collateral. Despite this loss of diversification, CDO tranches were given the same proportion of high ratings by rating agencies on the grounds that mortgages were diversified by region and so 'uncorrelated'—though those ratings were lowered after mortgage holders began to default.