Collateralized debt obligations (CDO)
What are they?
CDO is a name that was broadly applied to all kinds of assets (mortgages included) that were securitized and then divided up into different levels ('tranches') of risk and sold on to investors.
To understand what a CDO is, you first need to understand the process by which one comes about.
Investment banks involved in the business of CDOs set up a special purpose entity (SPE) to do the business for them. SPEs were technically independent of the banks themselves; this was seen as a good thing because any related risk was then taken off the banks' balance sheets and didn't affect their capital adequacy ratios.
SPEs invested in assets that could be securitized - for example, sub-prime mortgages, car loans and credit card loans. In the boom years of 2005 and 2006, it's thought around 70% of the assets that SPEs invested in were related to mortgages.
So what is a CDO? A CDO is equity or debt issued by the SPE itself. Investors could buy different types of this equity or debt depending upon their appetite for risk.
For example, a risk-averse investor would buy AAA-rated senior tranches of debt - holders of which would be paid back first out of the cashflows coming from the underlying assets (the sub-prime mortgages and the like). By comparison, an investor who didn't mind a bit of risk would buy equity, and would be the first to suffer as a result of any losses. A lot of CDO debt was sold to structured investment vehicles.
What have they got to do with the financial crisis?
CDOs are seen as being at the heart of the credit crunch. From 2003 to 2007 their issuance soared as investors lapped them up. In 2004 the total value of CDOs issued globally was $157bn, according to the Securities Industry and Financial Markets Association (SIFMA). By 2007 this had risen to $503bn.
Why did investors like CDOs so much? It helped that the least risky bonds issued by SPEs were often given AAA ratings by ratings agencies: they offered good returns, but were seen as offering minimal risk of default.
When the credit crunch struck, investors' appetite for CDOs hit rock bottom. Many CDOs were linked to subprime mortgages, which investors wanted nothing to do with. Even CDOs which were totally unrelated to sub-prime mortgages were shunned - largely because CDOs are so complex that it was difficult for investors to gauge which ones were invested in subprime mortages and which ones weren't.
As a result, CDO issuance declined a huge 95% in the first quarter of 2008 compared to the same quarter of 2007 (according to figures from the SIFMA).
With no one wanting to buy CDOs any more, they became virtually worthless. This was a big headache for banks, for several reasons.
In the first place, many had bought CDOs themselves and saw their value wiped out when things went wrong. Secondly, although most SPEs were off banks' balance sheets, some had clauses saying that if the value of assets involved fell below a certain threshold, banks would step in to rescue them. And lastly, many banks had set up the SIVs which bought the CDOs, and felt obliged to step in when things went wrong - or risk losing their reputations in the market.
The resulting writedowns were huge. In March 2008, BusinessWeek quoted figures from Standard & Poor's estimating that total writedowns on CDOs and other asset backed securities by banks in Europe and the US amounted to $110bn. It didn't stop there: Merrill Lynch alone revealed that it had been forced to write down a further $5.3bn of CDOs in the second quarter of 2008 when it announced its results in June.
In late October 2008, Bloomberg predicted another big round of CDO writedowns as CDOs related to corporate debt also went into default. That prediction was borne out as nearly half of all asset-backed CDOs, or $300 billion worth, defaulted by September 2009. Even so, banks, including Morgan Stanley, continue to slice up and repackage CDOs for sale.
Last updated on 7 September 2009.
