Collateralized debt obligation


Financial Alphabet Soup

Securitization didn't stop with plain-vanilla RMBS. It evolved rather into a dizzying, mind-numbing alphabet soup of financial products. The most notorious was called a collateralized debt obligation (CDO). This was essentially just a mutual fund for bonds and loans. Like a stock mutual fund, which holds stocks from many different companies, a CDO buys bonds; these can be straight-up corporate bonds, or securitizations backed by mortgage loans, credit cards, auto loans, and so on. One key benefit of stock mutual funds is diversification; they enable investors to avoid the risk of keeping too many eggs in one basket. In theory, the same benefit applies to a CDO.

If the CDO invests in a wide enough variety of bonds, it should be less risky.7 The CDO's lineage can be traced back to the late 1980s, but it came into its own in the early 2000s.8 CDOs were backed initially by investment-grade corporate loans and bonds and were particularly attractive in the wake of the tech-stock bust, when businesses had to offer high interest rates to attract nervous investors to buy their debt. CDO managers could make good money by simply collecting these interest and principal payments, passing most of it along to CDO investors and keeping a cut for themselves.

But this simple scheme became increasingly difficult as the economy improved; financial pressure on firms receded, as did bankruptcies, and corporate bond yields declined. CDO originators mostly investment banks quickly focused their attention on higher-yielding credit-card and auto-loan-backed securities, and ultimately on mortgage securities, including those backed by subprime loans.

The product they created was referred to as an ABS CDO (because "asset-backed security collateralized debt obligation" was quite a mouthful), and it exploded onto financial markets. ABS CDO issuance soared from virtually nothing in 2002 to what would have likely been $300 billion in 2007, if not for the subprime financial shock ABS CDOs were overwhelmingly popular; they seemed to offer a win-win proposition for everyone. Investors liked CDOs for their high returns, apparent diversification benefits, and the ability to precisely calibrate the risk they were taking on. CDOs have the same tranching structure as traditional securitization, with payments going first to senior tranches, and then mezzanine tranches, and an equity tranche that shouldered the most risk.

CDO managers collected fat fees that were especially attractive if the CDO allowed for active management of the securities in the CDO. Managers could buy and sell securities out of the CDO to enhance its return or lower its risk. CDO originators also earned lucrative fees and solved one of their biggest problems in putting together a securitization namely finding enough investors for all the tranches. At times, depending on market conditions, investors weren't quite as interested in one or other of the tranches. Mezzanine tranches in particular could be a tough sell. Most investors either wanted the safety of a senior tranche or the high return of the equity tranche, not the stuff in the middle.

So-called mezzanine CDOs were created from the mezzanine tranches of traditional securitizations, tranching them up further and creating more of the better-liked senior and equity tranches, but now within a CDO.

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This article was sent to us by: Silvia McVolan at 06102010

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