A collateralised debt obligation (CDO) is a type of financial product – a credit derivative – which is backed by an underlying pool of loans. An investment bank pulls together mortgages, bonds, car loans, or any other type of debt, bundles them all up, then repackages them to sell to investors.
You can think of this process – securitisation – as like baking a cake. The different loans form the ingredients of the cake. The cake is then sliced into “tranches”. The riskiest tranches (those with the lowest credit rating) are last in the queue to get paid, while the least-risky tranches – the senior tranches – are first. So if any of the loans default, the riskiest tranches will suffer losses first. This is reflected in the higher yields on offer on the latter.
There are many different types of CDO, including mortgage-backed securities (MBS); asset-backed securities (ABS), which might contain car loans and credit card debt; and collateralised loan obligations (CLOs), which are backed by loans to businesses.
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The benefit to the bank of securitisation is that it gets the loans off its balance sheet and thus frees up more capacity for further lending. The benefit to investors is that the underlying loans behind CDOs are usually higher risk and so will offer better yields than most other debt. But because the investor is buying into a pool of loans, the risk is reduced (certainly for investors in the more senior tranches).
CDOs first appeared on the scene as far back as 1987, when they were backed by junk bonds. But they are best known for their starring role in the global financial crisis from 2007 to 2009. The US property bubble of the early 2000s created huge demand for exposure to CDOs backed by US sub-prime mortgages. When the housing bubble burst and homeowners started to default on these mortgages, the value of the CDOs collapsed and via various interconnections, threatened the solvency of the global financial system.
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