The collateralized debt obligation is a twist on ABS and based on a mix of ABS, residential or commercial MBS, and even derivatives like credit default swaps (see below). The value of the CDO is based on the value of these underlying assets.
CDOs were constructed so that the assets they contained could be divided into different groups, or tiers (or tranches in Wall Street-speak), with separate credit ratings meant to appeal to a broader range of investors. Sound complicated yet? The top tier was the “safest” with the highest credit rating, going on down to the bottom. If defaults on the underlying assets began, the lowest tiers lost money first.
But investors like banks, insurance companies, hedge funds and investment managers looking to outperform their benchmarks looked to investments like CDOs for better yields. CDOs were sold as instruments that could contain risk while providing high income. But when they faltered, the CDOs became impossible to sell and banks, funds and others holding them had to write off a significant amount of their value.
Investors who bought the CDOs had taken their eyes off what made up the securities in the first place, the quality of the loans and the types of borrowers they represented, Tavakoli said.
Wall Street also managed to magnify these risks by creating CDO-squared and CDO-cubed, taking specific parts of the CDO credit layer and ramping up the wager, often with derivatives.
In 2007, more than $1 trillion of CDO were outstanding, according to Sifma. At the end of last year, $716 billion was outstanding, nearly all of it ($542 billion) in a subcategory called collateralized loan obligations, which represent bundles of leveraged loans to companies. CLOs have been a hot investment lately, with the dollar amount outstanding nearly doubling since 2013.