(LifeWire) - Like the junk bonds of the late 1980s, collateralized debt obligations, or CDOs, have become the financial headline of their age.
These investment vehicles took much of the blame for turning a downturn in the US housing industry into the general credit crisis of late 2007. But it's important to remember that the term CDO refers to a broad range of investment vehicles, some much easier to understand than others, and some much better at spreading manageable risks among a broad group of investors - the original intent of these securities - than others.
Selling Slices of Risk
Let's start with a basic definition. First introduced in 1987, collateralized debt obligations are simply collections of loans that are bundled together, usually by a bank or by a brokerage house, and sold to investors. The loans can range from short-term corporate business debts to home mortgages.
The key is that the debts are grouped together and sold in slices, known as tranches, according to their expected level of risk. The safest levels, known as the senior tranches, carry the least risk of non-repayment and generally pay the lowest interest rates. The next levels, known as mezzanine debt, are riskier and carry a higher payout. The riskiest levels, known as equity debt, pay the highest periodic interest payments but also carry the highest risk of default.
In theory, everyone benefits from when risk is spread among the largest number of investors possible. Investors in the riskiest equity tranches are the first to lose their payments if loans in the pool start to default, but they get the highest payouts in the meantime. Investors in the mezzanine class get the high payouts they might expect from relatively risky loans, but they are somewhat insulated, because equity shareholders will take the brunt of the earliest defaults, leaving them whole if the damage does not cut too deeply. And senior investors get the benefit of higher payouts than they would normally get from super-safe bonds, because they are, after all, invested in a grouping of loans that includes lower-quality borrowers. But they are the last to suffer the consequences of loan defaults, because the mezzanine and equity investors will take their lumps first.
How CDOs Grew
The concept grew popular through the easy-credit years that followed the terrorist attacks of 2001. The Securities Industry and Financial Markets Association, a trade group, tracked the growth in global CDO issuance from $157 billion in 2004 to a peak of $552 billion in 2006, tailing off only slightly to $486 billion in 2007
In effect, the rapid rise of CDO sales allowed borrowers to tap a whole new vein of cash as banks and other financial institutions threw money around, assuming they would always have the ability to sell off the debts to a vast global body of willing investors, in some cases retaining the servicing rights on these liabilities in exchange for even more attractive fees (serving rights are a huge business in which an institution is paid to collect, maintain records about, and otherwise manage debt often owned by a third party).
A slew of variants arose in the process, giving rise to such exotic animals as the "synthetic" CDO - a financial instrument whereby investors don't invest in actual loans but instead (in effect) insure groups of loans against default in exchange for regular premium payments, spreading the risk ever further from the original writer of the loan to the general marketplace.
As long as the general financial health of US borrowers remained sound, this system worked like magic for all involved. The investment houses that created CDOs profited from their creation and from their subsequent management. The major ratings agencies, including Standard & Poor's and Moody's, profited from helping investment firms structure their CDOs to obtain the highest possible credit ratings, and then again from providing the credit ratings.
Investors also remained relatively safe until - well, until they weren't.
Cracks Appear
The first break in investor confidence in the CDO approach came in the summer of 2007, when a wave of mortgage defaults among mostly subprime borrowers cut more deeply into some CDO tranches than investors had thought probable. As the nation's housing market and general economy softened further, investors began to suspect the health of even the highest tranches in some CDO instruments - especially those, such as the synthetic CDOs, that carried the highest rates of leverage with the least protection.
Ultimately, a freeze in confidence led to a chill in sales, which, in turn, made it ever more difficult for banks and other institutions to perform a "mark to market" on their CDO inventories - in other words, to estimate a reasonable sales price for what they owned. Large write-offs in asset value (at least on paper) at several major banks and investment institutions were among the results.
