- A secured debt bond (CDO) is a structured credit product that pools assets and conditions them for sale to institutional investors.
- The assets backed by these securities serve as collateral that gives the CDOs their value.
- Research revealed that CDOs were at the heart of the 2007-2008 financial crisis.
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A secured debt obligation (CDO) is a type of security that derives its value from the underlying assets. These assets can include commercial or residential mortgages, bonds, auto loans, student loans, and other types of debt. Assets are bundled and bundled into a product that can be sold to investors as an income producing asset. The promised repayment of the underlying debt serves as collateral.
How do CDOs work?
Investment banks,
retail banks
, commercial banks and other financial institutions create CDOs to sell in the secondary market. As these are extremely complex instruments, it takes sophisticated computer modeling and a team of quantitative analysts to condition the debt and assess the loan bundles that make up a CDO.
Then it takes a number of professionals to bring security to the market. The CDO manager selects the debt for collateral, which can range from mortgages, student loans, and auto loans to credit cards or business debt. Once the CDO manager has selected the debt to be pooled, investment banks can get to work to structure the security. Rating agencies, such as Standard & Poors and Moody’s, assign credit ratings to the CDO.
Finally, the CDO is sold to institutional investors such as pension funds, insurance companies, investment managers and hedge funds. These investors often buy CDOs with the expectation that they will offer higher returns than their fixed income portfolios of similar maturity. CDOs are not available to retail investors and are typically sold to institutional investors in lots valued in millions of dollars.
How CDOs are structured
The CDO market exists because these securities guarantee cash flow to the owner. However, these cash flows depend on the cash flows of the original borrower. The investor receives interest at the indicated coupon rate as well as the principal when the CDO matures. Most CDOs mature at ten years.
CDOs are divided into tranches, each of which reflects a different level of risk. Senior tranches are the least risky, with good credit ratings and lower risk of default. In the event of loan default, the holders of the senior tranche are the first to be paid from the underlying collateral. Payment continues based on the credit ratings of the tranches, with the lowest rated tranche being the last to be paid.
The mezzanine tranche is located between senior debt and subordinated debt. Mezzanine tranches are rated from B to BBB. In the event of default, the mezzanine is paid before the subordinate (junior) installments. As with any fixed income security, the safest tranche will carry the lowest coupon rate, while junior debt will have a higher coupon rate because it carries the greater risk of default.
Are CDOs Responsible for the Global Financial Crisis?
The first secured debt securities were created by Drexel Burnham Lambert in the 1980s, when Wall Street was booming. The bank was well known both for its junk bond business and employed Michael Milken, who was instrumental in developing the junk bond market and was later jailed for breaking securities laws.
Interest in CDOs declined in the 1990s, but increased dramatically in the early 2000s. CDO sales increased from $ 30 billion in 2003 to $ 225 billion in 2006. The United States were experiencing a boom in the real estate market, and financial institutions were quickly creating mortgage-backed CDOs. Home buyers were encouraged by low interest rates, easy credit, and little regulation. In 2003-2004, banks turned to subprime mortgages as a new source of collateral.
In the subprime market, banks offered mortgages to borrowers who would never have qualified under previous standards. The underwriting process became so lax that in many cases full income documentation was not even required. The variable rate mortgage (ARM) was even more dangerous for subprime borrowers. They offered very low interest rates for the first few years of the mortgage, which could then be significantly increased a few years later.
CDOs issued prior to the global financial crisis were mostly made up of securities backed by subprime mortgages, and those backed by other CDOs were also common. In 2006, almost 70% of new CDO pledges were in subprime mortgages, while 15% were secured by other CDOs.
In 2006, investment banks turned to short-term secured borrowing to support CDO activity. On average, they were driving over 25% of their balance each night. When the housing bubble burst, uncertainty surrounding asset prices led lenders to cut overnight borrowing, leaving banks exposed to falling asset prices with little capital. CDO trading stopped, and it was only with the intervention of the
Federal Reserve
buy CDOs that have restored the market.
As Dr. Robert Johnson, professor of finance at Creighton University’s Heider School of Business, explains: “CDOs are extremely difficult to analyze and evaluate. Issuer models did not take into account the correlation between mortgages pooled in CDOs. an economic downturn, mortgages will move in sync. ”
Post-crisis analysis revealed that CDOs were at the heart of the financial crisis. Issuers and investors have ignored warnings about the CDO time bomb and have failed to understand and manage the risks. Bank balance sheets were often not transparent and institutions across the sector were deeply interconnected. Trillions of dollars in risky mortgage-backed securities have been implanted throughout the financial system.
It all came to a head in March 2008, when Bear Stearns found itself almost strapped for cash. Faced with bankruptcy, the company sold itself to JPMorgan. Lehman Brothers was the next to drop. It was only government intervention that saved the financial system and the economy from collapse. A government bailout program has benefited some institutions deemed “too big to fail”.
Advantages and disadvantages of CDOs
Like all assets, CDOs have their pros and cons. Johnson cites diversification as an advantage. “CDOs are created by pooling debt and spreading it over a large number of mortgages. So the investor is exposed to a range of risk levels, ”he says.
By using CDOs, commercial and retail banks can reduce the risks on their balance sheets. They can also trade illiquid assets for CDOs in order to earn
liquidity
. Banks can use the extra cash to expand loans and generate income.
CDOs have two main drawbacks. The first is their complexity, which makes them extremely difficult to analyze and value. CDOs are also vulnerable to repayment risk, as the original borrower can choose to repay the principal, thereby depriving the investor of a cash flow that would typically last until maturity.
Are CDOs Popular Today?
Following the financial crisis, CDOs came under scrutiny. The result was the Dodd-Frank Wall Street Act of 2010 on reform and consumer protection. The law brought about sweeping regulatory reforms aimed at ensuring that the country never experiences another crisis like the one of 2007-2008.
Among other measures, the Act was designed to protect investors, increase disclosures, require risk retention and impose capital requirements. It required creators to keep a specified percentage of a CDO issue, in order to have “skin in the game”. Investors in asset-backed securities are now required to hold more capital than if they were to invest in other asset classes. Following the enactment of Dodd Frank, the market has seen a steady increase in CDO issuance since 2011.
Attempts were made to weaken the law in 2017, and in 2018 President Donald Trump enacted the Economic Growth, Regulatory Relaxation, and Consumer Protection Act. This new law exempted many financial institutions from Dodd-Frank regulation.
The financial report
Secured debt securities serve several purposes. They allow financial institutions to remove debt from their balance sheets to gain liquidity. Investors appreciate the cash flow generated by coupon payments and hope that CDO returns will exceed that of standard fixed income portfolios.
Investment in CDOs is limited to institutional investors (insurance companies, pension funds, hedge funds, etc.). However, for the retail investor, there are mutual funds and exchange traded funds that include CDOs in their portfolios.
