Collateralized debt obligations (CDOs) are tricky things to understand and they are also both credited and blamed for the economy. Collateralized debt obligations are investments that financial institutions, such as banks, create so that they can get rid of some of their debt and free up more room in their balance sheets to issue more loans. With collateralized debt obligations, lenders will stockpile their loans, such as auto loans or mortgages, and sell the interest to a third-party investor. It benefits the lender because not only do they now have more money to lend but they also don’t have to chase down people who have defaulted on a loan. It also benefits the investor who buys the CDO because they are now making profit off a loan that they never issued.
CDOs have many different categories, or tranches. These tranches are divided up into equity securities, junior securities, and senior securities. These tranches determine which categories will be paid first should other tranches be defaulted on. This means that if there are not payments made on the CDOs, or the CDO does not perform as expected, first payments will be given to senior tranches, then junior tranches, with equity tranches being the last to receive funds from defaulted CDOs. Senior and junior tranches are given ratings of A to AAA, meaning that they take precedence and equity tranches are given ratings of B to BBB. These ratings are indicative of the collateral that the CDO is based upon and also speaks of how high a credit risk a particular CDO is.
One of the main downfalls to CDOs is that the company that buys the CDO does not really know the full value of the CDO. This means that although the investor will know that they are receiving a pool of collateralized debts, they do not know the value of the debts. The only information they are given is through the portfolio manager. The portfolio manager is a designated person at the original lending company that compiles CDOs and pairs interested investors with loan portfolios. The investor then has only the word of the portfolio manager regarding what lies within said portfolio.
Another downfall of CDOs is that there are many, many different types of these portfolios. Cash-flow, or market-value, CDOs consist of portfolios that pay interest and gives cash-flow to the investor. If the cash-flow is lower than expected, investors will be paid according to the tranches that their portfolio lies. Those who have equity tranches will be paid last, while those with senior tranches will be paid first. Balance-sheet CDOs and arbitrative CDOs are two other distinctive types of CDOs. With balance sheets, the lending institution is simply trying to sell off its loans to free up other money to hand out more loans. With arbitrative CDOs, lending institutions are trying to add value to existing portfolios by grouping them into tranches and regrouping the collateral.
Collateralized debt obligations in the beginning were praised for being an answer to the quick down-turn of the United States in 2005. This was because they gave lending institutions more money to lend by freeing up some space on their balance sheets. However, when the economy crashed in 2008, many people turned to CDOs to blame. This was because when people started to lose their homes due to foreclosure, no one really knew who owned the mortgages because everyone seemed to have a hand in them. The fact that many of the companies that invested in CDOs didn’t really know what they were getting, and it only compounds the problem.
