Collateralized debt obligations (CDOs) are derivates that are used for repackaging the debt products and are sold in the secondary market. Banks and other financial institutes have large portions of asset-backed loans and debt products. These institutes sell these debt obligations to investors in the secondary market.
Collateralized Debt Obligations are backed by assets and offer security to investors. These derivatives are classified based on the credit ratings of the debt instrument. Investors would seek a higher rate of return on investments with lower credit rating CDOs. CDOs are important but risky products for banks and financial institutes to monetize large assets held as reserves.
What are Collateralized Debt Obligations?
Collateralized debt obligations (CDOs) are derivative products sold by banks and other financial institutes. These are pooled debt products into a repackaged product that offers returns to investors. The prices of CDOs are derived from the price movements of the underlying debt product(s).
Collateralized debt obligations are called so because these are backed by collateral. In the case of default, the debt products become collateral for the investors. However, these debt products can comprise secured and unsecured debts. Thus, CDOs are categorized into different categories according to their risk profile called trenches.
CDOs can consist of several types of debt products. A CDO can have only one type of debt or a mix of debt products as well. These debt products include bonds, mortgages, credit card loans, bank loans, and so on.
How do the Collateralized Debt Obligations Work?
A Collateralized Debt Obligation (CDO) is created by a bank by pooling different debt products into a single fund. These debt products indicate the security and credit rating of the CDO. These products include corporate bonds, mortgage bonds, mortgage loans, auto loans, credit card loans, and so on.
Banks generate income from these debt instruments. That generated income is then distributed to the investors in the CDOs. The CDO portfolio is structured according to the credit rating and hence offers different yields on investment.
A collateralized debt obligation is a portfolio of several debt instruments. These instruments are categorized based on their credit ratings and risk profiles. The categorization is termed as trenches of CDOs.
These trenches include:
- Senior debt – with AAA or above ratings
- Senior debt with AA ratings
- Mezzanine rating with BBB or above
- Junior debt with a B rating
The credit rating will impact the rate of return as well. As a higher credit rating means more security, hence, these debts would offer a lower yield on investment. Conversely, unsecured or lower rating debt instruments would offer a higher yield for higher risks.
Special Considerations with Collateralized Debt Obligations
Collateralized debt obligations are derivatives. It means they derive their value from the performance of other assets; debt products in this case. As has happened in the past, if customers of these debt products default on their payments, it eventually will affect the CDOs. It has happened in the past when customers of sub-prime mortgages started to default on their payments. In turn, mortgage debt CDOs lost their values and banks lost billions of dollars of their investments.
The investors of CDOs also do not fully understand the risk. As they cannot appraise a large pool of debt products bundled into a single one. Also, it is difficult to value a CDO for various reasons. Hence, investors in CDOs are always at risk of default and their collateral would also lose value. It is because the CDO’s value depends directly on the value of the debt products in contains.
Advantages of Collateralized Debt Obligations
CDOs offer several advantages to banks and investors alike.
- CDOs transfer the risk of default of debt products from banks to the investors.
- Banks receive cash for further investments and offering new debt products.
- CDOs are more profitable and more liquid products for banks than other forms of debt instruments.
- Investors receive a higher rate of return on such risky investments.
- Investors can use CDOs as marketable securities for making short-term profits.
Disadvantages of Collateralized Debt Obligations
Collateralized debt obligations come with several risks and disadvantages too.
- CDOs are complex debt products.
- These are risky products and their value depends on the performance of other debt products, hence called derivative instruments.
- It is difficult for investors to appraise the security and risk of the CDOs.
- CDO products can cause economic recessions and downfalls if not managed properly as we had seen in the past with the global financial crunch.
Conclusion
Collateralized debt obligations are derivative instruments. These are a portfolio of different debt products such as bank loans, mortgages, credit card loans, bonds, etc. Banks can use these instruments to generate profits and liquidity. However, investors of CDOs remain at risk despite the collateral pledged against the default risk.
