Collateralized debt obligations, also known as CDOs, are securities that are collateralized by bonds, loans, and other assets. Typically, a bank or brokerage house bundles together a group of loans. These securities are then sold off to investors in slices, or tranches. The cash flows that the underlying asset produces are paid out to investors in these different tiers. Each slice or tranche pays a different respective rate depending on the level of risk associated with it. Those with the lowest risk are paid off first at a lower rate. The tranche with the lowest risk is known as the senior tranche because it is the first to pay cash flows from the underlying asset. Following the senior debt, the mezzanine and then the equity debts are paid off. These subsequent payments have a higher associated rate due to a higher level of risk undertaken. Sometimes, these junior and equity debts are not paid due to failure of the underlying asset. Senior debts may also experience non-payment, but with much less frequency. CDOs were originally created to increase liquidity. They enable banks and corporate entities to sell off debt. This in turn allows them to use this new capital for other investments or loans. However, doing so does not necessarily reduce risk, but rather spreads risk and ambiguity concerning the true value of the underlying asset among a large number of investors. Additionally, a structural problem with CDOs is that they allow for significant fees to be generated upon creation. Consequently, originators of CDOs have incentive to focus on loan volume rather than loan quality. This paper will thoroughly analyze CDOs’ complexity, variety, trade process, and relevance to the financial crisis. Intially, Drexel Burnham Lambert Inc created CDOs in 1987 for a savings institution called Imperial Savings Association. Within the next ten years the fairly new concept, collateralized debt obligations, became the quickest growing segment of the asset-backed securities market. However, several factors contributed to this rise in fame. In 2001, David X. Li introduced a computer-based financial model that quickly computes the likelihood that corporations will default on their bond debt. This model suggested the return investors should expect to receive from the credit derivative, as well as the risk involved and ways to reduce that risk. As a result, large investors began to use the model to undertake huge gambles. Another factor that has contributed to the rapid growth was the introduction of the synthetic CDOs market. Synthetic CDOs involve investors insuring loans against default. In return, these investors receive regular premium payments. In this way, investors are not actually investing in real loans but are gaining exposure to a fixed income asset portfolio. By 2005, nearly 75% of issued CDOs were synthetic CDOs. This report, constructed by research firm Celent, estimated the approximate global CDO market at 1.5 trillion USD and projected growth to 2 trillion by the end of 2006.
Sources of Funds Naturally, the complexity of the CDOs gradually expanded to include a wide range of funds and functions. Within the category of collateralized debt obligations, there are different types of structures for these securities. Each can be categorized by their source of funds, motivation and the funding used to pay out investors. The first classification for collateralized debt obligations is the source of funds for paying investors of these securities. Within this classification, the CDOs can be funded in one of two ways. The first type, cash flow CDOs, is funded through the interest and principal of committed liabilities. A portfolio of cash bearing securities, which are used to pay the investors their interest, based on their respected tranches, backs these CDOs. With interest and payments from the liabilities being funded by the collateral in pools of debt assets,