CDO, Collateralized Debt Obligation, became well known term after the global financial crises. The subprime mortgage bubble was created by an enormous amount CDOs. They became financial weapons of mass destruction. But what are collateralized debt obligations really?
CDOs are securities that are made up of bundles of asset-backed bonds, or to put it in simpler terms, portfolios of bonds or credit default swaps. The first CDO was issued in 1987 and until 2002, they were mostly made up of corporate and emerging markets bonds. By keeping the debt in the CDOs diversified, the risk was smaller at the same time as the return was typically better than for normal bonds.
But in 2003 some people started become greedy and things started to go in the wrong direction. Mortgage-backed securities started to increase in the CDOs. According to some estimations, already in 2004 more than half of the of the collateral in CDOs was made up of mortgage-backed securities. In other words, the diversification was decreasing. And the subprime mortgage bubble was just getting worse.
With the diversification getting smaller, the CDOs should really have become riskier. But the creators of CDOs had a way of getting around this problem. CDOs were sliced and diced into tranches. These tranches determine how the cash flow of interest and principal payments are divided. The riskiest tranche paid the highest yield but would also be the first to lose out if any of the assets in the CDO defaulted. In essence, the lower the yield, the more secure the tranche was supposed to be.
In other words, CDOs could be tailored to suit both people who wanted to speculate, high risk but also high return, as well as those who preferred low risk and low return. Not only that but also to suit everyone in between these two extremes.
With the increasing dependence on mortgage-based securities in CDOs, things started to get risky. Unfortunately, most people realized this once it was too late. Despite that risk was concentrated rather than diversified, CDOs and related financial instruments still got the highest rating by the rating agencies.
Things got more complicated by the creation of CDO squared, CDOs made up of CDOs. Unfortunately, it was just a way of hiding the fact that much of the underlying assets were made up of subprime mortgages. Far too many of them were so-called NINJA loans, to people with no income, no job, no assets. Even worse was that many of them had been allowed to borrow 100% of the property price. Add to that often an initial teaser rate was used to keep the monthly payments low, and you have a recipe for disaster. As long as house prices kept on rising, things looked good. But the frenzy just pushed already high house prices through the roof and once the market crashed, so did the value of the CDOs.
If it was not bad enough that CDOs with triple A-rating become either worthless or in best case, impossible to value, a lot of financial institutes had used leverage. They had borrowed money to buy what turned out to be more or less worthless CDOs and many of them could not repay their debts. Even worse, in a global world, almost every financial company was in one way or other involved, either by directly owning CDOs or by having lent money which went into CDO investments.