Collateralized Debt Obligations are one of the financial weapons of mass destruction that helped to derail the global financial system in the financial crisis of 2007-2010. They are literally securities that are supposed to be of investment grade. The backing of collateralized debt obligations proves to be pools of loans, bonds, and similar assets. These investments are rated by the main ratings agencies of Moody’s, Standard and Poors, and Fitch rating companies.
The actual value of collateralized debt obligations comes from their asset backing. These asset backed securities’ payments and values both derive from their portfolios of associated assets that are fixed income types of instruments. CDO’s securities are divided into different classes of risk that are called tranches.
The senior most tranches are deemed to be the most secure forms of securities. Since principal and interest payments are given out according to the most senior securities first, the junior level tranches pay the higher coupon payments and interest rates to help reward investors who are willing to take on the greater levels of default risk that they assume.
The original CDO was only offered in 1987 by bankers for Imperial Savings Association that failed and became folded in to the Resolution Trust Corporation in 1990. This should have been a warning about collateralized debt obligations, but their popularity only grew apace during the following ten years. CDO’s rapidly became the fastest expanding part of the synthetic asset backed securities market. There are several reasons for why this proved to be the case. The main one revolved around the returns of two to three percentage points greater than corporate bonds that possessed identical credit ratings.
CDO’s also appealed to a larger number of investors and asset managers from investment trusts, unit trusts, and mutual funds, to insurance companies, investment banks, and private banks. Structured investment vehicles also made use of them to defray risk. CDO’s popularity also had to do with the high profit margins that they made for their creators and sellers.
A number of different investors and economists have raised their voices against collateralized debt obligations, derivatives in general, and other asset backed securities. This includes both former IMF Head Economist Raghuram Rajan and legendary billionaire investor Warren Buffet. They have claimed that such instruments only increase and spread around the uncertainty and risk that surrounds these underlying assets’ values to a larger and wider pool of owners instead of lessening the risk via diversification.
Though the majority of the investment world remained skeptical of their criticism, the credit crisis in 2007 and 2008 proved that these dissenters had merit to their views. It is now understood that the major credit rating agencies did not sufficiently take into account the massive risks that were associated with the CDO’s and ABS’s, such as a nationwide housing value collapse.
Because the value of collateralized debt obligations are forced to be valued according to mark to market accounting, where their values are immediately updated to the market value, they have declined dramatically in value on the banks’ and others owners’ balance sheets as their actual value on the market has plummeted.