 Personal Finance PowerPoint Presentation, Collateralized Debt Obligation CDO. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Collateralized Debt Obligation CDO, which you can find online. Take a look at the references, resources, continue your research from there. This is by Carla Tardy, updated March 8, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is a collateralized debt obligation, a CDO? A collateralized debt obligation CDO is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loans default, supporting the value of the loans. So, understanding collateralized debt obligations CDOs, the earliest CDOs were constructed in 1987 by the former investment bank, Drexel Bernheim Lambert, where Michael Milken then called the quote, junk bond king end quote, resigned or reigned. The Drexel bankers created these early CDOs by assembling portfolios of junk bonds issued by different companies. So those are going to be the high risk type of bonds that could have a higher return related to them, but have more default risk. CDOs are called, quote, collateralized, end quote, because the promised repayments of the underlying assets are the collateral that gives the CDOs their value. Ultimately, other securities firms launched CDOs containing other assets that had more predictable income streams, such as automobile loans, student loans, credit card receivables and aircraft leases. However, CDOs remained a niche product until 2003-2004 when the US housing boom led CDO issuers to turn their attention to some private mortgage-backed securities as a new source of collateralized CDOs. Now, of course, we're going to have the crisis or recession with the housing bubble that happened, which is going to mean that these kind of products got kind of a bad rep during that time, but they were packaged in with a lot of other kind of issues at that point in time that led to basically the research. So it's an interesting topic to dive into and more depth will touch on it a little bit here as we understand the collateralized debt obligations. Collateralized debt obligations exploded in popularity with CDO sales rising almost tenfold from $30 billion in 2003 to $225 billion in 2006, but their subsequent implosion triggered by the US housing correction, so we've got like a recession bubble pop so on, saw CDOs become one of the worst performing instruments in the subprime meltdown which began in 2007 and peaked in 2009. So the bursting of the CDO bubble inflicted losses running into hundreds of billions of dollars for some of the largest financial services institutions. So basically no one really saw this coming like you would think they kind of should have been able to predict to some degree, given the dynamics of everything that was going on, but of course hindsight is hindsight, right, hindsight is 2020. So these losses resulted in the investment banks either going bankrupt or being bailed out via government intervention and helped to escalate the global financial crisis, the great recession during this period. Despite the role and the financial crisis, collateralized debt obligations are still an active area of structured finance investing. So you might think, I mean, a lot of people, there's a lot of people to blame and when a recession happens, so you can think about, well, the banks are involved because they were able to kind of shift the risk and then you've got these investments that took place that were quite complex in nature and then possibly mask some of the risks. You've got rating agencies that basically were rating certain securities quite high because you would think that mortgage backed securities, for example, would be backed by the mortgage backed by the home. So they didn't really see the see things coming. So there's a lot of people you can blame obviously the complexity or more complex investment tools like the collateralized debt obligations are among the things that are going to be blamed. So you would think they're going to go down and basically popularity, but you would think that the strategy, if it was integrated properly, had the correct oversight transparency and the rating agencies were able to just to judge it and so on in a proper function, you could see how that could play out and still be a viable thing under the right conditions possibly. So CDOs and the even more infamous synthetic CDOs are still in use as ultimately they are a tool for shifting risk and freeing up capital, two of the very outcomes that investors depend on Wall Street to accomplish and for which Wall Street has always had an appetite. The CDO process to create a CDO investment banks gather cash flow generating assets such as mortgages, bonds and other types of debt and repackage them into discrete classes or tranches based on the level of credit risk assumed by the investor. These tranches of securities become the final investment products, bonds whose names can reflect their specific underlying assets. So for example, mortgage backed securities NBSs are comprised of mortgage loans and asset backed securities ABS contain corporate debt, auto loans or credit card debt. Other types of CDOs include collateralized bond obligations CDOs, investment grade bonds that are backed by a pool of high yield, but lower rated bonds and collateralized loan obligations CLOs, single securities that are backed by a pool of debt that often contain corporate loans with a low credit rating. Collateralized debt obligations are complicated and numerous professionals have a hand in creating them. These firms who approve the selection of collateral structure, the notes into tranches and sell them to investors, CDO managers who select the collateral and often manage the CDO portfolio, rating agencies who assess the CDOs and assign them credit ratings, financial guarantors who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments, investors such as pension funds and hedge funds. CDO structure, the tranches of CDOs are named to reflect the risk profile, for example senior debt, Mazanine debt and junior debt pictured in the sample below along with their standard and poor S&P credit ratings, but the actual structure varies depending on the individual product. So we've got the debt here, we've got the maturity, the rating, the yield, the price, the coupon and the trench. So in the table note that the higher the credit rating the lower the coupon rate, rate of interest to bond pays annually. So obviously if you have a more secure rating then you would expect then the what you're going to be earning the coupon rate from it to be lower. If you're taking on more risk then you would expect the coupon rate has to be higher because the market wants to compensate that higher risk. Note again when there was a problem in the housing bubble market for example one of the issues was with the rating agencies that didn't seem to be reflecting accurately the levels of risk. So hopefully that's one of the things that are more dependable you know at this point in time as they're looking into these and having a better understanding of them. So if the loan defaults the senior bondholders get paid first from the collateralized pool of assets followed by bondholders in the other tranches according to their credit ratings. The lowest rated credit is paid last. So the senior tranches are generally safest because they have the first claim on the collateral. Although the senior debt is usually rated higher than the junior tranches it offers lower coupon rates. And then conversely the junior debt offers higher coupons more interest to compensate for their greater risk of default. But because they are riskier they generally come with lower credit ratings. So how are collateralized debt obligations CDO created to create a collateralized debt obligation a CDO and basement banks gather cash flow generating assets such as mortgages bonds and other types of debt and repackage them into discrete classes or tranches based on the level of credit risk assumed by the investor. These tranches of securities become the final investment products bonds whose names can reflect their specific underlying assets. What should the what should the different CDO tranches tell tell an investor the tranches of a CDO reflect their risk profile for example senior debt would have a higher credit rating than Mazanine and junior debt. If the loan defaults the senior bondholders get paid first from the collateralized pool of assets followed by the bondholders and the other tranches according to their credit ratings with the lowest rated credit paid last. The senior tranches are generally safest because they have the first claim on the collateral. What is the what is a synthetic CDO. A synthetic CDO is a type of collateralized debt obligation CDO that invests in non cash assets that can offer extremely high yields to investors. However they differ from traditional CEOs which typically invest in regular debts debt products such as bonds mortgages and loans and that they generate income by investing in non cash derivatives such as such as credit default swaps CDs options and other contracts. So synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed by the investor.