Collateralized debt obligation

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.

The CDO is "sliced" into sections known as "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual.

In 2005, as the CDO market continued to grow, subprime mortgages began to replace the diversified consumer loans as collateral. By 2004, mortgage-backed securities accounted for more than half of the collateral in CDOs. According to the Financial Crisis Inquiry Report, "the CDO became the engine that powered the mortgage supply chain", promoting an increase in demand for mortgage-backed securities without which lenders would have "had less reason to push so hard to make" non-prime loans. CDOs not only bought crucial tranches of subprime mortgage-backed securities, they provided cash for the initial funding of the securities. Between 2003 and 2007, Wall Street issued almost $700 billion in CDOs that included mortgage-backed securities as collateral.

The rise of "ratings arbitrage"—i.e., pooling low-rated tranches to make CDOs—helped push sales of CDOs to about $500 billion in 2006, with a global CDO market of over US$1.5 trillion. CDO was the fastest-growing sector of the structured finance market between 2003 and 2006; the number of CDO tranches issued in 2006 (9,278) was almost twice the number of tranches issued in 2005 (4,706).

Subprime mortgages had been financed by mortgage-backed securities (MBS). Like CDOs, MBSs were structured into tranches, but issuers of the securities had difficulty selling the more lower level/lower-rated "mezzanine" tranches—the tranches rated somewhere from AA to BB.

To deal with the problem, investment bankers "recycled" the mezzanine tranches, selling them to underwriters making more structured securities—CDOs. Though the pool that made up the CDO collateral might be overwhelmingly mezzanine tranches, most of the tranches (70 to 80%) of the CDO were rated not BBB, A-, etc., but triple A. The minority of the tranches that were mezzanine were often bought up by other CDOs, concentrating the lower rated tranches still further.

IMF Diagram of CDO and RMBS

In the summer of 2006, the Case–Shiller index of house prices peaked. In California, home prices had more than doubled since 2000 and median house prices in Los Angeles had risen to ten times the median annual income. To entice those with low and moderate income to sign up for mortgages, down payments and income documentation were often dispensed with and interest and principal payments were often deferred upon request.

Mezzanine tranches started to lose value in 2007, by mid year AA tranches were worth only 70 coins. By October triple-A tranches had started to fall. Regional diversification notwithstanding, the mortgage backed securities turned out to be highly correlated