From being a niche investment product in the 1990s to a catalyst for the global financial crisis, Collateralised Debt Obligations (CDOs) have gained significant notoriety. So, how did CDOs become so prominent? In this article, we look to trace their evolution from inception to the present day.
Collateralised Debt Obligations (CDOs) are structured financial products that are backed by loans (and other assets) which are then sold to institutional investors. Essentially, cash-flow generating assets (bonds, mortgages and other debt) are bundled together into discrete tranches and sold to investors.
The names given to these tranches are determined by the type of underlying debt that each tranche contains. Mortgage-backed Securities (MBS) are derived from mortgage loans, whereas Asset-backed Securities (ABS) contain assets such as corporate debt and credit card debt. CDOs are so-called because the expected payments of the underlying assets are the collateral that gives the CDO its value. There are several different types of CDO – most notably Collateralised Bond Obligations (CBOs), an investment-grade security where the underlying instruments have a high yield coupled with a lower credit rating. There are also Collateralised Loan Obligations (CLOs), a security whereby the underlying instruments are different types of debt. Quite often, these are corporate loans with junk credit ratings (“BBB” or lower Standard and Poor’s credit rating).
Although initially constructed in 1987, CDOs remained relatively niche for the first 15 years and mainly contained underlying securities with reasonably predictable income streams (for example, car loans and student loans). It wasn’t until 2003-2004 when the US was in its housing boom when CDO issuers started using subprime mortgages as underlying instruments. It was taking this approach that led to the CDOs popularity to soar. Between 2003 and 2006, sales in CDOs rose from $30 billion (USD) to $225 billion (USD).
In 2006 the US housing market started to slow. The housing bubble had been causing inflation which led to the US Central Bank raising interest rates to correct it. As a result, many subprime mortgage holders were no longer able to meet their mortgage repayments and started defaulting on their mortgages. Mortgage lenders were then subsequently selling these houses but into a declining housing market. As a result, the demand for CDOs began to waiver.
Left with CDOs that were becoming worthless, holders invented new ways to package them in order to sell them and ultimately remove them from their books. One way to do this was to create CDOs whose underlying securities were also CDOs. This is known as CDO-Squared. Essentially, the toxic parts of a CDO could be put inside another CDO, making the original CDO easier to sell. This cycle continued with the toxic parts of the CDO-Square being put into another CDO and so on. At the height of the housing boom in 2005 the riskiest mortgages typically made up about 5% of a CDO. By 2007 this had ballooned to nearly 40%.
This all started to come to a crashing halt in 2007 with the US housing market correction and subprime meltdown. CDO issuers became stuck with tranches so toxic they were impossible to sell. CDOs rapidly became one of the worst-performing financial instruments. As credit rating agencies started to downgrade them, pension funds were forced to sell their holdings as they were no longer legally entitled to hold them. Many holders were forced to write off billions of CDOs in their US mortgage books. HSBC wrote off $10 billion (USD), whereas CitiGroup lost $34 billion (USD) and Merrill Lynch $26 billion (USD). AIG (which had sold nearly $500 billion (USD) worth of Credit Default Swaps to effectively insure against defaulting CDOs) could not meet its payments.
Perhaps the most well-known casualty of holding CDOs was Lehman Brothers, which at the time of collapse, was massively invested in mortgage-backed securities (in particular, subprime mortgages, commercial mortgages, high-yield securities and leveraged loans).
In recent years, CDOs have started to make somewhat of a comeback. Losing their tainted ‘CDO’ name, they are now called ‘Bespoke Tranche Opportunities’ (BTOs). BTOs are much more tailored than traditional CDOs and highly customised based on investor’s requirements. They are essentially a CDO that is backed by single-name Credit Default Swaps whose primary investor are hedge funds. BTOs are highly illiquid with a very small secondary market. This makes them very risky as a lack of a market depth makes daily pricing of these instruments difficult.
At present, BTOs are not thought to be a threat – $50 billion (USD) were sold in 2017, substantially lower than the peaks achieved by CDOs seen in the previous decade.
James Girling
Managing Consultant