What are Collateralized Debt Obligations and How do they Work?

Collateralized debt obligations (CDOs) are a very important and popular type of credit derivative. With the growth in structured finance, the origination and trading of collateralized debt obligations (CDOs) has seen a massive uptick. Their demand has increased multifold and as a result, newer products such as synthetic collateralized debt obligations (CDOs) are also being used widely in the marketplace.

In this article, we will explain the concept of collateralized debt obligations (CDOs) in detail. We will have a look at plain vanilla CDOs and synthetic CDOs and will try to understand the difference between them.

What are Plain Vanilla Collateralized Debt Obligations (CDOs)?

The term collateralized debt obligations (CDOs) was made famous during the 2008 credit crisis. These instruments are basically the result of what is called the "securitization" process. The securitization process is a mechanism to delink the credit risk of the originator from the credit risk of the underlying asset.

In simple words, this means that several loans are bundled together to create an asset pool. There are securities issued to investors wherein they purchase the cash flows which would emanate from this underlying cash pool. These securities are issued in tranches wherein the lower tranche securities have a higher chance of defaulting.

The end result of this process is that even if the bank originating the security goes bankrupt, it would have very little impact on the amount of cash flows being generated from these securities. Similarly, if the cash flow from these securities dries up, it would not impact the bank since they have already offloaded these assets from their books. Collateralized debt obligations provide a mechanism for banks to limit their exposure to debt by allowing the sale of debt that has already been originated.

What are Synthetic Collateralized Debt Obligations (CDOs)?

In the above example, the securities being sold were backed by actual assets i.e. cash flows being generated by loans. This is the reason they were called plain vanilla collateralized debt obligations (CDOs).

Structured finance has made it possible to create collateralized debt obligations (CDOs) from derivative products instead of from underlying assets. Such instruments are called synthetic collateralized debt obligations (CDOs). Synthetic CDOs can be thought of as being a meta derivative. This means that they are a second-order derivative. Their value is dependent upon the value of another derivative which in turn is contingent upon the value of an underlying asset.

How do Synthetic Collateralized Debt Obligations (CDOs) Work?

The credit default swap is the instrument most commonly used in the creation of synthetic collateralized debt obligations (CDOs). Normally, a group of investors comes together to create a fund pool. This fund works as an insurance company. It provides protection to other investors by selling credit default swaps. The working of the credit default swaps has already been explained in an earlier article. These credit default swaps require no initial cash outlay and generate money in the form of periodic premium payments.

The investment bankers bundle together these credit default swaps and sell them as securities. These securities are called synthetic collateralized debt obligations (CDOs). Just like plain vanilla CDOs, the tranching process takes place here as well. This means that buyers of lower tranches are exposed to more risk and return whereas buyers from higher classes are exposed to less risk and return. The only difference is that the asset being sold is not the bond but a credit default swap. Synthetic collateralized debt obligations (CDOs) have also become very popular because they create an extremely liquid market for credit default swaps.

How do Collateralized Debt Obligations Work in Case a Credit Event Takes Place?

If any of the credit event mentioned in the contract does take place, it becomes the legal responsibility of the collateralized debt obligation holder to compensate the sellers of credit default swap. Hence, in such cases, the trustees of the fund dip into the coffers and payout the amount based on what was agreed upon in the contract.

In case, the amount of money in the fund falls below a certain threshold, the fund calls for more money to be contributed. Synthetic CDOs are considered very risky since they sell protection worth several times the money that they have on hand. However, tranching has made the diversification of risk possible. The top two tranches are very secure and the chances of them facing a credit event are extremely less.

Why are Collateralized Debt Obligations Considered to be Very Risky?

The problem with collateralized debt obligations is that they could expose the investors to a lot of risks. The liability of investors may not necessarily be restricted to the amount of money that they have put in the pool. This is because there could be multiple credit events that the credit default swaps would have to insure. This is the reason that in the 2008 crisis, the people holding CDOs were negatively impacted by the outcomes. The impact was so severe that several funds had to file for bankruptcy within a short span of time.

Just like all credit derivatives, collateralized debt obligations were created as a means to reduce risk. However, over time they have been used for speculative purposes which amplifies the risk on the balance sheet of the individual players as well as the system as a whole.