What is Collateralized Debt Obligation?

A collateralized debt obligation is marketed to investment firms.

Drexel Burnham Lambert, a former investment organization, first presented CDOs on the US financial scene in 1987. However, it did not garner as much attention until 2008. Collateralized debt obligations (CDOs) picked up steam, with sales nearly doubling from $30 billion in 2003 to $225 billion in 2006.

In other words, it is a mixture of several other, smaller loans which are repacked based on the level of credit risk, and suggested for institutional investors. The smaller loans can be anything from student loans, and mortgages, to bonds.

The time frame between 2003 and 2008 was when the majority of CDOs that were sold were comprised of mortgage-supported securities, which was way riskier. Therefore, many CDOs began to significantly lose their worth when more and more people were forfeiting their mortgages.

When the housing market collapsed in the United States, CDOs surrendered their place as one of the most favored derivative investment choices. Nonetheless, banks continue to employ them on a somewhat lesser level to produce liquidity relatively quickly.

To be fair, the main focus of CDOs is to mix a specific amount of loans into a bigger asset. The asset is resold to a bigger investment company at the end. In this case, individuals or organizations who originally surrendered the loans will get a lump sum of money. The new investor, on the other hand, will gain the loans and the collateral among them.

Properties, cars, and commodities can be a form of collateral that is given to a lender so the borrower could take out a loan. The collateral in the context of collateralized debt obligations is frequently a vehicle or a piece of real estate. Banks generally manufacture CDOs, which are subsequently sold to institutional investors.

In a scenario where banks choose a composition of loans and assets for CDOs, they are searching for ways to develop a balanced ratio between risk and reward.

A CDO can be made up of a wide range of assets. For instance, mortgage-backed securities are made up of mortgage loans. Asset-backed securities, on the other hand, are made up of business and private debt, credit card debt, and auto leases and loans. 

Any of these loans and financial obligations can be included in a CDO.

Considering their part in the financial crisis, collateralized debt obligations are still a popular investment option in structured finance. CDOs are still in use because they are fundamentally a mechanism for moving risk and freeing up capital.