what is a collateralized debt obligation 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 loan defaults investopedia xiaojie liuunderstanding collateralized debt obligations cdos the earliest cdos were constructed in 1987 by the former investment bank drexel burnham lambert where michael milken then called the junk bond king reigned the drexel bankers created these early cdos by assembling portfolios of junk bonds issued by different companies cdos are called collateralized because the promised repayments of the underlying assets are the collateral that gives the cdos their value 12to 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 for example mortgage backed securities mbs 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 cbos 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 3ultimately other securities firms launched cdos containing other assets that had more predictable income streams these included automobile loans student loans credit card receivables and aircraft leases however cdos remained a niche product until 2003 2004 during the u s housing boom issuers of cdos turned their attention to subprime mortgage backed securities as a new source of collateral for cdos 4cdo structurethe tranches of cdos are named to reflect their risk profiles for example senior debt mezzanine debt and junior debt pictured in the sample below along with their standard and poor s s p credit ratings but the actual structure varies depending on the individual product investopedia sabrina jiangin the table note that the higher the credit rating the lower the coupon rate rate of interest the bond pays annually 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 5the 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 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 senior debt higher credit rating but lower interest rates junior debt lower credit rating but higher interest rates cdos and the subprime mortgage crisiscollateralized debt obligations exploded in popularity in the early 2000s when issuers began to use securities backed by subprime mortgages as collateral cdo sales rose almost tenfold from 30 billion in 2003 to 225 billion in 2006 3a subprime mortgage is one held by a borrower with a low credit rating which indicates that they might be at a higher risk of default on their loan these subprime mortgages often had no or very low down payments and many did not require proof of income to offset the risk lenders were taking on they often used tools such as adjustable rate mortgages in which the interest rate increased over the life of the loan there was little government regulation of this market and ratings agencies were able to make investing in these mortgage backed securities look attractive and low risk to investors cdos increased the demand for mortgage backed securities which increased the number of subprime mortgages that lenders were willing and able to sell without the demand from cdos lenders would not have been able to make so many loans to subprime borrowers 6some banking executives and investors did realize that a number of the subprime mortgages that backed their investments had been designed to fail but the general consensus was that as long real estate prices continued to go up both investors and borrowers would be bailed out however prices did not continue to rise the housing bubble burst and prices declined steeply subprime borrowers found themselves underwater on homes that were worth less than what they owed on their mortgages this led to a high rate of defaults 7the correction in the u s housing market triggered an implosion in the cdo market which was backed by these subprime mortgages cdos became one of the worst performing instruments in the subprime meltdown which began in 2007 and peaked in 2009 the bursting of the cdo bubble inflicted losses running into hundreds of billions of dollars for some of the largest financial services institutions 8these losses resulted in the investment banks either going bankrupt or being bailed out via government intervention this impacted the housing market stock market and other financial institutions and helped to escalate the global financial crisis the great recession during this period despite their role in the financial crisis collateralized debt obligations are still an active area of structured finance investing 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 outcomes that investors depend on wall street to accomplish and for which wall street has always had an appetite benefits of cdoslike all types of assets cdos have benefits as well as drawbacks their role in the housing bubble and the subprime mortgage crisis was the result of their main disadvantages complexity which made them difficult to value accurately and being vulnerable to repayment risk particularly from subprime borrowers however there are also two main benefits 