The Complex Structure of Collateralized Debt Obligations

The US subprime crisis began to unfold when the American housing market was burst with record-level delinquencies and defaults coupled with negative economic sentiments that led to broad sell off of collateralized debt obligation (CDO) holdings by investors. So what kind of financial animal is this so-called CDO?

CDOs are consolidations of a group of fixed income assets divided into tranches in accordance with the cash flow and risk category. Higher rated tranches, protected by the subordinated security structure, offer lower coupon rates or interest rates, like the triple-A and mezzanine tranches. Meanwhile, the lower rated tranche, i.e., subordinated tranche, offers higher coupon or interest rates to compensate for the higher risk.

Furthermore, CDOs are complex financial instruments born out of the concepts of securitization or the process of transforming illiquid financial assets, like mortgages and credit card receivables, into marketable securities. The results that spawned from this innovative process are called structured finance instruments, which are backed by the cash flow of the underlying pool of assets. Such instruments include asset-backed securities (ABS), mortgage-backed securities (MBS) and CDO. ABS are bonds or notes collateralized by the cash flows from a specified pool of underlying assets, while MBS are ABS which cash flows are backed by the principal and interest payments of a set of mortgage loans.

The are two major types of CDOs, such as the collateralized loan obligations, which are backed primarily by leveraged bank loans, and structured finance CDOs, which are backed primarily by ABS and MBS. The latter type, backed by subprime mortgages, is the main culprit in the present credit crunch.

When American subprime borrowers started to default on their obligations, the effect was so devastating in the US housing market. The damage was so severe especially for the subprime backed CDO that the effects even went up to the higher rated tranches. These higher rated tranches had also found its way to the portfolio of investors outside the US due to its investment-grade appeal. Thus, when the credit crisis broke out it rippled globally.

On the othere hand, since there is no formal exchange for CDOs, valuation, transparency and credit rating became a concern by major banks and investment firms. As a result, massive writedowns took place among the financial heavyweights like the Citigroup, HSBC, Bear Sterns, Morgan Stanley, among others, which prompted rating agencies to downgrade their credit ratings on these investments.

Most analysts say that the credit crisis could be averted had the holders of the higher rated tranches did not hit panic button and unload their investments; however, “herd mentality” prevailed among them which had caused a downward spiral of CDO prices.

Yet, for all its flaws and the havoc it wrought, CDOs are still a good investment choice for those who are seeking higher yields and diversification. It is only a matter of time that investors should wait for the CDO market to recover itself from its downfall and correct itself on its next sojourn.