Collateralized Debt Obligation, Definition and Risks
What is Collateralized Debt Obligation?
A Collateralized Debt Obligation (also known as CDO ) is virtually a debt obligation, with the latter exercising the collateral security role. A CDO consists of hundreds or tens of ABS bonds, which in turn are guaranteed by a large number of individual debts. Collateralized Debt Obligation is considered one of the primary causes that led to the crisis of subprime securities.
The reimbursement of CDOs is not based on the liquidation of assets by the issuing company or on the income prospects of a given company, but only and exclusively from a set of underlying bonds that are defined, in fact collateral and which identify a financial or real asset. which guarantees the timely payment of a debt.
In the case of a Collateralized Debt Obligation, the company issuing the security does not issue bonds to finance investment plans, since it does not perform a real economic activity but rather consists of buying and holding a portfolio consisting of ABS bonds and their any tranches.
The latter are usually cataloged according to the risk that their underlying assets represent. After proceeding with the purchase of the bond portfolio, the issuing company transforms it into a Collateralized Debt Obligation and then transfers it to a company established specifically for its detention and defined SPV ( Special Purpose Vehicle ), which in turn provides for the division of ABS bonds in several tranches and giving higher priority to the senior CDO ones.
Collateralized Debt Obligations are an advantage for the issuer, since they are a tool that can contain many small parts of low or medium quality debt and make them a unique, high quality instrument. This factor is made possible by the massive diversification that is carried out within the CDO bond portfolio, which, as in many other situations, considerably reduces the risk deriving from possible insolvencies.
Precisely because of its lower riskiness, a CDO stock can be more easily placed in a financial market than the single underlying bonds, which, on their own, may not be very liquid. ABS investors prior to the creation of CDOs were likely to buy the risky senior, while the banks in their portfolios held the junior ABS, more risky but also more profitable for this.
This senior-junior subdivision left many free and non-held mezzanine ABSs and one of the reasons that led to the creation of CDOs was precisely to make this particular tranche of ABS more attractive on the market. The rating of CDOs containing ABS is usually very high, precisely because it allows the issue of senior tranches that previously would not have been possible to create.