How these investments work
Collateralized debt obligations are a collection of secured debts, which is where the “collateral” part comes in. With secured debts, borrowers are required to put up an asset as collateral. If they default, that asset can be seized.
They are typically taken on by institutional investors like pension funds, insurance companies, banks, investment managers and other financial institutions.
Different types of CDOs may be known by different names, based on the type of loans packaged in the CDO. For example, a CDO of mortgage loans is known as a “mortgage-backed security” (MBS), while other collections of debt like credit cards, student loans and corporate debt are known as “asset-backed securities.”
The advantage of CDOs is that, when the economy is strong, these high-risk investments can turn out better returns compared to other fixed-income products in their portfolio. For institutional investors like pension funds, insurance companies and hedge funds, that translates into higher profits.
Since CDOs aren’t tangible assets, their value is determined through a computer model. As those have become more complex, so has evaluating risk.
To mitigate that for slightly more conservative investors, CDOs are divided up into risk levels, or tranches. CDOs are placed in these tranches by credit rating agencies, which assign it a credit rating.
If a loan were to default, senior tranches (with the highest credit ratings) would be prioritized in being repaid over the subordinate tranches. But they also receive a lower coupon rate compared to junior tranches with lower credit ratings.
Where you may know CDOs from
CDOs are a riskier investment than your standard stocks and bonds portfolio, as there’s always the chance that some borrowers may default on their loans — and when they do, the results can be dramatic.
The collapse of mortgage-backed securities in the U.S., caused by excessively optimistic assessments of MBS by credit rating agencies, led to the 2008 financial crisis. That caused CDOs to fall out of favour.
U.S. banks were selling homes to people who realistically couldn’t afford them, so when housing prices dipped starting in 2006, many of those people defaulted on their loans.
For the banks and institutional investors who held mortgage-backed securities, it was a huge issue. The situation didn’t begin to improve in the U.S. until the Federal Reserve stepped in and bought those CDOs.
To be sure, Canada has its own mortgage-backed securities, but they are very different from the ones that brought the U.S. housing market to its knees. Canada's MBS program is run by Canada Mortgage and Housing Corp., and it didn't collapse during the financial crisis.
Canada avoided the worst of it
While the initial crisis began in the U.S., its implications were felt worldwide.
Canada’s Bank Act prevented Canadian banks from taking on the same risky investments as lenders in the U.S. did, but that didn’t stop the impacts of the U.S. recession being felt north of the 49th parallel.
Partly because CDOs were less common in this country, no Canadian financial institutions ended up failing, and the country’s recession was comparatively mild stacked up against other downturns in decades before.
Although they offer the possibility of great rewards, the history of CDOs shows you should be cautious when risking big money in debt markets.