Collateralized debt obligations were first introduced oi the U.S. financial landscape in 1987 by the former investment bank, Drexel Burnham Lambert. However, this type of derivative really came into the spotlight during the global financial crisis of 2008. In essence, collateralized debt obligations are a combination of numerous smaller loans which are put together and offered to an institutional investor. These smaller loans can include anything from mortgages to automobile leases and student loans. The idea behind a CDO is to combine a number of loans into this bigger asset, which is then resold to a bigger investment company. In this scenario, the people or institutions who initially gave out the loans receive a lump sum of money, while the new investor gets the loans and all the collateral behind them. Collateral is any form of asset (property, car, commodities) that is given to a lender in order for the borrower to take out a loan. In the case of collateralized debt obligations, the collateral is usually a car or a property. CDO’s are typically created by banks and then offered to institutional investors. When banks select a mixture of loans and assets for a CDO, they are looking to create a balanced ratio between risk and reward. There are a wide variety of assets that can be included in a CDO. Mortgage-backed securities, for example, consist of mortgage loans, while asset-backed securities consist of corporate and private debt, automobile leases and loans, and credit card debt. A CDO can include any of these types of loans and debt obligations. While between 2003 and 2007, CDOs were regarded as the next big hit in institutional investment, they quickly saw their demise with the sub-prime mortgage crisis that hit the U.S. in 2007. Unfortunately, many of the CDOs that were sold between 2006 and 2008 comprised mortgage-backed securities, which in turn carried higher risk. As more people were defaulting on their mortgages, many of these CDOs started rapidly losing their value. Since the housing bubble burst in the U.S., CDOs have somewhat lost their spot among the most preferred derivative investment options. Even so, banks still utilize them on a much smaller scale to generate liquidity faster. Collateralized debt obligations remain some of the more risky investment opportunities out there. However, their practical usefulness for banks is undeniable. Of course, investors who are more prone to making risk-heavy purchases are also drawn towards CDOs, as the potential gain with them sometimes far outweighs the risk. CDOs are also a great way to diversify your investment portfolio.
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