What is a CDO? | Collateralized Debt Obligation | Credit Derivatives
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- čas přidán 12. 06. 2024
- What is a CDO? | Collateralized Debt Obligation | Credit Derivatives
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What is a CDO?
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a PD derived from ratings on those bonds or assets. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA; AA; A; BBB; Residual.
Separate special purpose entities-rather than the parent investment bank-issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as "CDO-Squared", "CDOs of CDOs" or "synthetic CDOs".
In the early 2000s, the debt underpinning CDOs was generally diversified, but by 2006-2007-when the CDO market grew to hundreds of billions of dollars-this had changed. CDO collateral became dominated by high risk (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually subprime mortgages. These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages, and are credited with giving lenders greater incentive to make subprime loans, leading to the 2007-2009 subprime mortgage crisis.
Dear Patrick. You make me wish I were back in graduate school and you were my teacher. How you manage to make such complex subjects seem so clear and simple, when they are anything but, is a true gift. Thank you for sharing!
Thanks!
Looking at you back then vs now you lost weight and made your production tier 1. Great to see how people grow over time
Very clear explanation, first I saw where CDOs are not described as only a tool for evil and greed. It makes much more sense that these got so popular, when you see the potential usefulness.
You’re cool man. Thanks for the seminar ❤
asked and answered, thanks Patrick
What is CDO? Lehman don't hurt me, don't hurt me, no mo'...
Great video Patrick. Thanks very much!
I like that in your new videos you don't stare right over me into the wall 😅
So helpful. Thank you.
Hello Patrick, thanks for the great content. On min 9:20 you explain that the effect between correlation of the loan borrowers and the risk of the Sr and Jr tranches. Why if there is low correlation the Jr tranches are more risky than with a high correlation?
I couldn’t understand that concept.
The idea behind these products is that you benefit from being exposed to a diversified basket of loans (diversification really just comes from low correlation). If correlation is high, investing in one of these products is like being exposed to one borrower, and that borrower by nature of the product has bad credit. If that one borrower defaults, it hits all tranches at once. Hopefully that makes sense to you.
I have another video I posted a few weeks ago on correlation for traders that you might find helpful.
Patrick Boyle Thank you, now I have a better understanding of the concept. Also I watched the video on the correlation topic minutes ago, it was very helpful!
FYI for those of you thinking back to 2008; The worst of these assets, the "toxic waste" class were often held by the banks issuing the CDOs since no one wanted to buy them. So before you make wild allegations understand the guys making the CDOs suffered the heaviest losses.
Is CDO loan asset administrator is it a customer service roles?
I'm looking into a company that currently has 17% CDO liability increase. Does the fact that the CDO shows up on their balance sheet mean they created CDOs and sold them for cash and now the debt obligation is owed or am i misunderstanding what it means to have CDOs as a liability on the balance sheet?
let's say there's a CDO with 2 tranches, AAA and junk, priced assuming 0 correlation when in fact the correlation is 1 (i.e. AAA too expensive, junk too cheap). Knowing the CDO has been priced with the wrong assumption, how'd a smart hedge fund profit from that? In order to long the junk tranche and short the AAA tranche the fund'll buy and sell the appropriate CDSs for the underlying mortgages/bonds? I wonder if anyone did that during the financial crisis.
That's essentially what Michael Burry (and others) did. He figured out that most of the bonds in the CDOs were junk and bought CDSs for them (which paid big time when everything defaulted/collapsed).
Imagine the same thing happening with crypto right now? 🤥 Can you make a video on crypto? Your thoughts or opinion?
Dear sexy Patrick… how do CDOs manage risk?