Collateralized debt obligation
Financial product / From Wikipedia, the free encyclopedia
Dear Wikiwand AI, let's keep it short by simply answering these key questions:
Can you list the top facts and stats about Collateralized debt obligation?
Summarize this article for a 10 year old
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS).[1] Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS).[2][3] 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.[4] Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.[5]
The CDO is "sliced" into sections known as "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority.[6] 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.[7] 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 (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual.[8]
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".[8]
In the early 2000s, the debt underpinning CDOs was generally diversified,[9] 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.[10] These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages,[11] and are credited with giving lenders greater incentive to make subprime loans,[12] leading to the 2007-2009 subprime mortgage crisis.[13]