Collateralized debt obligations (CDOs) are an unregulated asset-backed and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided into different tranches according to the value placed on the assets by the issuer: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. CDOs have risen to infamy on the back of the sub prime mortgage melt down led from the US since mid 2007. Some blame the financial woes of the 2007-2008 credit crunch on the complexity of CDO products, and the failure of risk and recovery models used by credit rating agencies to accurately value these products. Some institutions buying CDOs lacked the competency to monitor credit performance and/or estimate expected cash flows. On the other hand, some academics maintain that because the products are not priced by an open market, the risk associated with the securities is not priced into its cost and is not indicative of the extent of the risk to potential purchasers31.

As CDO products should be valued on a mark to market basis (where securities are marked in balance sheets at current market price), this coupled with the paralysis in the credit markets and the collapse of liquidity in these products led to substantial write-downs in 2007. Additionally a major loss of confidence has occurred in the validity of the process used by ratings agencies to assign credit ratings to CDO tranches and this loss of confidence has persisted through 2008. Research firm Celent estimated the size of the CDO global market at close to $2 trillion by the end of 2006. CDOs vary in structure and their underlying assets, but the basic principle is the same. Essentially a CDO is a security constructed to hold assets as collateral and to sell packages of cash flows from those assets to investors. It is a means to securitise debts. With growing demand for CDOs and other high yielding securities investment, banks saw an opportunity to package up sub prime mortgages together with higher grade mortgages and other debts into one vehicle. A CDO investor takes a position in an entity that has a defined risk and reward, not directly in the underlying assets (eg the mortgage). Therefore, the investment is dependent on the quality of the metrics and assumptions used for defining the risk and reward of the tranches. Many CDOs have been proven to be hopelessly overvalued in light of the poor quality of underlying mortgages included in many of them and in light of the US housing bubble, and subsequent price slide.

CDO issuers, usually the investment banks, earn commissions at time of issue and management fees over the life of the CDO. Investors have often been highly leveraged using loans to benefit from the positive spread between the high returns on tranches of CDOs and their cost of borrowing.

Many institutions became vastly over-leveraged in the seeking of high returns. A simple example demonstrates this. A bank with $1 million of capital would borrow $29 million to then buy $30 million of structured product like a CDO, for example written over mortgage debt. The interest payments on the CDO of $30 million are much higher than the cost of borrowing on the $29 million. Twenty percent ($6 million) of the mortgages go into default, with a poor recovery rate (say 2 thirds or $4 million). This leaves a capital loss of $2 million which wipes out completely the original $1 million of capital and leaves a net loss of $1 million (capital of minus $1 million, assets of $28 million which are falling, and liabilities of $29 million). When the above example becomes real, but is in billions of dollars then the scale of the problem can be felt. With the mix of borrowings (leveraging) and now severe housing market downturn, the losses have been catastrophic on these products. And even the higher quality tranches of debt have suffered significant losses. The now defunct Bear Stearns, which at the time was the fifth-largest U.S. securities firm, said on July 18, 2007 that investors in its two failed hedge funds will get little if any money back after “unprecedented declines” in the value of securities used to bet on subprime mortgages.