Origins
The Collateralized Debt Obligation (CDO) emerged in the late 1980s as an extension of the securitization revolution that had transformed the mortgage market. While the basic structure of pooling and tranching existed in mortgage-backed securities, CDOs expanded this technology to include corporate bonds, leveraged loans, and eventually other asset-backed securities themselves.
CDO managers used what critics called “financial alchemy” to transform lower-rated debt into supposedly safe AAA-rated securities. By pooling together diverse obligations and using the “waterfall” structure of tranching, they could mathematically demonstrate to rating agencies that the senior portions of the pool were protected from all but the most catastrophic scenarios.
Structure & Function
CDOs function by pooling diverse assets—corporate debt, car loans, or other mortgage-backed securities—and then slicing the pool into tranches. The senior tranches (the “super-seniors”) were regarded as so safe that they were once insured for “almost free money” by AIG and others.
The most lethal innovation was the Synthetic CDO, which did not contain actual mortgages but rather credit default swaps that referenced them. This allowed for the “cloning” of risky debt; even if no new mortgages were made, the supply of securities became infinite. Further layering occurred with CDO-squareds, which were securities backed by the unsold portions of other CDOs, creating a recycling effect that multiplied the same toxic risks.
Historical Significance
The CDO is historically significant as the instrument that turned a localized housing decline into a systemic global meltdown. Because they were stuffed with “risk-layered” subprime loans and then sold to institutional investors who relied on ratings rather than analysis, they functioned as a “neutron bomb” of financial products that hid their true danger from the public.
When the housing bubble burst, the “mechanical assembly line” of CDO production collapsed as it was revealed that 93% of AAA-rated subprime tranches issued in 2006 were eventually downgraded to junk. The CDO market demonstrated the dangers of a financial system that prioritizes ratings arbitrage and fee generation over the fundamental quality of the underlying collateral.
Key Developments
- 1983: Creation of the first CMO/proto-CDO structures.
- 1987: Drexel Burnham Lambert creates early CDO structures for leveraged loans.
- 1997: J.P. Morgan launches BISTRO, the first major synthetic credit derivative offering.
- c. 2003: Chris Ricciardi joins Merrill Lynch, turning the firm into the world’s leading CDO underwriter.
- 2004: CDO sales hit $69 billion as the market shifts toward subprime collateral.
- 2005: Hedge funds like Magnetar begin using the “correlation trade,” buying equity tranches while betting against the whole structure.
- 2006: CDO issuance peaks; most new product contains high concentrations of subprime mortgages.
- 2007 (July): S&P and Moody’s place hundreds of subprime tranches on review for downgrade; the CDO market freezes.
- 2007 (August): Bear Stearns CDO hedge funds collapse, signaling the crisis to come.
- 2008: The CDO market effectively ceases to function as losses mount.
- 2010: SEC charges Goldman Sachs with fraud over the ABACUS CDO; $550 million settlement.
- 2012: CDO issuance remains minimal compared to pre-crisis levels.